Lesson 3: How do commodity futures markets work?

In yesterday’s lesson you learnt about some of the major factors that affect the price of commodities. Today’s lesson looks at commodity markets in more detail, in particular how commodity futures markets work.

A commodity futures contract is a type of derivative. A contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future.

Commodity producers can use commodity futures to secure a price for their commodity. As you saw in lesson 1 a farmer doesn’t want to risk planting a certain crop only to see prices fall once it is ready to harvest. Commodity futures contracts can secure a price for his crop many months ahead of it being harvested. Commodity futures contracts are also used by buyers of commodities to reduce the risk that they are not exposed to the price of an important commodity spiking higher.

Finally, as you saw in the previous lesson, speculators can also buy and sell commodity futures contracts based on their view as to where the price will be at some point in the future.

Commodity futures exchanges

Commodity futures exchanges make business considerably more efficient and less risky for both commodity producers and consumers by bringing together those willing to take on risk from those looking to reduce risk.

The first futures exchange market was the Dōjima Rice Exchange in Japan, established in the 1730s to meet the needs of samurai who, being paid in rice, needed a stable conversion to currency in the event of a bad harvest.

The world’s oldest commodity futures exchange with standardised exchange-traded futures contracts was the Chicago Board of Trade (CBOT), which began in 1864 with wheat, corn, cattle and pigs being widely traded.

The futures curve

Commodity futures contracts typically expire each month of the year. The closest dated contracts tend to see the largest trading volume, while those further out see far less trading activity. The shape of this series of future contract prices is known as the futures curve.

A futures curve is described as “in contango” when prices for future delivery are higher than the nearest dated contract. In general, traders are willing to pay a premium to avoid the costs associated with transporting, storing and insuring a commodity.

In contrast, when the shape of the futures price curve is downward sloping, the futures price of a commodity in say six months’ time is lower than the current spot price, and so the market is said to be in backwardation.

If a futures curve moves towards backwardation it is a good sign that the current underlying conditions in a commodity market are getting tighter. The opposite of which is so when the curve moves towards contango.

What good are speculators?

Whenever commodity prices increase sharply, speculators often get the blame. This can be especially sensitive when it is the price of agricultural commodities that are rising.

Speculators who expect wheat to be in short supply and see wheat prices rising in the future can back their hunches by purchasing wheat futures contracts on a commodity futures exchange.

But remember, buying a futures contract for wheat does not reduce the quantity of wheat that is available for consumption. If many speculators share the view that shortages will worsen and prices will rise, then their demand for wheat futures will be high and, consequently, the price of wheat for future delivery will also rise. This then provides the incentive for farmers to plant more wheat and/or increase yields to serve this demand, helping to alleviate future shortages.

Financial speculators also provide a much needed source of liquidity to physical buyers and sellers, while also passing risk on from those unable and/or unwilling to bear it, onto those that can.

I hope you found this lesson on commodity futures interesting.

In the next lesson you will see why cycles are so important in commodities and why they are so significant to understanding and profiting from commodity markets.

Go to lesson 4

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