How do you invest in commodities and what is roll yield? I keep seeing terms like contango and backwardation.

Commodities investing has unique mechanics because most investors use futures (not physical ownership) to gain exposure. Roll yield — the return from rolling futures contracts — is critical to understand.

Sources of Commodity Futures Return:

Total Return = Spot Return + Roll Yield + Collateral Yield

1. Spot return: Change in the commodity's spot price
2. Roll yield: Gain or loss from rolling expiring futures into the next contract
3. Collateral yield: Interest earned on the cash posted as margin (T-bill rate)

The Futures Curve and Roll Yield:

Contango (Futures > Spot):

The next-month futures price is ABOVE the spot price. When your front-month contract expires, you must buy the next contract at a higher price — you're selling low and buying high each month. This creates NEGATIVE roll yield.

Why contango exists: Storage costs, insurance, and financing costs push futures above spot. If it costs $2/barrel/month to store oil, the 3-month future should trade approximately $6 above spot.

Backwardation (Futures < Spot):

The next-month futures price is BELOW the spot price. When rolling, you sell the expiring contract (near spot) and buy the cheaper next contract. This creates POSITIVE roll yield.

Why backwardation exists: High convenience yield — producers and consumers value having physical inventory so much that they accept below-spot futures prices. This happens during supply shortages.

Worked Example:

Crude oil spot: $78/barrel

1-month future: $79.50 (contango)

2-month future: $81.00

You hold the 1-month future. At expiry, it converges to the new spot ($78 if unchanged). You then buy the new 1-month future at $79.50.

Roll yield = (Expiring price - New contract price) / Expiring price

Roll yield = ($78 - $79.50) / $78 = -1.92% per month

Annualized, this contango drag could cost 15-20%. This is why long-only commodity ETFs often significantly underperform spot price changes.

Now in Backwardation:

Natural gas spot: $3.50/MMBtu

1-month future: $3.35 (backwardation)

Roll yield = ($3.50 - $3.35) / $3.50 = +4.3% per month — positive roll yield rewards long futures holders.

Investment Implications:

• In persistent contango, futures investors earn LESS than spot price appreciation
• In persistent backwardation, futures investors earn MORE than spot price appreciation
• Smart commodity strategies tilt toward backwardated markets and away from contango

Practice commodity futures analysis in our CFA Level II question bank.