The investment world is going through tumultuous times right now, and nowhere are conditions more difficult than in the energy industry. Falling demand for oil due to the coronavirus pandemic began at the same time that major oil-producing companies like Saudi Arabia and Russia were starting to ramp up production, and the unprecedented results have included negative prices on near-term oil futures contracts.

Many investors go to where the action is, and that means a lot of people without knowledge of the energy markets are rushing in to try to profit. Before you start jumping into niche investments in energy that you don't fully understand, it's vital to familiarize yourself with how those markets work. That way, you can avoid rookie mistakes that could cost you more than you're prepared to lose.

Right now, the biggest problem energy investors face is something called contango. Below, we'll look at what contango is and why you can't afford to ignore it if you're investing in the oil patch right now.

Four oil wells silhouetted against an orange sky.

Image source: Getty Images.

It takes two (futures contracts) to contango

Investing in futures markets is different from buying stocks. With futures, you're not just buying a commodity. You're also agreeing to take it at a specific time.

Timing is often a vital consideration for futures trading. For instance, gasoline futures for delivery in the summer months are typically more expensive than gasoline futures for winter months, because demand for gasoline rises with the increased driving activity in the summer. With heating oil futures, that dynamic is reversed -- prices are highest in winter and lowest in summer due to demand from those with oil-fired furnaces. With crops, prices are often low during harvest months and higher in months when harvested crops are in shorter supply.

Futures traders use two terms to refer to the relationship among futures contracts for different months. When futures contracts expiring sooner are priced lower than those expiring later, the market is said to be in contango. When nearer-term futures have higher prices than longer-term futures, the market is in backwardation.

Turmoil in the oil pits

All of this might seem purely academic, but as energy investors have found out in recent days, it can have very real impacts on investment performance. Some of the recent activity in oil futures has been between oil producers seeking to lock in future prices for their production and oil refiners looking to obtain supplies of crude to make refined energy products like gasoline.

However, many of those using oil futures right now are speculators. They have no interest in actually taking delivery of crude oil or other energy products. They just want to profit from changes in energy prices, intending to close their futures positions before they expire.

On Monday, April 20, futures traders got a firsthand look at what can cause extreme contango. May crude oil futures contracts were approaching expiration, and many speculators had bet on a potential rebound in oil prices once coronavirus lockdowns end. Yet those speculators ran out of time for a price uptick. Meanwhile, there's no longer ample storage capacity for oil, making it practically impossible for most players in the energy industry to take delivery on futures contracts.

Those dynamics pushed May futures prices into negative territory on Monday. Speculators were willing to pay more than $35 per barrel at some points just to be able to close their positions and avoid having to deal with thousands of barrels of crude getting delivered to them.

June futures contracts, however, didn't see the same volatility. They fell about $2.50 per barrel, but they closed Monday above $21 per barrel. Contracts for September delivery fetched almost $30 per barrel.

What contango means for investors

Where contango affects investors the most is with ETFs that track futures contracts. In the crude oil arena, United States Oil Fund (USO 1.08%) has gotten the most attention lately, because many saw it as a way to profit from rising oil prices. However, when the oil market is in extreme contango, it gets a lot harder to use the fund to profit.

The problem is this: United States Oil Fund invests in near-term futures contracts that expire over the next couple of months. However, when those contracts approach expiration, the fund has to roll its positions into the next month's futures.

That's not a huge issue when oil futures don't have a lot of contango. It can even be a benefit when markets are in backwardation, because in that case the fund gets lower prices for the later-month futures contract than it had on the earlier-month futures positions that it's closing.

When extreme contango prevails, though, there's a huge price to pay. Based on Monday's closing prices, rolling forward June contracts to July would cost the fund more than $5 per barrel, with June futures at $21 and July futures at $26. Even if spot prices rise to $26 by July, United States Oil Fund won't see any benefit from that move. If spot prices remain low, the fund will suffer further losses even without corresponding changes in spot prices.

Be smart about oil stocks

To invest in the energy market right now, you have to know as much as you can about the investments you're making. The futures-linked United States Oil Fund has exposure to contango that could be devastating. Oil refiners that paid higher prices to lock in future supplies of crude are also seeing massive futures-related losses. Those few producers that hedged their price exposure by locking in prices to sell their crude at higher levels, on the other hand, look smart right now.

Before you buy an energy stock, take a look at its reports to see whether it's using futures contracts, and if so, how. That way, you'll be able to tell whether contango is a benefit or a risk to that company -- and what impact future price moves are likely to have on its business.