Raw material prices have been on the rise since the Russian invasion of Ukraine. Prices of wheat, corn, oil and gas reported in the media, including Boerenbusiness, are mostly quotes on the futures market. But how does the futures market work again and how are prices established?
Basically, a futures market is nothing more and less than an instrument to record the future purchase/sale of a product on the financial market. In this way, a buyer or seller early hedges a price risk for a product that he has to buy or sell on the physical market in due course.
An example: a grain grower has x number of hectares of wheat that he can store himself. In September 2021, he will already start investing in cultivation: the seed is bought, the land is plowed and the wheat is sown and there is already quite a bit of money in the cultivation before the winter. This increases further in the spring with the purchase of fertilizer and crop protection, and in the summer and autumn the costs for harvest and storage are added. All the while, the grower is at risk, while he will not know what he can get for the wheat until December 2022. The futures market offers the possibility to hedge that risk by already selling (part of) the expected harvest during the season. Suppose in January the contract for December is €250 per tonne. The grower thinks this is a good price and decides to sell his harvest on the futures market.
settlement
The wheat contracts on the Matif, but also, for example, on the CBoT, are subject to physical delivery. On the Matif this means that on the expiry date of the contract, the wheat - which must meet the specifications of the contract - must actually be delivered by the seller to a silo in Rouen on the date stated in the contract, where the buyer then should load. At the CBoT in Chicago, the corn and wheat are divided among twelve ports in the United States. The EEX potato futures market does not have this obligation. Here the contracts are settled on the basis of cash settlement, an average of the physical quotations.
However, actually letting a wheat contract expire is rarely done. According to the literature, on a futures market (be it oil or wheat) only 1% of contracts are actually delivered. If we go back to the example of the grain grower, this means that before the expiry of the futures market contract, he physically sells the wheat through his usual channel and at the same time buys back the contract on the futures market, thereby reducing his position. If the price has remained the same from January to December and the physical market is in line with the futures market, the grower sells his wheat to a buyer of choice on the physical market for €250 per tonne. The grower thus 'buys' back his contract on the futures market for €250 and the wheat has effectively yielded €250.
If the price has fallen during the year, the picture looks different. Suppose the price has dropped to €200 per tonne in December. For that price he sells his crop to a trader on the physical market and for that price he can also buy back his contract on the futures market. Effectively, he would still have sold his wheat for $250 per tonne, $200 in the physical market plus $50, which is the difference between the futures market contract $250 in January minus $200 in December.
The same mechanism also works the other way around when prices rise. When the price rises to €300 in December, the grower sells his wheat to the buyer at this price, but he also has to buy back his contract for €300. Effectively, the price at which the grower sold remains €250 per tonne. $300 in the physical market minus $50 the difference between the January and December futures contract. In the example we have assumed a selling party. The same principle applies to buyers, but in reverse.
Futures market also has risks
The futures market is an instrument for hedging risks, but that does not mean that there are no risks associated with the instrument. Think, for example, of differences between what is paid on the physical market and the price of the futures market. Futures market contracts with physical delivery have a kind of escape in that respect. If the difference is too great, sellers can sit out the contract and accept the cost of physical delivery. This option is not available for markets that operate on the basis of a cash settlement and settlement must take place on a quotation that is a good and realistic reflection of the physical market. The EEX potato futures market works with a mix of quotations in Belgium, Germany, France and the Netherlands. For example, the CME Group (the parent company of CBoT) works for slaughter cattle with USDA prices. If the futures market is significantly higher than the physical market and the cash settlement, the seller has to make up for that difference.
In addition, trading on the futures market can also place a heavy burden on liquid assets. As has become clear in the example, a player in the futures market must be able to make up for the difference between the historical buying or selling price of the futures market contract. A bank that grants the participant access to the futures market therefore requires that this difference be paid into the futures market account. If we go back to the example and the grower has sold for €250 and the current price is €300, the difference of €50 must be paid into the futures market account so that the bank and the stock exchange can be sure that the buyer is able to fulfill his obligations. to come.
Suppose a grower has 50 hectares of wheat and counts on 10 tons per hectare, then the harvest will be 500 tons. When half of this (250 tons) is hedged at €250 per ton, there is €62.500 in the bank account. If the futures market suddenly starts to move (as is now due to the war in Ukraine) and the price rises by € 100 per ton in a few days, that difference must be immediately supplemented. In this case, an additional €25.000 must be deposited. This puts considerable pressure on the liquidity of the selling party. In the example it is a limited volume, but consider what that means for large players who have thousands of tons in position. Then you talk about millions that have to be paid in a few days. That money has to be there, because rules are tough in that area to guarantee financial security in the futures market. Failure to top up in time means that positions are forced to cut (liquidation).
speculators
Until now, we have not taken into account one large group that is active in the futures market. After all, not only players who actually trade wheat are active on a futures market, but also speculators. They run no price risk on wheat that actually has to be bought or sold - the underlying asset - but use the price changes to make money on the futures market. Suppose the speculator makes a (technical) analysis of the wheat market and concludes that the wheat price on the futures market is low and that it is likely to rise in the near future. For example, he buys contracts at €250 per ton in the hope of selling them later at, for example, €275 per ton. An important part of trading on the futures market is done by speculators. In a normal market, the speculators act like oilmen in the market, filling the gaps between buyers and sellers.
When the market is seriously disrupted, other forces are released. With a rapidly rising price, a speculator can earn or lose a lot of money in a short time (often in hours) and that attracts interest. The speculator enters with the expectation that the price will rise quickly. Based on a technical analysis or psychological barrier, he determines a price level at which he wants to exit. When that price is reached, he takes his winnings and gets out again. That profit can then be used to repeat the same trick in the still volatile market. As a result, the price is inflated and for the speculator the trick is to determine when the balloon will burst and then be off the market.
Supervisors find this undesirable and also dangerous behavior. Prices can be manipulated by major players and in a short time (minutes) huge course changes can occur. This extreme volatility contributes to a crash in a market. As a result, stable parties can in principle get into serious trouble. If we go back to the grower in our example, every time the price rises, he has to pay the difference into his futures market account and there are limits to this even for a financially very strong company. Exit without major losses is not possible and the seller is trapped in his position.
In 2010, such an event occurred on the Dow Jones Industrial Average, causing the stock to lose 1.000 points (just under 10%) in ten minutes. To prevent such extremes, various exchanges work with a limit up/down. This means that there is a daily price range between which a price may move. When the limit is reached during a trading period, various actions can be taken that are defined in the stock exchange rules. Depending on the market, trading may be temporarily suspended and the limit may be shifted, the limit may be held or trading for that day may be halted altogether. These differences in rules can also partly explain differences between, for example, the price movements on the Matif and CBot.