Following up on the helpful comments to my recent USO post, I found this section in the GSG prospectus which clearly explains the risk of contango markets or the “absence of backwardation”:

“During a period when commodity prices are fairly stationary, an absence of ‘backwardation’ in the prices of the commodities included in the S&P GSCI-ER may itself cause the price of your Shares to decrease.

As the futures contracts that underlie the S&P GSCI-ER near expiration, they are replaced by contracts that have a later expiration. Thus, for example, a contract purchased in March may specify a June expiration. As that contract nears expiration, it may be replaced by selling the June contract and purchasing the contract expiring in September. This process is referred to as ‘rolling.’

Historically, the prices of some futures contracts (generally those relating to commodities that are typically consumed immediately rather than stored) have frequently been higher for contracts with shorter-term expirations than for contracts with longer-term expiration, which is referred to as “backwardation.”

In these circumstances, absent other factors, the sale of the June contract would take place at a price that is higher than the price at which the September contract is purchased, thereby allowing the contract holder to purchase a greater quantity of the September contract.

While many of the contracts included in the S&P GSCI-ER have historically exhibited consistent periods of backwardation, backwardation will likely not exist at all times. Moreover, some of the commodities reflected in the S&P GSCI-ER historically exhibit ‘contango’ markets rather than backwardation.

Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months due to the costs of long-term storage of a physical commodity prior to delivery or other factors. The forward price of a commodity may also fluctuate between backwardation and contango.

The absence of backwardation, or the existence of contango, in the commodity markets could result in losses, which could adversely affect the value of the S&P GSCI-ER and, accordingly, decrease the value of your Shares.”

A decent “Plain English” explanation of backwardation and contango… I love when the mysterious “other factors” appear to explain price movement.

Here’s Merrill Lynch’s version, from their PROCEEDS prospectus:

“The Commodity Index is a rolling index

The Commodity Index is composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts have a set expiration date and normally specify a certain date for delivery of the underlying physical commodity.

In the case of the Index, as the exchange-traded futures contracts that comprise the Index approach the month before expiration, they are replaced by contracts that have a later expiration. This process is referred to as ‘rolling.’

If the market for these contracts is (putting aside other considerations) in ‘Backwardation,’ where the prices are lower in the distant delivery months than in the nearer delivery months, the sale of the nearer delivery month contract would take place at a price that is higher than the price of the distant delivery month contract, thereby creating a positive ‘roll yield.’

While many of the contracts included in the Commodity Index have historically exhibited consistent periods of backwardation that has resulted in an element of roll yield enhancing the Commodity Index’s past performance, there is no indication that these markets will consistently be in backwardation or that there will be roll yield in future performance.

Instead, these markets may trade in contango. Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months. Certain of the commodities included in the Commodity Index have historically traded in contango markets.

Contango (or the absence of backwardation) in the commodity markets could result in negative ‘roll yields’ which could adversely affect the value of the Commodity Index and the value of the PROCEEDS.”

Putting aside other considerations, I think I like Merrill’s version better.