Todd Shriber: Commodities novices and seasoned vets alike need to be aware of the “C” word and by “C” word I don’t mean corn, cotton or Cushing, Oklahoma. I mean contango. The simple definition of contango is when the price of a near-dated, or front-month, futures contract is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date, according to Investopedia.
Using a hypothetical example, let’s assume West Texas Intermediate crude oil for August delivery is trading at $100 a barrel, but the December futures contract is trading at $95. That is contango and that means traders would expect a decline to the spot price before August futures expire.
Sounds pretty benign, right? Trust me, it’s not. Contango can really chip away at your returns, particularly if you’re using ETFs like the U.S. Oil Fund (NYSE:USO) or the U.S. Natural Gas Fund (NYSE:UNG). I’m not going to get in the debate regarding whether or not owning shares of an ETF like the SPDR Gold Shares (NYSE:GLD) represents actual ownership of gold because that’s a story for another day, but it is worth noting that ETFs like GLD are one way of fighting contango because they offer exposure to spot prices.
As investors in GLD know, the ETF does a fine job of tracking spot gold prices. Unfortunately, the same cannot be said of USO and WTI crude, as the chart below illustrates.
Contango is a big culprit behind the wide chasm between the performances of WTI and USO. USO is composed primarily of front-month futures contracts. That means when those contracts expire, USO’s issuer has to go out and purchase the next month’s contracts, running up investor expenses. Making that scenario even worse is that there is no time limit on contango. In theory, contango could exist in any commodity for all 12 months of the year or even longer.
Obviously, that scenario stinks, but don’t fret. There are alternatives for investors when it comes to crushing contango and they don’t all mean leaving the commodities futures arena in favor of physically-backed funds such as GLD.
Investors looking for oil futures exposure should pass on USO in favor of the Teucrium WTI Crude Oil Fund (NYSE: CRUD). CRUD allocates 35% of its weight to the June or December WTI futures contract, whichever is nearest to the spot price. Then it devotes 30% to the June or December contract following the aforementioned and 35% to the December contract that immediately follows the aforementioned, according to the Teucrium Web site.
For investors looking for exposure to agricultural commodities while mitigating the risks associated with contango, the Teucrium Corn Fund (NYSE:CORN) uses a similar approach. Another oil futures ETF that is superior to USO actually comes from USO’s sponsor. I refer to the U.S. 12 Month Oil Fund (NYSE:USL), which does offer exposure to the front-month contract, but also works in contracts from the next 11 months, cutting back on rolling expenses and the specter of contango.
Best of all, CRUD and USL have outperformed USO over the past three months by decent margins. It’s fine to let the pundits talk about contango and they should, but make it an effort to avoid it whenever possible. Your portfolio will thank you.
Todd Shriber is an ETF fanatic, a former hedge fund trader, and a journalist. Todd started his professional career with Bloomberg News, where he covered banks, energy and technology. After leaving Bloomberg, Todd became a trader at a California-based hedge fund where he specialized in trading financials, energy, basic materials, and ETFs.
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