Commodity Markets and Futures Trading

Although it is increasingly more common for stock market discussion to include futures markets in the same breath, commodity markets and dealing in commodity futures are a uniquely different realm than trading shares in the stock market. To understand commodity markets and how they work, it is worthwhile taking a brief look at their evolution.

In the purest and most traditional sense, a commodity is any agriculture produce such as potatoes, corn, soybeans, cotton, sides of beef, or the famous pork bellies. In other words a nations basic foodstuffs. Because these are all raw materials or primary products, they play an important role in sustaining an economy, but because of their supply being very vulnerable to weather conditions and growing seasons, the price of commodities fluctuate wildly, making it difficult for producers and processors to establish a reliable business plan.

Although markets for buying and selling commodities and commodity futures contracts were established in the 1800’s as a means of stabilizing costs, it is the wild price fluctuations that make commodities trading so interesting to investment speculators. Any time there is an opportunity to sell something for considerably more than one paid, there exists an interesting investment scenario.

Unlike a stock transaction where the shares actually represent equity in a company and can be held for an indefinite time period, futures are binding contracts which must be fulfilled on a specified delivery date. They have a finite lifespan. A contract is created when one party sells (referred to as going short), and another one buys (goes long). The number of buy contracts always equals the number of sell contracts.

Originally, Commodity Market buyers actually took possession of the shipments they purchased, and some still do, but the majority volume of contracts are transactions among speculators where both the buyer and seller, acting independently liquidate their positions before the contract expires. The end result is the buyer sells futures and the seller buys futures.

Trading in futures contracts of commodities is an exciting venture for those who are interested in the rewards of highly speculative investments.

The Winnipeg Commodity Exchange is the only Canadian exchange devoted to agricultural futures contracts. Canadians probably place most of their transactions on The Chicago Mercantile Exchange which is the world’s largest. Other Canadian exchanges such as the TSX, Vancouver, and Montreal have commodity futures trading facilities.

The idea of commodity trading has served a very useful purpose through our history and sparked an inventive explosion of expansionism, applying the procedure to other “commodities” and financial instruments, in the pursuit of investment profit opportunities. Though futures, in their most strict sense were introduced as described above, numerous devised scenarios for their use have become commonplace and things which really do not fit a dictionary definition of commodity are commonly classed as such.

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One interesting example of how far removed and inventive future contracts have evolved are those traded on the Canadian Climate Exchange of the Winnipeg Commodity Exchange. With the government introduced Clean Air Act, companies are required to meet certain levels of reduction in greenhouse gases and other environmentally unfriendly emissions. Reduction quotas are established and companies bettering their quota are issued climate credits. These credits can be purchased by companies who fail to meet emission reduction and apply them against their deficiency. A growing and vigorous market for the sale and purchase of emission credits now exists.

Trading in commodities seems a simple procedure. Keep your eye on price changes in a commodity of interest, do your homework on conditions impacting the future price of that commodity, and offer a long position (buy) at a price you feel will return a worthwhile profit by your chosen settlement date. If the market finds someone willing to sell short (take you up on your settlement price) a standardized contract is made.

Know what kind of contract you are getting into.

Most basic is to investigate just how much you are buying. That may seem simple, but different commodities use different measures to arrive at what constitutes a unit. A single unit of ethanol for example is not a liter or gallon, but 29,000 US gallons. A standardized contract unit of rubber is 1 kg but a unit of polypropylene is 1000 kg. The quoted price on the screen for both could well be per kg. You will not want to enter into a deal for 100 units of polypropylene for example, thinking you have purchased the 100 kg your budget can afford and find you have taken on an obligation for 100 metric tons.

Understand there are two distinctive instruments. Futures Contracts and Forward Contracts are different animals. In a Forward Contract, one party is obligated to sell a cash commodity and the other party must buy at a forward price agreed to in advance. There isn’t an exchange of cash at the making of the contract. Cash changes hands only at maturity. Forward Contracts are exchanged on Over the Counter Markets and there is not a secondary market for Forward Contracts. In a Futures Contract, there is also a buy and sell agreement, but it is in accordance with the Standardized Contract of the Exchange. In these contracts the final settlement payment is assured, as there is a margin requirement that must be settled daily in accordance with the spot price. What this means is a forward contract can be at credit risk because it is entered into without a single cent of down payment. Should the market price fall too much, the buyer could back out without paying and the seller would find himself stuck with a devalued commodity. The buyer in a Futures Contract puts up a percentage of the settlement price and in the event of increases in the current market price (spot price), he must add cash to maintain his margin position. You as buyer, can also liquidate your position at any time by becoming a seller.

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It gets much more involved and interesting than that.

Presently, Futures Markets have overgrown the concept of their origins to include every imaginable “commodity” and permutation. Speculators can exchange contracts in gold, foreign currencies, light sweet crude, gulf coast gasoline, natural gas, stock derivatives and interest rates through such instruments as T-bills, coffee, industrial metals from zinc to recycled steel. With the addition of the New York Mercantile Exchange the composite of all “commodity” trades far outstrips futures trading in traditional commodity markets. Futures play a massive role in the financial system, with daily trades equaling US $2 trillion.

An explanatory scenario on Futures Trading

To clearly illustrate the working of a futures transaction, follow what happens as a coffee grower in Columbia wants to secure a selling price for next seasons crop at the same time a Canadian coffee processor wants to calculate his profit on tins sold to his retail customers. Our grower and processor enter into a Futures Contract to deliver 10,000 kg of Columbian coffee to the port of Barranquilla for export to Canada next October at $1. per kg. Both are happy with their price because they believe they will realize a reasonable profit for their product.

It is their contract and not the coffee that can be bought and sold in the futures market.

In their contract and in every futures contract everything is specified as to quantity, quality, specific price per unit, delivery date, and method of delivery.

The profits and losses of a futures contract depend upon the movement in the spot market for their contracted coffee. In August, a freeze in Brazil damages the coffee crop and Columbian coffee increase to $1.25 per kg because of the shortage of Brazilian supply. Our Columbian seller looses out on .25 per kg because the amount he will receive is .25 less than market. Our Canadian buyer now holds a coffee contract worth .25 more than he is paying for it. On the day of the price change, the grower’s account is debited $2,500. which is .25 per kg on 10,000 kgs. The Canadian processors account is credited an equal amount because his 10,000 kgs is now worth more. This kind of adjustment to the accounts is made every day there is a change in the market price for Columbian coffee.

Because the accounts of both parties are adjusted each day, most futures transactions are settled in cash, and the actual commodity (in this example, coffee) is bought or sold in the cash market. Prices in the cash market for coffee will move parallel to the futures market.

Should either our Columbian grower or Canadian processor decide to close out their futures position, the contract will be settled at the cash market price. In this example, Columbian coffee is now worth $12,500. for 10,000 kg., the grower will have lost $2,500 when he closes out his futures contract and the processor will have gained $2,500.

But, the processor still needs his coffee to carry on in business and the grower still has to get rid of his coffee. The grower sells his 10,000 kg on the cash market for $12,500., which is $2,500. more than he had anticipated for his crop, but he must cover a $2,500. on the futures market, so he still nets out at $1.00 per kg for his coffee. A loss in the futures market offset by a higher selling price in the cash market is called hedging. The processor still has time, so waits because he has heard rumors of a bumper crop of Columbian and Central American coffee. One month later this turns out to be true and the Canadian processor buys the coffee he needs on the cash market for $1.00 per kg. or $10,000.The processor has acquired his coffee at the price he originally planned for and made a profit in the futures market. Had the price of coffee continued to rise rather than fall, our Canadian producer could have hedged some of a further increase in the cash market with his profits from the futures market.

What is clear in our example is futures contracts are really financial positions. In fact neither party needed to be involved in the coffee business to take a financial position in coffee futures. They could have been market speculators.