Concepts in this lesson
- Contango
- Later futures months priced above nearer ones, usually because holding the thing until then costs money.
- Backwardation
- Later futures months priced below nearer ones, usually because the thing is scarce now.
- Cost of carry and fair value
- Holding costs over time, interest and storage less income; a future's fair value is today's price adjusted by that cost.
- Roll (futures)
- Closing a futures contract near expiry and opening the same position in a later one to keep the exposure.
01Oil below zero
On April 20, 2020, the US oil futures contract for May delivery settled at minus $37.63 a barrel. People holding the contract paid others to take it off their hands. The same day, the contract for June delivery, the same oil one month later, settled at $20.43.
The world hadn't stopped needing oil. It had run out of room for it. With much of the world in lockdown, US refineries were running 24% below the year before, and the tanks at Cushing, Oklahoma, where that contract is delivered, were about three-quarters full and still filling. A barrel in May was a problem; a barrel in June was still worth something.
That gap between two months of the same oil has a name: contango. Usually it is a few cents or dollars and nobody outside the oil market notices. This lesson is about what sets that gap, what flips it the other way, and who pays when it gets wide.
02Contango: later costs more
A futures contract fixes today the price of something delivered later, and oil trades for many delivery months at once, each at its own price. The nearest is called the front month; the price for oil delivered right now is the spot price. Line the months up and you have the futures curve. When later months cost more than nearer ones, the market is in contango; when they cost less, it is in backwardation.
Contango comes from a plain fact: holding a physical thing costs money. Oil needs a tank, wheat a silo, gold a vault and insurance, and the money tied up in them could be earning interest. A buyer who wants oil in six months can buy it now and pay to keep it, or buy a six-month future. The two should cost about the same.
Oil is $70 a barrel today. Storage costs $0.50 a barrel a month, and cash earns 4% a year.
Buy a barrel now and keep it six months: $70 + $3.00 of storage + $1.40 of lost interest = $74.40.
If the six-month future traded at $78, a trader could buy oil at $70, store it, sell the future at $78 and pocket the $3.60 difference with no risk. Traders doing exactly that pull the future back down. So in normal times contango is capped at about the full cost of carrying the oil: storage plus interest.
Contango is the normal state for things that are plentiful and costly to keep. It gets steep when there is too much of the thing and storage runs short, because a tank costs more when every tank is full. As April 2020 showed, the cap is only as solid as the supply of tanks.
03The roll: rent on a tank you never see
A future expires, and as it nears expiry its price converges on the spot price, because at expiry they are the same thing. Anyone who wants to hold oil futures for longer than a month or two, such as an oil fund, has to roll: sell the expiring contract and buy the next one.
Oil sits at $70 all year. The next month's future is 1% higher, at $70.70, close to the full cost of carry from the example above.
Each month you buy the next future at $70.70. By expiry it has converged to $70, and you roll again at $70.70: about 1% lost every month while oil goes nowhere.
Of that 1%, about a third is the interest the curve charges for tying money up, and the cash sitting behind your futures earns that back. The other two-thirds is rent on a tank you never see. After twelve months, $1,000 is about $924. The oil price: flat.
That drag is called negative roll yield. A futures holder pays the market's storage bill without ever owning a barrel, which is why a fund that holds oil futures can lose money in a year when the oil price doesn't fall. In backwardation it runs the other way: each new contract is bought below spot and drifts up toward it, and the holder can earn more than the oil price's move.
Holding futures in contango is sitting in a cash game with a time charge. Every half hour the dealer takes a fee from your stack whether you played a hand or not. The game can be dead flat all night and you still go home lighter. Backwardation is the rare room that pays you to sit, and it only pays while the waiting list is long.
04April 2020, explained
Put the pieces together. A futures contract that reaches expiry has to be settled: whoever still holds the May contract at the end takes delivery of 1,000 barrels a contract at Cushing. On April 20, the day before that contract's last day of trading, anyone still holding it with no tank to put oil in had to get out, and the few buyers with storage could name their price. In the US Energy Information Administration's words, holders were "in effect paying a counterparty to allow them to exit their positions."
Most traders had already left the May contract by then, the US futures regulator found afterward, and liquidity in it had dropped. Some of those still in were small investors far from any oil tank. Customers of a Bank of China product tied to the May contract lost their margin and were told they owed more. Interactive Brokers, an online broker, booked a loss of about $104 million after customers held long positions in contracts settled on its price as it went below zero.
That was contango pushed to its limit. The cap we met earlier, the cost of storing the thing, only holds while there is somewhere to store it; in April 2020 storage was close to running out, so that cost, and the gap, had no ceiling. The next day the May contract expired at $10.01, with June at $11.57.
The biggest US oil fund, the United States Oil Fund (USO), wasn't caught holding May. It normally moves from the nearest contract to the next about two weeks before expiry, so it had left May behind before April 20. Its damage came from the roll. As the curve steepened it spread its money into later months, the exchange capped how many June contracts it could hold, and its own futures broker barred it from June altogether. In the first half of 2020, USO's value per share fell 72.6%; the oil futures benchmark it aims to track fell 35.7%. On April 28 it did a 1-for-8 reverse split, after its value per share had fallen to $2.04.
05Backwardation: now costs more
Less than two years after oil went below zero, the curve flipped hard the other way. After Russia invaded Ukraine, buyers scrambled for oil they could get now. On March 8, 2022, the front US oil contract settled at $123.70 a barrel, while the contract for delivery three months later settled at $110.83: $12.87 less for the same oil, a little later.
Sometimes a thing is wanted now. A refinery that runs out of crude has to shut down; a power plant short of gas pays whatever it takes. When supply is tight, holding the physical barrel is worth more than its storage bill. Traders call that extra value the convenience yield. When it outweighs the cost of carry, the spot price rises above the later months, and the curve slopes down.
There is no cap on backwardation the way there is on contango. To profit from a steep contango you buy now and store. To profit from a steep backwardation you would need to sell oil you don't have today and buy it back cheaper later, and you can't borrow a barrel from next year. The only people who can sell into the high spot price are those already holding inventory, and in a shortage they tend to keep it.
06What it does to related securities
| Who | Steep contango | Steep backwardation |
|---|---|---|
| Funds that hold oil or gas futures | Lose on every roll, even when the oil price is flat | Earn on every roll, while the shortage lasts |
| Products that track VIX futures (bets on stock market swings) | The VIX curve is usually in contango, so these lose steadily | The curve flips in a market panic, and these can jump |
| Storage owners and oil tankers | Storage is in demand: buy now, store, sell forward, and the curve pays the rent | Storage empties as owners sell inventory into the high spot price |
| Oil producers' shares | Investors value producers on the whole curve, not the headline price. In steep backwardation the headline overstates what a driller can lock in for next year's oil; in contango it understates it. | |
| Producers and users that hedge (drillers, farmers, airlines, refiners) | Forward prices sit above spot: a producer is paid to sell later, a user pays to lock in later supply | Forward prices sit below spot: a producer locks in less than today's headline, a user locks in less |
| Bitcoin funds | A fund that holds bitcoin futures rolls like an oil fund, and bitcoin futures have spent long stretches in contango; the prospectus of one, ProShares' BITO, warns that this can make it trail bitcoin itself. A fund that holds the coins themselves, like IBIT, has no roll. | |
| Gold | An upward-sloping curve is, in the World Gold Council's word, "typical": gold's contango is set mostly by the cost of carry, so a backwardated gold curve is a rare alarm | |
| Natural gas | The curve follows the seasons: winter months usually cost more than summer ones, because heating demand peaks then. Not every slope means a glut or a shortage. | |
| Stock-index futures | In a small contango when interest rates are above the index's dividend yield, and a small discount when they are below, as the futures lesson shows; it isn't about scarcity | |
The VIX products are the starkest case. The prospectus for VXX, an exchange-traded note that tracks short-term VIX futures, tells buyers in plain words: "The long term expected value of your ETNs is zero." The roll is why.
07Try it: roll a year of futures
Set the slope of the curve, how much the oil price moves over the period, and the interest the cash earns. The gold line is $1,000 in futures, rolled every month; the dashed line is the headline oil price, scaled to $1,000. The gap between them is the roll.
Three things to try. Set the slope to 0.3% a month, about the interest alone: the futures holder keeps pace with the oil price, and everything above that is the rent. Set it to −1%, backwardation, with the price flat: the futures holder makes money while oil goes nowhere. Then set a steep contango, +5% a month, the kind of slope that appears when tanks are filling up, and watch how fast the roll eats a position the headline says should be flat.
08Common misreads
- "Contango means the market expects higher prices." Mostly it means holding the thing costs money. Backwardation says the thing is scarce today, and that the market expects the shortage to ease. Read the curve as "how tight is the market now?" before "where is the price going?"
- "An oil fund tracks the oil price." A fund that holds futures tracks the futures, roll included. Over a year the two can be far apart.
- "Backwardation is a free gain." The roll pays the holder only while the shortage lasts, and shortages end, sometimes in a crash.
- "A negative oil price means oil was worthless." US oil for May delivery at Cushing, Oklahoma, and some US grades priced off it, went below zero for a day. The June contract, and Brent, the international benchmark, stayed above zero.