A Primer on Commodity Futures

Published on 27th November 2007

Conventional wisdom tells you that a bull market in oil is born from the seeds of geopolitical unrest, economic uncertainty and social conflict.  For agricultural products on the other hand, being the main commodities in major world markets, three factors determine when a bull turns to bear and vice versa: weather, volatility and seasonality.  In Africa, commodities trading only exist at spot level with no single futures markets in existence. 

In Kenya for example, the Kenya Agricultural Commodities Exchange (KACE) Limited executes all commodities trades.  The market is limited as it deals with agricultural commodities only. It is also restricted to small scale farmers who want a level playing ground in the auction of their farm produce mainly maize, tea and coffee. 

Emerging Africa Capital Ltd (EmAC) is setting up a Commodity Futures Exchange that seeks to work closely with the KACE to bring on board a wider participation by a larger group of Kenyans.EmAC will through this venture, involve widely untapped avenues like energy, metals, grains, livestock and other exotic commodities.

Why would one invest in commodities and not the conventional stocks or bonds as always done in the past?  What difference does it make when one invests in commodity futures instead of the conventional financial products?

To begin with, commodity futures are derivative securities but not claims on long lived corporations. If you were to invest in coffee produced by Sasini Ltd (formerly Sasini Tea and Coffee) for example, you would claim on Sasini Ltd, as you would if you had 10,000 shares of the company.  Secondly, commodity futures are short maturity claims on real assets.  Unlike financial assets, they have pronounced seasonality in price levels and volatilities.  And lastly, the paucity of data factor.

The major difference between stocks and commodity futures investors is that in stocks, investors are compensated for risk, that is, they hope that future cash flows will outweigh current cash flows in a company.  Using the example of Sasini Ltd again, an investor would invest in Sasini Ltd shares at say Kshs. 16.00 hoping that with the anticipated increase in earnings, the price may be shifted to Kshs.19.00.  If a decline in earnings shifts the price to Kshs. 13.00, an investor gets a negative compensation.

This drop shifts the demand on the company’s stock downwards as it means a company is unable to maintain the shareholder optimism.  This is due to the fact that by subscribing into the company’s stock, a shareholder lends money to that company to share in the future earnings. 

On the contrary, commodities futures do not raise resources for firms to invest.  Rather, they allow firms to obtain insurance for the future value of their outputs or inputs.  Investors in this case will receive compensation for bearing the risk of short term price fluctuations.Commodity futures do not represent direct exposure to actual commodities.  Instead, they represent bets on expected future spot price.  Inventory decisions link current and future scarcity of the commodity and consequently provide a correction between the spot price and the expected future spot price. 

A commodity futures contract is an agreement to buy or sell a specified quantity of a commodity at a future date at a price agreed upon when entering into the contract- the futures price.  The futures price is different from the value of a futures contract.  Upon entering a futures contract, no cash changes hands between buyers and sellers and hence the value of the contract is zero.

To determine the futures price, think of the alternative to obtaining the commodity in the future: simply wait and purchase the commodity in the future spot market.  Because the future spot price is unknown today, a futures contract is a way to lock in the terms of trade for future transactions.   

By entering into a futures contract, an investor assumes the risk of unexpected movements in the future spot price.  Unexpected deviations from the expected future spot price are by definition unpredictable and should average out to zero over time for an investor unless the investor has an ability to correctly time the market. 

If the investor does not benefit from the expected spot price movements and is unable to outsmart the markets, the other way to benefit is risk premium: the difference between current futures and expected futures spot price.  If today’s futures price is set below the expected future spot price, a purchaser of futures will on average earn money.  If the futures price is set above expected future spot price, a seller of futures will earn a risk premium.

As the maturity date nears, the futures price starts to approach the spot price of a commodity.  At maturity, the futures contract will become equivalent to a spot contract and the futures price will equal the spot price.  The investor then earns a risk premium. 

There is however no legal framework for trading in commodity futures.  If one has to come to the local market soon, more private than public regulation will be in force.  Investing in commodities has far too many benefits. In a country whose population mainly relies on production of agricultural produce, developing the commodities markets would add a lot of value.   

For the past five years, prices of major agricultural commodities have increased by over 100 percent.  This improvement is partly due to the development of the KACE which has provided room for level playing ground to the farmers. In such a case, it would be important to advance this to another level by setting up a commodity futures market.  In so doing, a larger population will be able to tap into the unrealized yet enormous benefits of the commodities markets. 

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