Producers and consumers of commodities use futures markets to protect against adverse price moves that could result in large financial losses. A producer of a commodity is at risk of prices moving lower while a consumer of a commodity is at risk of prices moving higher.
Hedging is an important tool when it comes to running a business from either of those perspectives. A hedge will guaranty a consumer a supply of a required commodity at a set price. A hedge will guaranty a producer a known price for their commodity output.
Many factors come into play when seeking to hedge against commodity price volatility. Essentially, prices are driven by either market factors, such as supply and demand, or non-market factors, such as the weather or geopolitical issues. As examples, a drought in the farming regions of the U.S. could cause a shortage of corn, and assuming demand stayed the same, prices would rise.
Advantages of Futures
Futures exchanges offer contracts on commodities. These futures contracts provide producers and consumers alike a mechanism with which to hedge their positions in commodities. Futures contracts trade for different time periods, allowing producers and consumers to choose hedges that closely reflect their risks. Additionally, futures contracts are liquid instruments, meaning there's a lot of trading activity in them and they're generally easy to buy and sell.
Aside from producers and consumers, speculators, traders, investors, and other market participants utilize these markets. The exchange requires those who hold long and short positions to post margin, which is a performance bond to cover potential losses.
Producers and consumers often receive special treatment on commodity exchanges. As hedgers, their margin rates are often lower than other market participants, who are trying to make money on trading, not protect against losses.
To hedge, it is necessary to take a futures position of approximately the same size—but opposite in price direction—from one's own position. Therefore, a producer who is naturally long a commodity hedges by selling futures contracts. The sale of futures contracts amounts to a substitute sale for the producer, who is acting as a short hedger.
A consumer who is naturally short a commodity hedges by buying futures contracts. The purchase of futures contracts amounts to a substitute purchase for the consumer, who is acting as a long hedger.
While supply and demand for commodities fluctuate, so does price. A producer or consumer who does not hedge assumes price risk. Producers and consumers who use futures markets to hedge transfer their price risk.
If someone holds the physical commodity, they assume the price risk for it as well as the costs associated with holding that commodity, including insurance and storage costs. The price of a commodity for future delivery reflects these costs, so in a normal market, the price of deferred futures is higher than nearby futures prices.
When a producer or consumer uses a futures exchange to hedge a future physical sale or purchase of a commodity, they exchange price risk for basis risk, which is the risk that the difference in the cash price of the commodity and the futures price will diverge against them.
Futures exchanges have associations that act as clearing houses, which means they become the transaction partner of a trade. They match up buyer and seller, check their creditworthiness, and ensure each one is paid what they're owed. Therefore the clearing houses help remove credit risk from the system.
A Drawback of Hedging With Futures
Hedging in the futures market isn't perfect. For one thing, futures markets depend upon standardization. Commodity futures contracts require certain quantities to be delivered on set dates. For example, a futures contract for corn might entail physical delivery of 5,000 bushels in December 2021. And sometimes quality—for example, the purity of precious metals—comes into play.
Hedgers sometimes produce or consume commodities that do not conform to the specifications of future contracts. In these cases, hedgers will assume additional risks by using standardized futures.
Alternatives to Futures Markets
Futures markets are not the only choice for hedgers. They can also use forwards and swaps to hedge. These markets entail principal-to-principal transactions—meaning no exchange is involved—with each party assuming the risks of the other. However, these tailor-made transactions may meet the specific needs of commodity consumers or producers better than standardized futures contracts can.
The Commodity Futures Trading Commission (CFTC) offers a useful glossary of commodity futures terms and definitions.