The market where the actual physical commodity is traded is called the spot market. It can also be called the physical market or the cash market. This is similar to the traditional type of market that physical commodities are delivered for immediate sale and use on the spot. There are many local places where the spot market and local spot market price is determined by the local supply and local demand. Consequently, there might be high spot prices at one location and low spot prices at the other location, depending on the local supply and demand.
The actual demand for the physical energy commodity can change over time. In earlier lessons, we learned some of the factors that can affect the demand, for example cold winter days or hot summer days. However, local supply has to be planned by the producers in advance and since producers don’t know the exact demand ahead of time, spot market prices can become very volatile.
Relationship between futures and spot market prices
Basis represents the difference in price between financial and physical markets. Locational Basis is the difference in value between the financial commodity contract delivery point and other cash points.
The relationship between futures and spot market prices can be explained by parallelism and convergence. These two form the basics of hedging and speculation. The effectiveness of hedging is highly dependent on this relationship.
Parallelism explains the close relationship (high positive correlation) between futures and spot market prices. It basically says futures and spot market prices follow each other (vary together) closely, (with a gap or difference that is called basis). Parallelism recognizes the fact that both financial and physical markets are influenced by similar things.
Close to the expiration date, the futures contract price tends to get very close (converge) to the cash market price. It is called convergence. This happens because they can be substituted, meaning that a futures contract close to its expiration date is similar to having an immediate delivery of the commodity in the cash market.
If the futures price is higher than spot, the futures contract is sold at a “premium” to cash. The converse is true when the spot price is higher and the futures contract is sold at a “discount” to cash, this happens when demand in the spot market is higher than the supply and the spot prices go up.
Relationship between futures contracts that expire in different months
As explained in the previous lesson, futures contracts expiring in the later month tend to have higher prices, meaning that the closer expiry month usually has a lower price. This is called contango market.
Contango market represents sufficient supply of the commodity in the spot market to meet the demand. In a contango market, contracts with a later expiration date are sold at a “premium” to closer contracts, and close to expiry futures contracts are also sold at a premium to the cash. The “premium” is because of the carrying charges. For example, let’s assume a consumer needs the commodity in three months. The consumer has two alternatives: 1) buy the futures contracts that expire in three months, or 2) buy the commodity in the cash market now and store it for three months.
There are some costs associated with the second alternative (buying the commodity in the cash market and storing it until it is needed). These costs are called carrying charges (carrying costs) and mainly include storage cost, insurance, and cost of borrowed money to finance the commodity.
Because futures contracts don’t require carrying charges, futures contracts with later expiration dates tend to be traded at higher prices. This is the reason that we usually experience a contango market.
There are also situations where the market experiences the inverted behavior. In such situations, futures market that are expiring in later months are traded at lower prices compared to the ones that are expiring in earlier months. This is called “backwardation” or an “inverted market”. This could happen when there is a supply shortage in the cash market. In that case, spot market prices would be higher than the futures market.
Arbitrage is buying the commodity at low price in one market and selling it at higher price in the other market and taking advantage of the price differences and making profit. Arbitrage causes the difference in prices to eventually decrease by balancing the supply in the two markets.
Locational arbitrage opportunity exists in the spot market as low risk. Spot market is spread out geographically and when the price difference in two locations is higher than the costs (mainly transportation cost) it’s a good opportunity for arbitrage.
As explained earlier, futures prices tend to be higher than spot prices and if the basis (price difference between futures and spot market) is higher than the carrying charges, arbitrage opportunity exists between futures and spot market. This arbitrage opportunity causes the convergence.