Commodity Futures Contracts

If you're a car manufacturer in India, you need a steady supply of steel for production.

The price of steel fluctuates based on market conditions, which can impact your production costs.

To mitigate this risk, you might enter into a futures contract to lock in the price of steel for the next six months, ensuring predictable costs. This contract helps you protect your business from price volatility and plan more effectively.

Similarly, commodity futures contracts allow producers, consumers, and investors to manage price risks in commodities.

What Are Commodity Futures Contracts?

A commodity futures contract is a standardized agreement between two parties to buy or sell a specific amount of a commodity at a predetermined price on a specific date in the future. These contracts are traded on commodity exchanges, such as MCX (Multi Commodity Exchange) in India or CME Group in the U.S.

Commodity futures contracts are widely used by producers (like farmers or miners) to hedge against price fluctuations and by investors to speculate on price movements in commodities like oil, gold, wheat, or copper.

Key Features of Commodity Futures Contracts:

1. Standardized Contracts:
Futures contracts are standardized in terms of the quantity of the commodity, delivery date, and settlement terms. This makes them easily tradable on exchanges.

2. Margin Requirements:
To trade futures, investors are required to deposit a margin — a percentage of the total contract value. This margin acts as a security to ensure that both parties honor the contract.

3. Settlement:
Futures contracts can be settled either by physical delivery (the actual commodity is delivered) or by cash settlement (the difference in the contract price and market price is paid). Most commodity futures are cash-settled, meaning the contract is settled in cash rather than with physical delivery of the commodity.

4. Expiration Date:
Every futures contract has an expiration date, which is the specific date by which the contract must be settled. If the contract is not settled by this date, it is rolled over to the next expiration date.

Why Trade Commodity Futures Contracts?

1. Hedging Price Risk:
Producers and consumers use commodity futures to hedge against price fluctuations in the underlying commodities. For example, a wheat farmer in Punjab can use wheat futures to lock in a price for their crop before the harvest, protecting themselves from falling prices.

2. Speculation and Investment:
Speculators trade commodity futures to profit from price movements in commodities. Futures allow investors to take positions based on their predictions of whether prices will rise or fall in the future.

3. Liquidity and Leverage:
Commodity futures are highly liquid, allowing for easy entry and exit from positions. They also offer leverage, meaning traders can control a large position with a relatively small amount of capital.

Example of Commodity Futures in Action:

Let’s consider an oil producer in India who fears that oil prices may fall in the coming months. The producer can sell oil futures contracts at the current price to lock in a favorable price for the future. If oil prices do fall, the producer will still receive the price agreed upon in the futures contract, thus avoiding losses.

Conversely, an investor who expects oil prices to rise might buy oil futures contracts. If oil prices rise, they can sell the futures contract at a profit. However, if oil prices fall, they will incur a loss.

In India, the MCX (Multi Commodity Exchange) is the primary exchange for trading commodity futures, with popular contracts for gold, silver, crude oil, and agricultural products like soybean and chana. Indian traders and businesses actively use these contracts to hedge against price risks in commodities, given the volatility and seasonal factors that influence commodity prices.

For example, crude oil futures are heavily traded on the MCX, and Indian refineries often use these contracts to lock in prices and manage their operational costs. Similarly, agriculture-based futures on the NCDEX (National Commodity and Derivatives Exchange) allow farmers to hedge against poor harvests or price drops.

Commodity futures contracts are a powerful tool for managing price risk and speculating on market movements. By understanding how these contracts work, investors can enhance their portfolio’s performance while mitigating the impact of volatility in the commodity markets. In the next chapter, we will explore Commodity Options and Their Applications, examining how options provide more flexibility and risk management strategies for investors and producers.