Why the Futures Market Matters to Everyone Part 2

In Part 1, I provided an introduction to the futures market, what’s wrong, and why it matters. In Part 2, we’re going deeper.

When we look at commodity futures curves, we see some variations in pricing. Let’s set commodity type C, amount A, and strike price P as constants, so the only changing variables are date D and contract price X. We have three possible conditions because as D goes further out in time, X can either increase, decrease, or remain unchanged.

If X increases as D increases, we have contango. This is generally more demand-sensitive and is the most common state of the curve. Intuitively, it makes sense that one would have to pay more money for a contract with a longer duration (assuming all else is equal) because the seller is essentially selling the buyer more time to act.

If X decreases as D increases, we have backwardation. This is generally more supply-sensitive, as in we have backwardation when the market is trying to price in a short-term supply disruption.

If X remains constant as D increases, we have a flat curve. It’s not contango and it’s not backwardation.

The curves ‘naturally’ want to be in contango, but they’ll flatten or even go into backwardation when a short-term supply disruption is expected, such as recently with the Middle Eastern and North African turmoil when some oil curves flattened and some even went into backwardation from their usual contango states.

Another aspect of the asset demand is Exchange Traded Funds (ETFs). ETFs are like mutual funds in that they can be formed with any focus, like commodities. However, unlike mutual funds, which you can only buy based on the closing price, one can buy ETFs in the pre-market trading, during regular trading, and in the aftermarket trading. You can also buy/sell options on many ETFs (options contracts are just like futures contracts except they cover shares of stocks or ETFs). Some commodity-based ETFs get their exposure by actually buying the commodity itself, but most use futures, which can be trouble depending on how the curves are behaving.

Let’s think in terms of supply and demand and how they relate to price. As demand increases, price increases assuming constant supply (and vice versa). As supply increases, price decreases assuming constant demand (and vice versa).

Prior to the passage of a law called the Commodity Future Modernization Act, pretty much the only source of demand for commodities was consumers or end users. However, this act created a new source of demand, namely the financial community. In essence, commodities went from being just strictly commodities to also being an asset class. So, demand has increased and this raises prices. It’s not unreasonable to say we’ve created an artificial source of demand.

The addition of more speculative money into the mix has also increased volatility. Remember how we surged to $150 oil in 2008 and then collapsed to $35 oil in 2009? That kind of volatility is a nightmare for business planning and it’s very hard on everyday people.

One could argue that all we have to do is increase production to allow supply to catch up demand. That’s a reasonable argument to address the extra demand, but it won’t solve the volatility problem and I don’t think we can increase production quickly or fully enough to satiate the user and asset demand.

I’m not saying that global demand for commodities from the user side hasn’t increased. It clearly has because of the rise of big emerging market countries like China, Brazil, and India. This is a good thing because it means the world’s getting wealthier and more people are living with a better quality of life.

I’m also not saying that speculators shouldn’t be allowed to speculate. They should be allowed to, and they’re not evil. But, the futures market is broken. Minor reforms could make a big difference, such as increasing margin levels, setting position size limits, and differentiating between the producer/consumer class and the investment/asset class. Due to the global nature of the futures market, this needs to be a global effort. If the USA makes changes, the speculators will simply go elsewhere.

I recommend Dan Dicker for further reading. He’s a former NYMEX oil futures trader with a couple decades of experience. Currently, he’s a market commentator at www.realmoney.com and recently wrote a book called, “Oil’s Endless Bid” that explores this topic. I’ve not read the book yet, but I’ve regularly read his columns for the past couple years.