Why Contango Is a 'Bull Killer' for Oil

Source: Seeking Alpha, Henrique Simoes  (9/13/10)

"Oil must rally enormously to overcome the contango effect."


Oil prices bottomed around US$33/barrel in February 2009 and stand now at around US$76.50/barrel.

Some quick math tells us we would've gained 130% holding oil from the bottom if we were lucky enough to get in at the exact bottom and wise enough to hold it until today.

Well, it's not that easy. If you bought oil at the bottom ~US$33/barrel and held until today, rolling over the contracts every month you would have profited only 47%. That is quite a difference from the expected 130% gain. What's the cause for this huge disparity?

It's the contango effect—a "bull killer" in the oil markets and commodities. Negative rolling prices imply that what would've been a home run (buying oil at multiyear lows) holding it through a big rally, wouldn't have been such a great move.

The popular oil ETF, USO, buys oil futures and rolls them over monthly. Its NAV is affected by the contango effect. USO bottomed at $22.86 and stands now at $33.77. It rallied "only" 47% vs. the 130% gain we should expect from buying at the bottom.

To profit in long oil positions, oil must rally enormously to overcome the contango effect. If one is neutral or bearish on oil, being short oil is an excellent choice. It's a carry trade that hasn't yet been perceived as such by the public, but many smart institutional players have been profiting from this quietly.

If oil price go up, or merely trades at this price for one year, you will profit ~12% (front month contracts have an implicit rolling yield of 1%) even if oil does not rally. That is very high dividend yield. And if you are bearish on oil and oil drops in price, you will profit from the drop—plus the contango effect.

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