Commodity Futures Roll Cost — Contango and Backwardation

Commodities like gold and crude oil are hard to store physically yourself. You can't keep 100 barrels of crude oil at home. So ETFs that invest in commodities usually buy 'futures' contracts to track the price movement.

Futures are 'a promise to buy or sell at this price on a specific future date.' But futures have expirations. As expiration approaches, to avoid taking physical delivery, the ETF sells the soon-to-expire contract (the near-month) and switches to the next month's contract (the far-month).

This 'switching' is called roll-over. The problem is that this roll-over is not free. Each time you switch, a cost may arise—or a gain may arise.

The cost and gain of roll-over depend on the 'shape' of the futures prices.

Contango: A state where a farther-out contract is more expensive than a nearer one. Due to costs like storage and interest, this is the 'normal' shape appearing in most commodities. In this case, rolling over means you sell the cheap near-month and buy the expensive far-month. That is, you 'sell cheap and buy expensive,' so a loss piles up each time you switch. This is called a negative (−) roll yield.

Backwardation: The opposite—a state where the farther-out contract is cheaper. It appears when the physical commodity is scarce or immediate demand is urgent. In this case, you sell the expensive near-month and buy the cheap far-month, so a gain (a positive roll yield) actually arises each time you switch.

A representative case is the U.S. crude oil ETF USO (United States Oil Fund).

When crude demand collapsed due to COVID in 2020, oil prices plunged, and on April 20, 2020, the near-month WTI went negative for the first time in history (a situation where, lacking storage space, people paid money to hand it over). At this time, the crude oil futures market fell into severe contango.

USO, which kept buying and rolling the near-month, paid large costs each time it rolled over. As a result, investors holding USO took on per-unit value losses that were hard to recover. The vanished return leaked out as the price difference (spread) between the monthly futures contracts each month.

In fact, one analysis says USO's near-month strategy fell behind crude oil itself by about half since 2014, and the main cause was exactly this roll cost.

Many people think 'if oil prices rise, a crude oil ETF will rise by the same amount.' But a futures-based ETF cannot replicate the spot price exactly. This is because a process called roll-over is inserted in the middle.

Especially for commodities where contango persists for a long time (crude oil, natural gas, etc.), the longer you hold, the more roll cost piles up like compounding, and the return can diverge greatly from the spot.

This is not to say 'commodity investing is bad.' It only means you should enter knowing the fact that 'what I'm buying is not the physical commodity but futures, and an unseen roll cost exists.' The habit of checking in the product's prospectus what the product holds and how is important.