ByWilliam R. Emmons , Timothy J. Yeager
Many commodities are traded in both spot and futures markets. The spot market is for trading today, whereas the futures market is for future delivery. Press reports sometimes imply that futures prices provide a good forecast of future spot prices. Does the futures market really provide us with a crystal ball? The short answer is yes and no: Futures markets sometimes forecast future spot prices, but sometimes they do not. When, how and why do futures markets provide reliable forecasts? To answer these questions, we must first understand the concepts of forward contracting, hedging and speculation.
A forward contract is a firm legal commitment made by a seller to deliver a pre-specified amount at an agreed time at a particular price. Contract details are agreed at the outset, but no money or commodities are exchanged until the settlement (delivery) date. A standardized forward contract that is traded on an organized exchange such as the Chicago Board of Trade (CBOT) is a futures contract. Agricultural futures contracts were first traded in Chicago during the mid-1800s; later, futures contracts on industrial commodities, precious metals, stock indexes, currencies and interest rate instruments were added, and other exchanges were opened.
Forward contracting is used for hedging a pre-existing risk and for speculating on price movements. A farmer with a corn crop in the ground is exposed to the risk that corn prices in the spot market will be low when his crop actually is harvested and sent to market. To hedge this risk, the farmer could sell a corn futures contract for delivery at harvest time. This contract locks in a price today for corn that will be delivered in the future; so, the price risk is hedged away.1 A speculator, on the other hand, buys or sells corn futures with no other risk exposure to the price of corn. A corn futures buyer profits when the price rises but loses when it falls.
Prices in futures markets sometimes function well as forecasts of spot prices. In other cases, they do not. For example, the federal funds futures market can be used to calculate market forecasts of Federal Open Market Committee (FOMC) interest rate changes. A bank loan officer, however, should not use soybean futures prices alone to forecast future spot prices when making a soybean production loan. To complicate matters further, a firm that needs to forecast oil prices six months from today sometimes can look to the futures market for a reliable forecast but sometimes cannot do so.
To account for these different scenarios, we need to separate commodities into three categories: non-storable commodities, storable commodities with large inventory "overhangs" and storable commodities with modest inventories.
Futures prices of non-storable commodities embody only market expectations of future supply and demand conditions. These commodities are the only ones for which futures prices serve as perfectly straightforward forecasting tools. Non-storable commodities are perishables--things whose quantity or quality characteristics change rapidly. Eggs, for example, are considered non-storable because they spoil quickly; a fresh egg is quite different from a month-old egg.
Futures prices of non-storable commodities can deviate significantly from spot prices because of anticipated changes in supply or demand. Suppose the market expected a reduced supply of eggs three months from now. The three-month futures price would be driven higher than the current spot price. Spot prices would not be affected because vendors cannot store the eggs (take them out of the spot market) to sell in the future. They must sell today's eggs based on today's market conditions. Conversely, if the market expected egg production to increase in three months, the futures price would be driven lower than the unchanged spot price.
A futures market also exists for federal funds, the interbank market for reserves (deposit balances held by banks at the Federal Reserve). These instruments are non-storable because a bank cannot hold reserves today to satisfy future reserve requirements. One can use federal funds futures prices to infer market expectations of the FOMC's future interest rate changes.2 Current conditions in the federal funds market are irrelevant for future conditions and vice versa.
For storable commodities with large inventory overhangs--say, several months' worth of consumption of the commodity--futures prices simply reflect the current spot price plus carrying costs. Carrying costs are the interest and storage costs that would be incurred between the current date and the maturity date of the futures contract if one held the commodity in inventory. For example, the Nov. 1, 2001, spot price for soybeans was $4.26 per bushel; the January 2002 futures quote on Nov. 1 was $4.34.3 The difference of 8 cents represents the per-bushel carrying costs of soybeans for approximately two months.
Why must spot and futures prices be linked by carrying costs? If the soybean futures price exceeded the spot price by more than carrying costs, then an arbitrageur could earn a sure profit by selling a soybean futures contract, purchasing the soybeans in the spot market with borrowed funds and delivering the soybeans to the buyer of the futures contract on the settlement date. Because the difference between the futures price received and the spot price paid would more than cover carrying costs, a risk-free profit would be guaranteed. Conversely, if the futures price fell below the spot price plus carrying costs, then market participants would sell their inventories in the spot market and buy futures contracts, putting simultaneous downward pressure on the spot price and upward pressure on the futures price. Thus, traders' pursuit of riskless profit opportunities would move spot and futures prices quickly back to the relationship we stated above: The futures price will be the spot price plus carrying costs. In effect, traders allocate the large existing inventory through time, governed by the cost of carrying inventory.
Interpretation of futures prices is somewhat more complicated for storable commodities in which current inventories are low relative to current consumption needs. In these markets, we must make a distinction between two cases. If futures prices are lower than spot prices (a pricing structure termed backwardation) then the non-storable commodities analysis applies: The futures price provides the market's forecast of the future spot price. If futures prices are higher than spot prices (a contango market), then the analysis of storable commodities with large inventories applies.
The oil futures market provides a good example of a storable commodity with typically modest inventory levels. If the supply of oil is expected to increase in the future, then futures prices will fall relative to spot prices. Although arbitrageurs theoretically could profit by selling oil in the spot market when that price is higher than the futures price, the shortage of inventory prevents it. As of Nov. 1, 2001, the spot price for a barrel of crude oil was $21.70; the November 2002 futures price was $21.27.4 Clearly, an arbitrageur could profit by selling spot oil in 2001 before the spot price declines, but inventory shortages prevent it.
If, on the other hand, supply is expected to be low in the future, expected future spot prices will be higher than the current spot price. The futures price could not go arbitrarily high above today's spot price, however, because arbitrageurs could buy "cheap" spot oil with borrowed money, sell oil futures contracts and store the oil for future delivery. By taking advantage of the expected high prices in the future and the storability of oil, the arbitrageur pushes the spot price higher and the futures price lower. This scenario is exactly the situation we described above for commodities with large inventory overhangs. In this case, the difference between the futures price and the spot price reflects merely the carrying costs, not the market's forecast of future spot prices. Thus, futures market prices for storable commodities with typically modest inventory overhangs must be interpreted with particular care.
Although futures contracts primarily exist to hedge risk or to speculate in commodities and financial markets, a side benefit is that they sometimes also produce good price forecasts. Care must be taken, however, to interpret these prices. Futures prices reflect market expectations regarding future supply and demand conditions for non-storable commodities. For storable commodities with sufficiently large inventories, however, futures prices simply reflect the spot price plus carrying costs. Yet another category of commodities, such as oil, effectively resembles a non-storable commodity under some circumstances and a storable commodity with a large inventory overhang under other circumstances. Thus, the futures markets are not perfect crystal balls after all.
Livingston, Miles. Money and Capital Markets: Financial Instruments and Their Uses. Englewood Cliffs, N.J.: Prentice-Hall Inc., 1990.
Robertson, John C. and Thornton, Daniel L. "Using Federal Funds Futures Rates to Predict Federal Reserve Actions." Federal Reserve Bank of St. Louis Review, November/December 1997, Vol. 79, No. 6, pp. 45-53.
Tomek, William G. and Robinson, Kenneth L. Agricultural Product Prices, 2nd Ed., Ithaca: Cornell University Press, 1981.