Commodity Futures, How They Work With Examples

Why Do Prices of the Things You Need the Most Change Every Day?

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Commodities futures contracts 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. It specifies when the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement instead of delivery. 

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 of a price drop.

Prices of commodities change on a weekly or even daily basis. Contract prices change as well. That’s why the cost of meat, gasoline, and gold changes so often.

Key Takeaways

  • Commodities futures are contracts that stipulate the price, volume, and date of the transaction
  • Commodities fall under the three major categories: food, metals, and energy
  • Futures contracts are sold on an exchange, which makes the transaction safer

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 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 provide another contract at the market price.

Commodities Exchanges

Future contracts are traded on a commodities futures exchange. These include the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange.   These are all now owned by the CME Group. The Commodities Futures Trading Commission regulates them. Buyers and sellers must register with the CFTC.

The role of the exchange is important in providing a safer trade.

The contracts go through the exchange's clearing house. Technically, the clearinghouse buys and sells all contracts. 

The exchanges make contracts easier to buy and sell by making them fungible. That means they are interchangeable. But they must be for the same commodity, quantity, and quality. They must also be for the same delivery month and location.

Fungibility allows the buyers to "offset" contracts. That's when they buy and then subsequently sell the contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason, futures contracts are derivatives.

How Futures Contracts Affect the Economy

Companies use futures contracts to lock in a guaranteed price for raw materials such as oil. Farmers use them to lock in a sales price for their livestock or grain. Futures contracts guarantee they can buy or sell the good at a fixed price. They plan to transfer possession of the goods under contract. The agreement also allows them to know the revenue or costs involved. For them, the contracts reduce a significant amount of risk.

Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of transferring any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on the future price of that commodity. Price assessment and price forecasts for raw materials are how commodities futures affect the economy. Traders and analysts determine these values.

Pros
  • These contracts ensure that the commodity producer receives a fixed sales price, come harvest or selling time

  • In a price drop, the producer does not lose money. He gets the agreed-upon price

  • Producers can limit their risk, in case of a price drop

  • Producers or companies can make better production plans

Cons
  • In the event of a price increase, producers can miss out on considerable gains. Contract prices are fixed.

  • Trading in these contracts is very risky. World commodity prices are highly volatile.

  • Commodity prices are influenced by world events, traders’ emotions, and market speculations, even when demand and supply remain at the same level

  • This investment type is best left to experts

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.

Before you invest, read Commodities Profiles and Day Trading in Commodities Futures. In addition, review the CTFC’s Guide to Fraudulent Activity and its Education Center.

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.

What makes oil prices so high? A devalued dollar and commodities traders’ actions are a few of the factors that influence the price of oil.

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. There is an inverse relationship between the dollar and commodities. 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.

Examples

There are many examples of how commodities futures trading affects prices. Here are some specific cases of when that happened in oil, metals, and food.

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. The price of oil impacts every good and service produced in America. For example, oil prices affect gasoline prices directly because 54% of the gasoline price is dependent on the price of crude. A rise in crude oil prices will raise the pump price as well.

In 2020, oil prices fell into negative territory.

In January 2020, the world's governments began restricting travel and closing businesses to stem the coronavirus pandemic. Demand for oil fell. In the first quarter of 2020, oil consumption was 5.6% lower than the first quarter 2019.

The supply glut was made even worse by a competition between Russia and OPEC. On March 6, Russia announced it would increase production in April. To maintain market share, OPEC announced it would also pump more oil. Prices fell even further. On April 12, 2020, OPEC and Russia agreed to lower output to support prices.

It wasn't enough to convince traders that supply wouldn't outpace demand. As of April 20, 2020, the price for a barrel of oil had fallen to -$37.63. Traders were willing to pay someone else to take delivery of the oil since storage facilities were near capacity.

Metals

On Sept 5, 2011, gold hit an all-time high of $1,895 an ounce. 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.

Gold prices reflect the U.S. economy. An increase in gold investments, which consequently drives gold prices up, could indicate that the economy is doing poorly. On the other hand, a decrease in gold prices could signify some health gains for the economy.

Food

During the financial crisis, commodities traders created high food prices. Food prices rose 4.0% in 2007 and 5.5%in 2008. That led to riots in less-developed countries. These food riots may have even led to the Arab Spring uprisings.

Article Sources

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  15. The World Bank. "Food Riots: From Definition to Operationalization," Page 4. Accessed April 24, 2020.