1.3 TRADING COMMODITIES ON FUTURE MARKETS

Several products covered by this book are traded on one or other of the world's many futures markets. Futures markets can be understood as a link between financial institutions and the commodity trade. Their origins date back to the nineteenth century when merchants needed to finance their commodity trading with money from banks and investment funds.

Every involved with commodities, from producer to retailer, knows how necessary it is to obtain credit and how unpredictable commodity prices can be used. The futures market can be used to help some of the larger players in the markets with both these problems.

Future markets also give a reference price to a commodity at any given time.

It is important to distinguish between futures markets and ordinary commodity markets. Every village market could be described as a commodity market in that they are places where sellers offer their goods for inspection and sale to buyers and where the price paid for the goods is acceptable to both buyer and seller.

In a futures market the seller promises to sell a certain quantity of a certain commodity at an agreed price, delivered to a specific location, to the buyer at a specific date in the future. The buyer might be a consumer of the commodity who wishes to cover their needs for that future date. On the other hand, the buyer might be a might be a bank, financial institution or private individual who wants to make the purchase because they believe that the price of the commodity will rise before the date agreed for delivery. They hope to sell the commodity at a profit before they are required to take of it.

The seller may also be a banker or investor. They would have taken the view that the price will fall before the agreed delivery date. They will have promised to deliver the goods even though they do not yet own them. If they are right, and the price does fall, they can buy the goods through the futures market nearer the delivery date at less than they have promised to sell them at and make a profit.

Most of the buyers and sellers on the futures markets never actually see the commodities in which they trade. For them, the market is just a means of making money. Consumers and producers are able to use these markets to their advantage, however. One useful aspect of a futures market for consumers and producers is its facility to provide a means of hedging a purchase or a sale. But what does the word 'Hedging' mean and why can it be useful?

Many commodities markets are very volatile - prices go up and come down unpredictably. This makes life difficult for consumers. Let us take the example of a chocolate producer who needs to make a sales contract with a supermarket chain to sell millions of chocolate bars at a fixed price for the whole of the following year. Nobody knows what the price for cocoa is going to be at the time he needs to buy the cocoa to make the chocolate. On the futures market, however, he can find a seller who is willing to supply cocoa at a fixed price for the period in question. If the price goes up on the world market, the buyer still gets his cocoa at the price agreed with the futures market seller. This type of transaction is known as hedging.

In practice the cocoa buyer, in this example, will make all his transactions on the futures markets paper transactions. Although futures markets theoretically allow for deliver of real commodities from the seller to the buyer, it is not their principal purpose and it rarely happens. In this example, the cocoa buyer will sell back the cocoa to the futures markets, at about the same time he needs physical delivery of the cocoa, and make a profit (since the price has gone up since he bought it). He will simultaneously purchase the same amount of physical bags of cocoa, say from Ghana, and, although the price he will pay for this cocoa will be higher than the price he paid for his original purchase on the futures market (again because the price has gone up in the meantime), the difference will be covered by the profit he makes on the futures transactions.

If the price falls, rather than rises, in this period, the cocoa buyer will make a loss on his transaction on the futures market but be able to buy the physical cocoa from Ghana at the lower, prevailing price. So whether the world market price goes up or down, the buyer has managed to buy his forward requirements of cocoa at a fixed price, has been able to sell chocolate bars to the supermarket chain at a fixed price.

Producers of commodities also use futures markets for hedging. They can make forward sales at fixed prices and use the sales contracts as collateral to borrow money from the banks to finance their production costs. They may also wish to hedge if they feel that the price of the commodity they produce will fall before they can deliver it to a customer.

Buyers are not requires to pay the total value of a purchase they make on the futures markets at the time the purchase is made. The buyer is required, however, to pay what is called a margin. This may only be a few cent of the value of the purchase, but the exact sum payable depends on the particular commodity and futures market used. If a buyer has bought a commodity on the market and its price falls between the time of purchase and the agreed delivery date, however, the buyer will be asked for a "margin call'. This means that he has to pay an extra sum of money, which would equal the loss he would make if he sold his purchase at the prevailing market price. If the price continues to fall, he will be asked to continue covering this potential loss with more margin calls. All these sums of money, plus any interest they earn, will be taken into account when the transaction is finalised.

Buyers and sellers are not able to trade directly in the futures markets. They have to use the services of brokers who are specialist dealers and members of the market in question. Only they are allowed to transact business in that market, but they act on behalf of many clients, buying and selling on the futures market according to their clients' instructions. In most futures markets brokers are also allowed to deal on their own account. This has led to a conflict of interest on some occasions, and clients should wary of taking their broker's advice regarding whether they think the market is going up or down, unless they know and trust the broker very well.

Buyers and sellers who wish to use futures markets must pay their brokers a commission fee on each transaction they make. This fee varies according to which market is used, what commodity is traded and the size of the transaction but it is usually a fraction of 1 percent of the value of the transaction. The broker, who is also responsible for setting and collecting margins and margin calls, is only likely to do business on behalf of clients that they know are able to meet any financial commitment they make. For this reason they only take on clients with good financial references.

Futures markets do not allow trades of less than a certain minimum quantity or 'lot' any given commodity. The value of one usually exceeds US$10,000, so only those interested in hedging or investing on a large scale can make use of the market.

The volume of trade in a commodity has to be very large indeed for it to be worth setting up a futures market to trade in it. Furthermore, only commodities whose qualities can be objectively and simply defined are traded on futures markers. (Billions of dollars worth of diamonds and oil paintings are bought and sold each year but they are not traded on futures markets. Their quality is based on subjective opinion and cannot be defined simply enough for forward purchase or sale.)

Many commodity markets trade in a large range of other commodities such as gold and oil and, in more recent years, in financial 'products' such as bond and currency futures. This trade in financial instruments and their derivatives, such as options, has now become so large that it completely dwarfs the trade in raw materials, especially the so-called soft commodities which are the subject of this book.

Of the commodities mentioned in this book only coffee cotton, soya beans, maize, cocoa, sugar, potatoes, sorghum, rubber, silk, castor oil, tea, palm oil, jute and rice are traded in any volume on one or other of the futures markets.

Different futures markets specialise in different commodities. This sometimes depends on their location. The Chicago market dominates futures trade in Soya because it is located near the world's largest soya-growing area. Silk futures are traded in Japan; Malaysia has a huge rubber trading market, and so on. Some futures markets dominate trade in a particular commodity for historical reasons. The Paris market specialises in white sugar, for instance, and the New York market is looked on the world over as the market marker in arabica coffee.

There are about 20 internationally recognised futures markets based mainly in the major financial centres of the world. Some have a very small turnover and are used almost exclusively by local traders and investors and only trade in one or two locally produced commodities.

Only the larger traders, producers and consumers of tropical products are likely to be financially strong enough to be able to make use of a futures market. It is important for all those who are involved with the commodities to take notice of the prices trading on these exchanges, however. The volume of transactions on these futures markets is very large, often larger than the entire global turnover of the physical commodity in question, because most of the volumes of trade on the markets are paper transactions. For this reason the prices traded for the commodities on futures markets carry great authority. The prices reflect the net results of transactions carried out by the experts employed by all the bankers, investors, traders, and producers, consumers who use the market. If most of the transactions in a commodity required to be delivered six months hence take place at a lower price on one day than they did on the previous day, it is likely to meant that deliveries for that future date are going to be more plentiful than was previously estimated. Price trends show the changing balance between world supply and demand.

Since so many people respect the ability of the futures markets to reflect the true market price of commodities, the markets are also used by buyers and sellers who wish to use a price formula in the contracts they make.

In June a large coffee farmers' cooperative in Mexico, for instance, might want to make a sale of 100 tonnes of its arabica coffee, which it expects to be able to deliver to a port in November. Rather than agree to sell to the dealer at a fixed price, they may agree to use something like the following price clause in their sales contract - "The sales price on a CIF Mexico basis will be fixed at five US cents per pound discount to the closing prompt-month New York coffee market 'c' contract price as traded on the first day of November.

This so-called pricing facility offered by the futures markets is probably most useful to all those involved in the commodity concerned, whether or not they actually use the market to make transactions.

In addition to the futures markets there are a great many more ordinary commodity markets, tea, and tobacco auctions and wholesale vegetable markets, for instance. They are to be found in almost every country and vary tremendously in size, range and structure. The prices traded on some of the larger ones are also used as a reference for pricing contracts.

Further details of commodity markets and futures markets can be obtained by writing to the appropriate trade association, addresses for many of which can be found in Part Three.

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