What commodity futures are all about
Say you’re a farmer who has just planted a yearly crop of wheat. From a financial perspective, you’re now in the somewhat awkward position of holding much of your net assets in the form of a planted-but-not-yet-ready-for-harvesting field of wheat. This unfortunately means that you’re heavily exposed to the market price of wheat: if, by harvest time, the price of wheat has gone down, you’ll find yourself significantly poorer than expected.
If the price goes up, you’ll be richer, but being (like most human beings) fairly risk-averse, you care less about each dollar of upside than of each dollar of downside. Even if you claim to hold a philosophical stance of complete risk-insensitivity, there’s still the matter of risk making it hard to make plans: you’d like to know what you’ll be able to buy next year! Or maybe you want to take out a loan which you’ll pay back after the harvest, and you want to be able to assure the bank that you’ll be able to pay it back.
As a farmer, you’re unlikely to own wheat futures per se. But you are structurally long wheat futures: that is, your expected future prosperity is much like it would be if you did own wheat futures. In fact, though you don’t own the type of wheat futures sold on futures exchanges, you kind of grow your own: those things standing in your field aren’t quite sheaves of wheat yet, not until harvest time. Right now they are the potential for wheat in the future—that is, they are natural wheat futures. By planting wheat you did the equivalent of buying a wheat futures contract from nature: you’re owed a certain amount of wheat to be delivered come harvest time. 1
Standard financial advice is to diversify your investments: don’t put all your eggs in one basket. 2 If you find yourself structurally long wheat futures, the obvious thing to do to get out of this predicament is to hedge your bets by selling some of them. Instead of waiting for the wheat to grow and then selling it, you should find someone to sell futures contracts to, with the intent of fulfilling those contracts using the wheat now growing in your field; or, in other words, go and sell some of those nature-provided wheat futures that currently constitute a scarily large percentage of your financial portfolio!
Historically, the desire of farmers to do this played a big part in the development of commodity futures markets. Farmers are in a particularly precarious position, with a significant fraction of their assets at any given time being buried underground in a field somewhere. But many businesses are prone to this sort of problem: if you plan on producing a given good, you’re structurally long futures of that good, and likewise anyone who needs a given good as an input is structurally short futures of it. This is bad: after all, you’re trying to run a business, not speculate on future asset prices, in either direction. The way you can escape this trap is by selling futures contracts (for a business with a structural long position, like farming) or by buying them (for a business that is structurally short. 3 )