Average level of contango/backwardation vs. subsequent one-month return, October 1997–August 2022
Sources: Parametric, Bloomberg, 9/20/2022. For illustrative purposes only. Past performance is not indicative of future results. It is not possible to invest directly in an index.
If conventional wisdom was correct and commodities only produced a positive return in backwardation or a negative return in contango, we’d expect to see a linear pattern starting at the lower left and moving to the upper right. Historical return patterns simply don’t support this notion. In fact, given the market’s average state ahead of time, outcomes seem rather random. BCOM rallied following a contango reading 51% of the time, but 49% of the time it didn’t.
Understanding why is mostly straightforward. In general, the price of a commodity tends to rise when demand exceeds current supply. If demand remains robust and supply insufficient, prices will rise high enough to cause the forward curve to move into backwardation. To investors, this is a strong signal of a deficit in the physical market, which could mean prices continue to rise alongside demand or that prices fall as new supply becomes available. Timing these calls consistently is challenging, and relying on any signaling from contango or backwardation historically hasn’t given investors a leg up. Moreover, it could’ve meant they missed out on the holy grail in commodity investing: a supercycle, abnormally strong demand growth followed by a lengthy rally in prices. Commodity supercycles include periods of both contango and backwardation.
Riding the supercycle
Commodity markets tend to go through extended periods of boom and bust, with prices often moving significantly above or below their long-term trends. These periods can even outlive the business cycle and at times will persist for a decade or longer. The most recent supercycle lasted from roughly the late 1990s through the Global Financial Crisis. Rapid economic growth in China, India, and other emerging-market economies drove strong demand for raw materials and a subsequent broad-based rally in commodity prices.
Between 1999 and 2007, returns for BCOM averaged 15% per year, but the index was in contango three-quarters of that time, as shown in the following chart. Nearly all of the last four years in this chart show commodities trading in contango, but index returns still averaged 12% per year. A portfolio that actively traded on these signals, buying when the market moved into backwardation and selling in contango, would’ve underperformed a static allocation by more than 8% per year.
BCOM price and level of contango (-) or backwardation (+), January 1999–December 2007
Sources: Bloomberg, Parametric, 9/20/2022. For illustrative purposes only. Past performance is not indicative of future results. It is not possible to invest directly in an index.
It’s striking how similar that period looks to today. Following a strong run-up in prices and a market that moved into heavy backwardation (1999 to 2000), prices pulled back in 2001, coinciding with a recession in the US during the spring. Demand for raw materials contracted, leading to excess supply and a market that moved into contango. Prices then rebounded and continued to move higher for the next six years. It’s possible that today, like the beginning of that period, we’re in the early stages of the next supercycle in commodities. If so, a potential near-term recession will have little success in derailing the long-term trend.
The bottom line
Though backwardation and contango have captured the imagination of many participants in the asset class, diversified commodity investors would do well to worry less about reacting to either condition. While an upward-sloping forward curve can be a drag on returns, future performance is inherently challenging to predict and not telegraphed by the level of contango or backwardation in the commodities market. Even periods of long-term growth for the asset class have come when contango was the normal condition of the market. Given the long-term benefits the asset class can provide, such as inflation protection and portfolio diversification, we believe adhering to a modest strategic allocation is the right approach.