Commodity Futures: How They Work with Examples
Why Do Prices of the Things You Need the Most Change Every Day?
Definition: Commodities futures are agreements to buy or sell a raw material at a specific date in the future at a particular price. The contract is for a set amount. The three main areas of commodities are food, energy and metals. The most popular food futures are for meat, wheat and sugar. Most energy futures are for oil and gasoline. Metals using futures include gold, silver and copper.
Buyers of food, energy and metal use futures contracts to fix the price of the commodity they are purchasing.
That reduces their risk that prices will go up. Sellers of these commodities use futures to guarantee they will receive the agreed-upon price. They remove the risk that the prices will drop.
That because the prices of commodities change on a weekly or even daily basis. Contract prices change as well. That’s why your cost of meat, gasoline and gold changes so often.
How They Work
If the price of the underlying commodity goes up, the buyer of the futures contract makes money. He gets the product at the lower, agreed-upon price and can now sell it at the today's higher market price. If the price goes down, the futures seller makes money. He can buy the commodity at today's lower market price, and sell it to the futures buyer at the higher, agreed-upon price.
If commodities traders had to deliver the product, few people would do it. Instead, they can fulfill the contract by delivering proof that the product is in the warehouse.
They can also pay the cash difference, or by provide another contract at the market price.
How to Invest
The safest ways to invest in commodities futures are through commodity funds. They can be commodity exchange-traded funds or commodity mutual funds. These funds incorporate the broad spectrum of commodities futures that occur at any given time.
Trading in commodity futures and options contracts is very complicated and risky. Commodities prices are very volatile. The market is rife with fraudulent activities. If you aren't completely sure of what you are doing, you can lose more than your initial investment.
How They Affect Prices
Commodities futures accurately assess the price of raw materials because they trade on an open market. They also forecast the value of the commodity into the future. The values are set by traders and their analysts. They spend all day every day researching their particular commodity. Forecasts instantly incorporate each day's news. For example, if Iran threatens to close the Strait of Hormuz, the commodities prices will change dramatically.
Sometimes commodities futures reflect the emotion of the trader or the market more than supply and demand. Speculators bid up prices to make a profit if a crisis occurs and they anticipate a shortage. When other traders see that the price of a commodity is skyrocketing, they create a bidding war. That drives the price even higher.
But the basics of supply and demand haven't changed. When the crisis is over, prices will plummet back to earth.
Also, commodities are traded in U.S. dollars. As the value of the dollar increases, the price of commodities falls. That's because traders can get the same amount of commodities for less money. (Source: "Inverse Relationships Between Dollar and Commodities")
Oil. Traders take into account all information about oil supply and demand, as well as geopolitical considerations. This affects oil prices. It is these assumptions behind oil prices that affect the economy so significantly. That’s because the price of oil impacts every good and service produced in America.
For example, in 2008 oil prices skyrocketed. It was despite the fact that global demand was down, and global supply was up.
The Energy Information Administration reported that oil consumption decreased from 86.66 million barrels per day (bpd) in the fourth quarter of 2007 to 85.73 million bpd in the second quarter 2008. During this same period, supply rose 85.49 million bpd to 86.17 million bpd. According to the laws of supply and demand, prices should have decreased. Instead, by May prices rose almost 25 percent, from $87.79 to $110.21 per barrel of oil.
The EIA reported that the "flow of investment money into commodities markets" caused the trend. Traders diverted money from real estate or stocks into into oil futures. Later that year, frenzied commodities traders drove the price up to its all-time high of $145 a barrel.
In 2011, oil prices didn't start rising until May, sending gas prices up immediately. That was a result of traders anticipating higher oil and gas prices due to higher demand from the summer driving season. Oil makes up 72 percent of the price of gas. When oil prices rise, it usually shows up in gas prices a three to six weeks later. For more, see How Crude Oil Prices Affect Gas Prices.
In 2012, Iran threatened to close the Strait of Hormuz, one of the world’s most strategic oil shipping lanes. Traders worried that a potential closure of the Strait would limit oil supplies. They bid up oil prices in March, sending gas prices higher in April.
In January 2013, traders bid up oil prices early in the year. Iran created the fear by playing war games near the Strait. By February 8, oil prices had risen to $118.90/barrel, sending gas prices to $3.85 by February 25. For more, see What Makes Oil Prices So High?
Metals. In 2011, gold hit an all-time high of $1,895 an ounce. Demand and supply hadn't changed, but traders bid up gold prices in response to fears of ongoing economic uncertainty. Gold is often bought in times of trouble because many people see it as a safe haven. For more, see Gold Prices and the U.S. Economy.
In 2014, the dollar index rose 15 percent. By 2015, aluminum prices had fallen 19 percent, and copper prices were down 27 percent. Oil was hit the worst, as prices fell to a 6-year low. (Source: “Copper, Aluminum Fall to Six-Year Low,” The Wall Street Journal, August 3, 2015.)
Supply and demand had some impact as well. China's economy started slowing, reducing demand for copper. As part of its economic reforms, China was shifting from construction to consumer spending. It wanted to rely less on exports, and more on domestic demand. That further reduced the need for copper, since housing construction uses a lot more copper than consumer products. China's construction industry had used 3 million to 4 million tons a year. That's equal to what was used by the entire economies of the United States, Japan, Canada and Mexico combined.
At the same time, China added to the supply of commodities, further lowering prices. In 2014, the country produced 52 percent of global aluminum. It boosted that amount in 2015, adding 10 percent to supply. (Source: "Metal Meltdown," Bloomberg BusinessWeek, October 11, 2015.)
In July 2015, the Shanghai Gold Exchange sold $200 million of gold. That sent prices down worldwide. It traded 316 tons in July, a 44 percent rise from 2014. The Bank of China became part of the London-based Gold Fix price-setting mechanism. The Shanghai Futures Exchange trades 31 percent steel, zinc, and aluminum. The London Metals Exchange was bought by the Hong Kong Exchange.(Source: "Giant Appetite," WSJ , August 26, 2015.)
Food. In 2008, commodities traders created high food prices. That led to riots in less-developed countries. First, traders diverted funds from the failing stock market into wheat, corn and other commodities. Second, they also diverted funds into oil prices. They created higher distribution costs for food. (Source: “Commodity Boom Continues to Roll,” BBC, January 16, 2008. “Riots, Instability Spread as Food Prices Skyrocket,” CNN, February 18, 2008.)