How commodities trade: Contracts: from a handshake to a clearing house

1.1 Spot, forward and long-term contracts each solve a different problem

A spot deal is a sale for immediate delivery, or for delivery after only the lag that loading and shipping require. Beyond that lag, Geman notes, the deal becomes a forward. A forward is bilateral: two parties fix quantity, grade, place, date and price today for delivery later. It can be tailored exactly, but each side carries the risk that the other defaults, and a unique contract is hard to sell to anyone else.

Most physical trade runs on bilateral contracts. Radetzki and Wårell call this the predominant arrangement in cross-border trade, ranging from a single cargo to repeated deliveries over a decade or more. Long-term contracts exist because large mines, smelters and power plants want assured outlets and supplies. They rarely fix one price for ten years. Instead they fix volumes and a formula, so the price floats with an exchange quote or a published assessment, usually as a monthly average. Copper concentrate, for example, is sold at the LME price less treatment and refining charges negotiated with the smelter, as Tilton and Guzmán describe.

Where no reference price exists, contracts become opaque. Uranium is mostly sold on long-term contracts whose prices are scattered and poorly reported, while the published series covers only a thin spot market. Producer prices, set by a dominant seller on a take-it-or-leave-it basis, survived in diamonds, platinum group metals and potash. Transfer prices inside vertically integrated firms, once common in oil, copper and iron ore, still dominate bauxite and alumina.

• Radetzki & Wårell (2021), A Handbook of Primary Commodities in the Global Economy · pdf pp. 117-122
• Geman (2005), Commodities and Commodity Derivatives · pdf pp. 14-18
• Tilton & Guzmán (2016), Mineral Economics and Policy · pdf pp. 95-98

1.2 A futures contract is a standardised forward with a clearing house behind it

A futures contract has the same economics as a forward, but the exchange fixes every term except price: quantity, grade, delivery place and delivery months. Because every contract for a given month is identical, a position can be sold at any moment to anyone.

The clearing house makes this possible. Once a trade is matched, the clearing house becomes buyer to every seller and seller to every buyer, so its net position in each commodity and month is always zero. Traders no longer need to trust each other, only the clearing house, which is backed by its members.

The clearing house protects itself with margins. Radetzki and Wårell describe an initial margin of 10-20% of contract value and daily marking to market. Their example: a buyer commits to $10,000 of a commodity and posts $1,500. If the price falls 20%, the buyer would rather walk away, lose $1,500 and buy the goods elsewhere for $8,000. So the clearing house calls for more cash well before the margin is used up, and if none arrives it closes the position and pays the loss from the deposit.

Leverage follows directly. Morgan gives a 1970s soybean case: a 5,000-bushel contract at $8.00 is worth $40,000 but needs only $4,000 down. A move to $10.00 costs the seller $10,000, two and a half times the deposit. Margins are a guarantee, not a ceiling on losses.

The price of this safety is rigidity. A futures contract rarely matches exactly what a hedger owns, which is the origin of basis risk.

• Geman (2005), Commodities and Commodity Derivatives · pdf pp. 16-18
• Radetzki & Wårell (2021), A Handbook of Primary Commodities in the Global Economy · pdf pp. 143, 149-151
• Morgan (1979), Merchants of Grain · pdf p. 462

1.3 Delivery, warehouses and storage tie paper prices to physical goods

Geman reckons that only about 1% of futures contracts end in delivery. Most are closed by an offsetting trade or swapped for a negotiated physical deal, an exchange for physical. Delivery still matters, because the threat of it forces the futures price to converge with the spot price at expiry.

To make delivery credible, an exchange specifies date, location, composition and shape, licenses brands and warehouses, and usually gives the seller the choice of what to deliver within the specification. Metal in an approved warehouse is held as warrants, which the clearing system allocates to buyers. Because sellers deliver the least valuable acceptable material, a buyer who needs a particular brand or place pays a physical premium on top of the exchange price. Geman puts it generally below 1% of the price, occasionally as high as 10%.

Storage links today's price to future prices. When stocks are ample, futures trade above spot, a contango. Arbitrage caps it: if storage costs 3% a year and interest 4%, the 12-month price cannot sit much more than 7% above spot, or traders will buy spot, store and sell forward. When stocks are scarce, spot trades above futures, a backwardation. No arbitrage caps a backwardation, because nobody can borrow from future harvests. What limits it is the convenience yield of holding stock: at some premium, holders release inventory.

The shape of the curve therefore reports on inventories. A deep contango says stocks are heavy; a steep backwardation says the market is short of material now.

• Geman (2005), Commodities and Commodity Derivatives · pdf pp. 25-27, 182-185
• Radetzki & Wårell (2021), A Handbook of Primary Commodities in the Global Economy · pdf pp. 153, 156-157
• Blas & Farchy (2021), The World for Sale · pdf pp. 99, 104-107

See it in the table

Check your understanding

Why does a futures buyer face a margin call before the initial deposit is used up?

Storage costs 3% a year and interest is 4%. What roughly caps the 12-month contango?

What did the 1985 tin default lead the LME to create?