Roll process
Futures trade at multiple maturities with different prices. As time goes by, long-term investors must perform a regular roll process in which contracts nearing expiration are sold and longer-dated contracts are purchased (assuming a long position; the reverse is true for short positions). For example, if an investor is long the current Henry Hub natural gas futures contract, he simultaneously can sell that month and buy the next-furthest-out contract to maintain the position.
Because the next contract probably does not cost the same as the current one, the roll process can be expensive if the market is in contango. Sometimes, the profit or loss resulting from the roll process can be the most decisive factor in commodity returns, even more so than the spot price. If the market is in contango, it will cost the investor to roll from one contract to the next. Conversely, if the market is in backwardation, where the forward price of a futures contract is below the expected futures spot price, the roll process may be favorable. “Time values” (below) shows prices for natural gas contracts; at this point, the market is in contango through February 2014, with each successive contract more expensive than the previous.
Managing expectations
Contango can create strong headwinds and surprise investors who hold long positions in commodity ETFs. If a futures contract in which an ETF invests is experiencing contango, a fund may be forced to sell low and buy high each time it rolls over to the next contract. This may not be significant if it were to occur only once or twice; however, the serial process of rolling from cheap contracts to more expensive ones may cause an ETF’s returns to diverge significantly from those of the commodity itself.
The UNG is an oft-cited example of the trouble contango can cause. UNG invests primarily in near-month natural gas futures contracts. When natural gas futures are trading in persistent contango, as they are frequently, the fund has to sell the expiring contract for a lower price than it must pay for the next contract, resulting in a loss each time the contract is rolled over. Meanwhile, if spot prices are rising, ETF investors may assume incorrectly that the value of the ETF will increase as well. As a result, ETF investors can be blindsided by losses and not even understand how or why they happened.
“Slip slide” (below) compares the natural gas futures contract with the UNG fund. Investors who saw rising prices in the natural gas contract most certainly were hoping for positive returns through the ETF; because of the impact of contango, many were sorely disappointed.
