Just so we’re on the same page contango is not a traditional Spanish dance performed by unnaturally fit young men and beautiful women in long flowing gowns. I will neither confirm nor deny that I embarrassed myself by making that mistake upon first hearing the term early in my career.

Contango exists when the futures price of a commodity for a specific date is higher than the expected price of that commodity on that date. Sounds convoluted does it not? Don’t leave yet, we’ve got this.

First a quick primer on the environment in which contango may exist, the futures markets! Negotiating a price today for the delivery of goods in the future is actually a very commonplace practice. Farmers are the classic example of participants in futures markets. Farmers will often “lock in” the price of their produce at the end of season at a specific price which in turn allows them to borrow against that future revenue stream to fund their current capital needs, e.g. machinery, labor, fertilizer.

John Maynard Keynes theorized that there were two groups of people who participated in futures markets; hedgers and speculators. Hedgers strive to protect against the risk that prices are unfavorable in the future. Sellers, such as farmers, hedge against the price of their agricultural goods dropping. Buyers, such as airlines, protect against the price of oil rising.

Speculators on the other hand often do not own the items they promise to deliver or intend to take delivery of the items they agree to buy! Instead they attempt to trade futures contracts for profits with little regard for the underlying commodity. The harm speculators cause and the benefits they provide has been the subject of many debates over the decades. We will make no attempt to settle the debate today.

Of particular interest to those who buy and sell futures contracts are the “spot price” and the “futures price”. The spot price is today’s price available in the market for a specific item. Corn (yellow) trades today (2/25/2015) at $3.61 per bushel. The December 2015 futures price is $4.13 per bushel. Should the futures price of corn continue to rise progressively with time we would say a state of contango exists. That’s really all it is, and it’s fairly common.

Imagine you represent a company that makes corn-bread mix that is sold in grocery stores. Your job is two-fold; first to ensure that your company has a steady influx of corn and other raw materials so you can produce and deliver your goods to market. Your secondary objective is to control input costs as the less you pay for raw materials the more profitable your company becomes. A great way to accomplish both of your responsibilities is to engage in futures contracts which guarantee the delivery of raw materials at specific prices on specific dates.

It should stand to reason that all things being equal the futures price will be a little higher than the spot price because of the costs associated with holding that commodity for the period between today’s agreement and future delivery. This is referred to as the “cost of carry”. If our farmer’s grain bins are holding corn until December she is in effect renting that space and bearing the risk of it spoiling. As such she needs to be compensated by way of a higher futures price.

Where things start to get odd is when the futures price is significantly higher than the spot price plus additional ancillary costs like cost of carry. This appears to us to be the case currently in oil. So why is this all relevant?

A recent thesis for our firm is that oil looks particularly interesting at these prices in the context of a three year time horizon. Said another way we think oil will be significantly higher at points between now and three years from now. How to capture that opportunity?

The go-to oil play is ticker USO, The United States Oil ETF whose objective is to reflect the performance of West Texas Intermediate (WTI) light, sweet crude oil. USO is heavily exposed to futures contracts in a state of serious contango. Essentially ETFs like USO “roll” monthly oil contracts, meaning before April’s contracts expire they are sold and the proceeds used to purchase May’s contracts. May we suggest this is no bueno? Due to contango May’s contracts are more expensive than April’s. To be clear, USO sells April’s contracts for a smaller amount than what they must spend to immediately buy May’s contracts and this happens month after month. As such we believe USO is an unattractive long-term solution for investors who want to be long oil.

So where did we turn? Well that’s the fun part. We’ll save a discussion of fundamental analysis for a future article. Until next month, olé!!