Commodity Futures

What Are Commodity Futures?

A wheat farmer in spring does not know what her crop will fetch in September. A bread maker does not know what flour will cost. Commodity futures let both of them lock in a price months ahead, so the uncertainty moves to whoever is willing to carry it. That simple bargain is one of the oldest in finance: rice traders in Osaka ran an organised futures market at the Dojima exchange in the 1730s, and the Chicago Board of Trade opened in 1848 to trade grain for later delivery.

Modern contracts cover almost every raw material that trades in bulk. Energy futures include crude oil, heating oil and natural gas. Metals range from gold and silver to copper and aluminium, and agricultural contracts cover corn, soybeans, coffee, sugar and cattle. Each one is a futures contract built around a physical commodity, which is what separates it from futures on stock indices or interest rates.

Standardisation is the key feature. Every contract of the same type has the same size, quality grade, delivery location and expiry month, so a barrel bought by one trader is interchangeable with a barrel sold by another. That uniformity lets thousands of strangers trade the same instrument on an exchange instead of negotiating private deals one by one.

How Do Commodity Futures Work?

Once you understand the basic promise, the mechanics come down to three things: margin, daily settlement and expiry. To open a position you deposit initial margin, a fraction of the contract’s full value set by the exchange. At the end of every trading day, the clearing house marks each position to the settlement price and moves cash from losing accounts to winning ones. If your balance falls below the maintenance margin, you receive a margin call and must top up the account or have the position closed.

Consider a trader who buys one WTI crude oil contract at $70 per barrel. The contract covers 1,000 barrels, so its notional value is $70,000, and suppose the exchange asks for $7,000 in initial margin with a $6,000 maintenance level. That is roughly 10:1 leverage, because $7,000 controls $70,000 of oil.

Now oil drops to $68 the next day. Each $1 move is worth $1,000 on this contract, so the account loses $2,000 and holds $5,000, below the maintenance level. The trader must deposit $2,000 to bring it back to $7,000. A 2.9% fall in oil has cost almost 29% of the original deposit, which shows how daily settlement turns small price moves into large cash swings.

Expiry is the last piece. Most traders never touch a barrel or a gold bar; they close the position or roll it, selling the expiring contract and buying the next month. Only a small share of contracts ends in physical delivery, but that possibility anchors futures prices to the real market, because anyone can buy cheap futures and take delivery if the price drifts too far from the spot price.

Contango vs. Backwardation in Commodity Futures

Futures on the same commodity trade at different prices for different months, and the shape of that price curve matters as much as the price itself. When later contracts cost more than nearer ones, the market is in contango. This is the normal state for storable goods, because someone holding oil or gold pays for storage, insurance and financing until delivery.

When nearer contracts cost more than later ones, the market is in backwardation. Backwardation signals scarcity: buyers pay a premium to get the commodity now rather than later. It often appears after supply shocks, when refiners or manufacturers cannot wait.

Why Are Commodity Futures Important for Traders?

Futures markets are where commodity prices are discovered. Producers, consumers, funds and speculators meet on one exchange, and the most active contract becomes the benchmark that physical deals, CFDs and exchange-traded funds reference. When a news headline quotes the price of oil or gold, it is usually quoting the nearest futures contract, not a price anyone paid for a physical cargo that day.

They also give businesses a practical tool for hedging. An airline that buys jet fuel can hold long oil futures, so a rise in fuel costs is offset by gains on the contracts. A gold miner can sell futures to lock in the price of next year’s output. Speculators take the other side of these trades and supply the liquidity hedgers need, and in the United States the CFTC oversees that market.

The risks are built into the same mechanics. Leverage and daily settlement mean a trader can be forced out of a position that would have been right in the end, simply because the cash ran out first. Rolling in contango slowly drains returns even when the spot price is flat, which is why long-only commodity funds often lag the commodity they track.

Delivery pressure can also break the link between futures and common sense. On 20 April 2020, the May WTI contract settled at about −$37 per barrel, the first negative price in its history. Storage at the Cushing, Oklahoma delivery hub was nearly full, and holders who could not take delivery paid others to take the contracts off their hands on the day before expiry.

Key Takeaways

• Commodity futures are standardised exchange contracts that fix today the price of a raw material delivered on a set future date.
• Traders post margin rather than the full contract value, and the clearing house settles gains and losses every day, so leverage turns small price moves into large cash flows.
• Most positions are closed or rolled before expiry, but the right to take delivery keeps futures prices tied to the physical market.
• The futures curve matters: contango makes rolling a long position costly, while backwardation rewards it and signals tight supply.
• Hedgers use futures to lock in prices for real business needs, while speculators accept that price risk in exchange for potential profit.