In Part 1, we learned about what affects spot prices for natural gas, and discovered the need to hedge against future risk in natural gas markets. How does one do that? One should probably not hide one’s cash in one’s mattress–it’s not doing you any good there!
Hedging one’s Bets: Natural Gas is a Lot Like Pork Bellies
Spot prices form the basis for calculation of prices of commodities futures contracts. In market-speak, a commodity is a physical good that’s pretty much the same regardless of where you buy it, or from whom you buy it; for instance, gold, copper, wheat, pork bellies. Yes, pork bellies are a thing. Contrast commodities with other goods, like, say, smartphones. Smartphones compete on the basis of features and brand loyalty and availability of mobile porn apps, whereas pork bellies are equally disgusting regardless of where you get them. Natural gas, oil, and coal are also the same regardless of producer. There is, of course, a basis grade for every commodity, which is a minimum standard for any given commodity. I mean, you want a uniform sliminess to your pork bellies, right? Right!
A futures contract is when someone agrees to buy a specific amount of a commodity at a fixed price at a specific date in the future. Why would you want to do that? Well, let’s illustrate: want to expand my manufacturing facility 6 months from now. I know I’ll need lots of natural gas to get it going. But I’m worried that the price of natural gas will go up in 6 months. The price seems fair now, but I can’t buy it now and store it until then; I don’t have those kinds of facilities. So, I agree now to buy a certain amount of natural gas in 6 months at a fixed price. This way, I’ve secured a price for the gas, which I believe reduces my future risk. The seller also secures a future buying price, which she believes reduces her future risk. We each hope the other is wrong, to a certain extent.
This contract now exists separately from the actual physical commodity, meaning that the contract, itself, can be traded on a formal market, like the NYMEX or the AMEX. It becomes a financial instrument entirely divorced from the actual delivery of the commodity. In fact, commodities are rarely physically delivered to anyone involved in futures contracts, which seems weird. How does anyone make or save money doing this?
Well, it’s easier and more accurate to think of holding a futures contract as holding a particular financial position with regard to a commodity, rather than having an interest in the delivery of the physical commodity itself. Think of it as a bunch of side-bets between people on future purchases. How does this work?
Detailed example: Skip this if you’re bored
On the futures market, positions are settled daily, with regard to the day’s spot prices. To illustrate: remember my expansion plans? Well, let’s say I bought a futures contract, in which a seller agreed to sell me 5,000 mmBtu (million British thermal units) of natural gas at $4.00/mmBtu in October. I’ve reduced some of my future risk by doing so, because I’ve locked in a price. But, let’s say, the next day, the spot price rises to $5.00/mBtu. That means I’ve profited by $5000. My account is credited with $5000 that day, and the seller’s account is debited $5000. This goes on every day, until the contract is settled. But the settlement is almost always done in cash, not actual delivery of the natural gas. So, let’s say in October, on the settlement date, the spot price sits at $5.00/mmBtu. My futures contract is settled with the seller, and I’ve profited by $5000. At that point, I can go on the cash market (the actual physical delivery market for natural gas), and use the $5000 profit I made on the futures contract toward the physical purchase of gas at the October spot price of $5.00/ mmBtu. This means I effectively secured a $4.00/mmBtu price, because I hedged against the market 6 months earlier.
The weird part:
You don’t even have to want natural gas delivered to you to get into this. Nor do you have to produce natural gas. You can just be a speculator. That goes for commodities futures markets in general. So, in one sense, commodities futures markets are a complicated system of side-bets on the trade of physical goods. These and other trades like them are therefore called derivatives, because they’re, well, derivative of the physical trading of goods.
THE IMPORTANT PART—Don’t skip this, you jerk:
In another, more important sense, futures markets are a complicated information system. Natural gas futures markets in the US, in particular, are indicators of overall perception of future economic risk and growth in domestic manufacturing. You can see how the flow of information is key here. Predictions about the state of economic growth, weather-driven changes in demand, production disruptions, and so on are reflected in spot prices and futures prices.
This flow of information helps with what’s called “price discovery”: basically, more information about supply and demand factors means that the prices of goods can be more accurate.
You’ve probably had a lot of beer since ECON 101, so let’s look at this in a more general way: In a barter economy, I have to know a lot of things to trade with you. If I raise goats, and you make beer, it takes a lot of negotiation to figure out how many goats equals how many beers. Currency helps cut down on that negotiation time. I know how many goats I have to raise to make the $5 I need to buy your beer, without even talking to you, and you know how many beers equals how much money I have (hint: it ends with me dancing badly to “Sexyback” and making out with a parking meter). In a complex global economic system, we need even MOAR information. Derivatives markets interpret a lot of complex information and interconnections, so that we can be pretty sure the price of things like natural gas reflects all that shit.
But people don’t only buy natural gas, and so there have got be more ways for people to hedge their risks. However, it’s not so easy for just anyone to invest in any market. That’s where OTC (over-the-counter) trading comes in. Stay tuned for Part 3! In the meantime, me and this parking meter are gonna get to know one another a little better.