Introduction

The futures market enables investors to access commodities that would be otherwise effectively uninvestable, however, there are important factors to consider when allocating to the asset class.

Physical vs futures

For commodities that are easy to store such as gold, issuers can offer investors exposure to the physical asset. In this scenario, exchange-traded commodities (ETCs) track the spot price of the underlying.

However, commodities such as oil or wheat are almost impossible to store in large quantities for any investor which is why the futures market is used by ETF issuers instead. 

While the futures market is the most accessible route for investors when exposed to these commodities, there are challenges that investors need to be aware of. The most important of these is roll costs, which is where contango and backwardation play a big role. 

Unlike physical ETCs – which offer exposure to the spot price of an underlying commodity – strategies that invest in futures contacts are required to roll from one contract to the other before the contract expires. 

Roll costs

When a market is in contango, it means each contract along the futures curve is more expensive than the spot price. If a market is in contango and it is time to roll on to the next contract, this will come at a cost to the investor. This occurs when the market forecasts the price of the commodity to rise in the future which leads to a premium being placed further along the futures curve.

Backwardation, on the other hand, is the opposite. If the future contacts of a commodity are lower than the spot price, this shows the market is expecting the price to fall. In this case, investors benefit when a strategy rolls from one contact to the next. It is less common and tends to occur when commodities are seasonal.

Final word

Overall, contango and backwardation are simply terms that define the shape of the futures curve for commodities.

The shape of the curve can have a significant impact on returns which is why some ETFs look to mitigate the challenges by adopting a rolling strategy.

This could include being selective about which futures contacts to buy or continually rolling from one contract to the next to avoid the effects of a market in contango.