Definitions: Contango and Backwardation
Contango occurs when futures prices are higher than the current spot price, creating an upward-sloping futures curve. If crude oil trades at $70 per barrel on the spot market but the 6-month futures contract is priced at $74, the market is in contango. Backwardation is the opposite: futures prices are below the spot price, creating a downward-sloping curve. If spot oil is $70 but the 6-month future is $66, the market is in backwardation. These terms describe the term structure of futures prices and have profound implications for anyone investing in commodities through ETFs or futures contracts.
Why Contango Is the Normal State
Contango is considered the 'normal' state for most commodities because it reflects the cost of carry: storage costs, insurance, and financing charges required to hold a physical commodity over time. Storing crude oil in tanks costs roughly $0.50-1.00 per barrel per month, so a futures contract expiring in 6 months should logically be priced higher than spot to compensate the seller for these carrying costs. Gold is almost always in contango because storage costs are low but financing costs (the opportunity cost of tying up capital in gold bars) are significant. Backwardation typically occurs during supply shortages when immediate delivery commands a premium over future delivery.
Roll Costs and the Impact on Commodity ETFs
Commodity ETFs that track futures contracts must periodically 'roll' their positions: selling expiring near-month contracts and buying longer-dated contracts. In contango, this means selling low (the cheaper near-month contract approaching spot) and buying high (the more expensive next-month contract), generating a roll cost that erodes returns. The United States Oil Fund (USO) is the most notorious example. Between 2009 and 2019, crude oil spot prices roughly doubled, yet USO lost approximately 75% of its value, primarily due to persistent contango and the resulting roll costs. In April 2020, when oil futures briefly went negative, USO's losses were catastrophic. Futures trading books explain roll mechanics and commodity market structure
Backwardation as an Opportunity
In backwardation, the roll works in the investor's favor: you sell the more expensive near-month contract and buy the cheaper next-month contract, generating a positive roll yield. This is why some commodity trading advisors specifically seek out markets in backwardation. Historically, commodities in backwardation have delivered positive excess returns over time, a phenomenon documented by Gorton and Rouwenhorst (2006). Energy markets tend to flip between contango and backwardation depending on supply-demand dynamics, while agricultural commodities often enter backwardation during harvest shortfalls.
Gold vs Oil ETFs: A Practical Comparison
Gold ETFs like GLD and IAU hold physical gold in vaults, completely avoiding futures roll costs. Their tracking error relative to spot gold is minimal (0.1-0.3% annually, mostly from the expense ratio). Oil ETFs like USO must use futures because storing millions of barrels of oil is impractical for a fund. This structural difference means gold ETFs reliably track their commodity while oil ETFs can diverge dramatically from spot prices. For individual investors, the lesson is clear: if you want commodity exposure, prefer ETFs backed by physical holdings (gold, silver) or those using optimized roll strategies that spread positions across multiple contract months. Avoid single-month front-contract ETFs in markets prone to steep contango.