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It’s The Slow Knife That Cuts The Deepest: How Insidious Contango Can Smother The Natural Gas Trader & How To Avoid It
Sunday, March 10, 2024
Investing in natural gas is hard enough as it is between dramatic swings in the temperature outlook during the winter, to hurricanes in the Summer, to a chronic oversupply that has persisted since the late 2000s. However, there is another insidious force that works against investors that can punish traders who try to stick it out. I am speaking of contango.
Investors with sufficient funds, licensing, and experience can access the natural gas futures market and trade individual contracts, from actively traded front-month contracts to low-volatility instruments that won’t expire for 5-10 years. However, the average retail trader is largely restricted to Exchange Traded Funds (ETFs). These funds seek to replicate the performance of an underlying commodity or index by buying shares or futures contracts and then selling fractional shares to consumers.
As a result of this contango, natural gas ETFs are effectively selling low and buying high each time they roll over their future contract holdings.
Interestingly, beginning in 2020, the 2x ETF BOIL began rolling from the front-month directly to the T+2 month contract, but doing so every other month. The idea was to reduce rollover-induced decay as the contango between the 2-month roll is almost always less than rolling from front-month to T+1 every month. Unfortunately, this move has not made the fund a better long-term investing option as it is also burdened by leverage-induced decay, which can be an even greater drag. Moreover, while the absolute contango-induced loss is reduced by this strategy, because BOIL is a 2x fund, it does experience twice whatever contango it is exposed to. Returning to the previous example, BOIL is down a whopping -98.5% since March 2020 while, as previously discussed, the front-month contract is flat. Ouch.
1) Avoid holding for prolonged periods of time. This is the most commonsense strategy. Natural gas ETFs are great for day-trading and swing-trading to capitalize in the short-term violent swings the commodity is known for. Rarely, such as in strongly uptrending markets, such as we saw for much of 2022, the impacts of contango can be overcome for months on end but I typically refrain from holding for longer than 1-2 months at a time.
2) Pick your moment. As discussed earlier in this article, the magnitude of contango varies significantly throughout the year and tends to be highest during the Fall Shoulder Season. Historically, the best time to hang onto these ETFs for a longer period is actually the April-August time frame that is just kicking off. It is this block of time when contango is relatively low and seasonal gains—as I discussed in last week’s Commentary—are at their maximum, as shown in the Figures to the right. In fact, April, May, and July are the only months out of the year when the average seasonality gains (+5.0%, +3.2%, +0.9%, respectively) top the average contango losses (+2.3%, +2.3%, and +0.6%). Of course, these are merely historical trends and every year will behave differently.
3) Trade the right ETF. Conder selling short the 2x inverse ETF KOLD in order to gain long exposure. In this strategy, the leverage-induced decay associated with KOLD’s 2x functionality works in favor of the shorter and can counter the impact of contango-induced losses leading to better tracking in the long-term. However, shorting any leveraged ETF, much less a leveraged ETF for a volatile commodity such as natural gas, carries the risk of losses that could—and have--easily exceeded 100%. Another disadvantage is that brokers offering shares to sell short will charge borrowing fees that can range from 5% per year to over 20% per year depending on the firm.
This is just one more reason why trading in the natural gas sector is not for the weak of heart. Good luck out there.