Contango

• The Bottom Line: Contango is a market condition where the future price of a commodity is higher than its current spot price, often creating a hidden “cost” that erodes returns for investors in many popular commodity ETFs.
• Key Takeaways:
• What it is: A situation in the futures market where contracts for later delivery are progressively more expensive than contracts for earlier delivery, creating an upward-sloping price curve.
• Why it matters: It can turn a seemingly straightforward investment in a commodity fund (like an oil ETF) into a losing proposition, even if the commodity's price stays flat or rises slightly. It's a critical concept for understanding risk in commodity-related investments.
• How to use it: A value investor uses the concept of contango not to trade futures, but to understand the supply/demand dynamics of an industry and to avoid speculative investment products that are likely to underperform over the long term.

Imagine you're a baker in a small town, and you need a constant supply of wheat for your famous bread. You could buy wheat every single day at the local market, but the price fluctuates wildly. To bring stability to your business, you go to Farmer Giles, the town's main wheat producer. You say, “Giles, I want to buy 100 bushels of wheat from you, but I don't need it today. I need it delivered three months from now. I'm willing to lock in a price today.” Giles thinks for a moment. The current market price (the “spot price”) for wheat is $5 per bushel. But if he agrees to sell you wheat for future delivery, he has to store it for you for three months. That storage isn't free. He has to pay for:

• Warehousing: Space in his secure, dry silo.
• Insurance: To protect against fire or theft.
• Financing: The money tied up in that wheat could have been earning interest in the bank.

This collection of expenses is known as the cost_of_carry. So, Giles says, “Betty, the baker, I can't sell it to you for $5. I have to charge you for the cost of holding onto it for three months. I'll sell it to you for delivery in three months at a price of $5.15 per bushel.” You agree. That locked-in price of $5.15 is a futures price. You have just witnessed contango. The futures price ($5.15) is higher than the current spot price ($5.00). The market is in contango because market participants are willing to pay a premium for future delivery to cover the costs and risks of storing the physical commodity. This is the normal state of affairs for most storable commodities like oil, gold, and agricultural products.

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” - Benjamin Graham

Understanding contango is crucial because it helps us distinguish between a sound investment operation and a purely speculative one, especially when it comes to commodities.

A value investor's primary focus is on buying wonderful businesses at fair prices. We typically don't “invest” in commodities directly, because a barrel of oil or a bushel of wheat doesn't produce cash flow, innovate, or build a brand. However, understanding contango is vital for three key reasons that directly impact our investment philosophy. 1. It Exposes the Hidden Trap in Many Commodity ETFs This is the single most important lesson for most investors. Many people, wanting to bet on a rise in oil prices, buy a popular oil ETF like the United States Oil Fund (USO). They assume that if the spot price of oil goes from $70 to $80, their investment will go up by a similar amount. This is a dangerous misconception. These ETFs don't buy and hold physical oil. They buy short-term futures contracts. When a market is in contango, these contracts are set to expire at a price lower than the price of the next month's contract. To stay invested, the fund must constantly:

• Sell the expiring, cheaper contract.
• Buy the next month's more expensive contract.

This process is called “rolling” the futures. In a contango market, you are systematically selling low and buying high, month after month. This creates a constant downward pressure on the fund's value, a phenomenon known as “contango drag” or “roll yield decay.” It's like trying to run up a downward-moving escalator. Even if the price of oil stays flat, your investment can slowly bleed to death. This is pure speculation, not investment, and it violates the principle of margin_of_safety. 2. It's a Window into a Company's Profitability As a value investor, you analyze businesses. Contango in a key commodity tells you something important about the industry's health and can affect a company's intrinsic_value. Imagine you are analyzing an airline. Fuel is one of its biggest costs. If the oil market is in steep, persistent contango, it signals a massive oversupply of oil. This might suggest that fuel prices are likely to remain low or stable in the near term, which is good news for the airline's profit margins. Conversely, if you're analyzing an oil exploration company, deep contango is a warning sign of a supply glut that could depress their selling prices for a long time. It helps you ask better questions during your business_analysis. 3. It's a Barometer of Supply and Demand Value investing requires a deep understanding of the economic environment in which a company operates. Contango is a powerful, real-time indicator of market sentiment about supply and demand.

• Steep Contango (prices far higher in the future): Signals a current market glut. There is so much of the commodity available right now that storage facilities are full, and producers are desperate to lock in future sales at almost any price above the spot price plus storage costs.
• Flat Contango (prices only slightly higher in the future): Signals a balanced market. Supply and demand are roughly in equilibrium.

This isn't about predicting prices. It's about understanding the current reality. A persistent supply glut can decimate an entire industry's profitability, and contango is one of the clearest signals of that glut.

You won't be “calculating” contango like a P/E ratio. Instead, you'll be observing and interpreting it as part of your broader analysis.

When a potential investment has significant exposure to a commodity, follow these steps:

1. 1. Identify the Commodity Exposure: Is the company a major producer or a major consumer of a specific commodity (e.g., oil, natural gas, copper, corn)? For an airline, it's jet fuel. For a food company like General Mills, it's wheat and corn. For a copper miner, it's copper.
2. 2. Check the Futures Curve: You don't need a fancy terminal. A simple search for “[Commodity Name] futures curve” (e.g., “WTI oil futures curve”) will usually bring up charts from sources like the CME Group or financial news sites. Is the curve sloping upwards? If so, the market is in contango.
3. 3. Analyze the Impact on the Business: Think like a business owner. If the market is in deep contango (oversupply), how does this affect my company's costs or revenues? Is this a temporary headwind or a long-term structural problem for the industry?
4. 4. Scrutinize Your Portfolio for “Closet Speculation”: Review your holdings. Do you own any commodity-tracking ETFs or ETNs? If so, investigate whether they are susceptible to contango drag. For most popular commodity funds, the answer is yes. Ask yourself: Am I investing, or am I unknowingly making a speculative bet against the headwind of contango?

The shape of the curve tells a story. Here’s a simple comparison to its opposite state, backwardation.

Let's consider two investors in 2015, a period when oil markets were in a very steep contango due to a massive global supply glut.

• Investor A: “Speculator Sam”

Sam sees that the spot price of oil has crashed from over $100 to below $50 a barrel. He thinks, “This is the bottom! It has to go back up.” He buys $10,000 worth of a popular oil ETF, “OIL-Tracker (Ticker: OLTKR)”. He's not buying oil; he's buying a fund that holds near-month futures contracts.

• Investor B: “Value Valerie”

Valerie also notices the low oil price. But instead of speculating on the price, she looks for a great business within the battered energy sector. She knows contango signals a glut, so she avoids highly indebted companies. She finds Durable Energy Corp., a company with a rock-solid balance sheet, low production costs, and smart management that has hedged some of its production. She analyzes its cash flows and determines its intrinsic_value is significantly higher than its current stock price, giving her a large margin_of_safety. She invests $10,000 in Durable Energy's stock. The Outcome a Year Later: The spot price of oil recovers slightly, from $45 to $50. Sam expects to have a small profit. Instead, he checks his OLTKR statement and is horrified to see his $10,000 is now worth only $8,500. Every month, the fund had to sell a cheaper expiring contract and buy a more expensive new one, with the difference bleeding his capital away. The contango drag was more powerful than the slight rise in the spot price. Valerie, on the other hand, sees that Durable Energy's stock has risen from $30 to $45. The company survived the downturn because of its low costs and strong balance sheet. It used the downturn to acquire weaker rivals at bargain prices. Because she invested in a well-run, cash-producing business rather than a speculative instrument, she was rewarded.

• Avoids Value Traps: It helps you steer clear of commodity ETFs that are structurally designed to underperform over the long term in many market conditions. This is a powerful form of risk management.
• Deeper Business Analysis: It provides a real-world, forward-looking indicator of the supply and demand pressures facing a company, allowing for a more nuanced valuation.
• Improved Macro Perspective: It helps you understand the health of entire sectors of the economy, providing context for your individual stock selections.

• The Temptation to Time the Market: Some people try to use the shape of the futures curve to predict price movements. This is a speculator's game, not a value investor's. The curve reflects what is known today; it is not a crystal ball.
• Not a Standalone Indicator: Contango is just one piece of the analytical puzzle. A company in an industry plagued by contango might still be a wonderful investment if it has a deep competitive moat, a great balance sheet, and superb management.
• Oversimplification: The “cost of carry” is the primary driver of contango, but other factors like market expectations and risk premiums also play a role. A value investor doesn't need to be an expert, but should recognize the concept's complexity.

• backwardation
• futures_contract
• cost_of_carry
• commodity
• speculation
• margin_of_safety
• circle_of_competence