Supply and demand is a key economic concept that attempts to explain what the market is willing to pay for a given product, where the quantity produced is equal to the quantity demanded. This interaction is key to the analysis of the price of a futures contract.
Fundamental analysts will use their knowledge of supply and demand factors to create their opinion of whether the futures contract is fairly valued, and if price will increase or decrease.
The factors that affect supply and demand are numerous and highly interrelated, the behavior of the markets is complex. Traders must focus on the key variables they feel are most the important price influencers for each commodity.
Some of these factors include:
- Unique factors for a specific market
- Interactions with other interconnected markets
- Interactions with the broad economy
- Natural cycles
- Spot and futures pricing
Unique Market Factors
Some markets have factors that will affect supply and demand uniquely for that market, and have little to no effect on another market.
For example, weather plays a very important role on the supply side of agricultural commodities, like soybeans, but may not be as relevant for markets like gold or equity indices. Traders will become familiar with the specific factors that impact their industry, and keep track of these factors as they trade.
Crops have a few key times during their growing cycle where weather can have a major effect on harvest yields; planting, growing and harvesting. If the climate is too wet or too dry during these times, supply might be adversely affected. But if conditions are favorable through the entire cycle, yields might increase. In some years there might be excess supply and in some years there might be low supply.
On the other end of the spectrum, weather will play less of a role in the supply of gold, or crude oil, where mining and drilling activities are less affected by weather.
But gold is much more impacted by changes in inflation than soybeans.
Supply and demand can also be connected; there are times when one futures contract might represent an input for another. The futures markets are interrelated and this relationship that can be calculated and analyzed by the fundamental analyst.
For example, corn can be used as livestock feed and in the production of ethanol. A corn trader might look at the corn market and its relationship to cattle, as well as its relationship to ethanol.
Another example is Crude Oil and Gasoline futures. Where the price of Gasoline futures can be influenced by supply and demand for gasoline and the price of the input commodity.
If a trader only focuses on supply and demand for one market, they might miss an important effect from a related market.
Economic variables are also very important to the pricing of futures contracts.
Economic data is released at regular intervals and can have a dramatic effect on prices in one sector. There are dozens of economic data reports released daily, with calendars available online. Most of the data will not directly impact the market when it is released but some data releases have the potential to move the market with every release. Announcements like the unemployment rate, GDP and FOMC interest rate decisions are powerful market movers and are watched closely by traders.
Traders should be aware of economic release dates and its related market impact, as not all data will always have the same impact. It is important to understand how the data fits in to the current economic landscape and whether the market has determined that it is important or not.
At times, certain data will have more of an effect on the markets than at other times. When Crude Oil was around $100, Crude Oil Inventory Reports effected, not only on Crude, but also the S&P 500. If we look at the current impact of the reports, it is limited to the energy market, making the report less important to traders of other markets.
Housing is also an indicator that has varied effects. As the economy pulled out of the market downturn of 2008, housing statistics were very important, as mortgages and credit were a large factor in the downturn. For a long time after 2008 traders eagerly anticipated the release of the newest housing data, which influenced the broad market. Now that mortgages and credit are less of an issue, housing numbers have a limited effect on the broad market.
All futures contracts will have an economic release that is specific to their sector.
For example, USDA crop reports are specific to agricultural futures, and detail plating conditions, progression of growth and harvest results. They are updated through the agricultural season, and futures prices react to the data, moving up if forecast crop yields are down and moving down if crop yields are higher than expected.
Another unique report for agricultural traders are weather reports, as overly wet or dry conditions can impact crop yields and ultimately price.
Since many futures represent commodities that do not have a continuous, supply like corn, or commodities that are in higher demand at certain time of the year, like heating oil, these seasonal patterns of supply and demand create natural cycles that influence the price of futures contracts.
For example, crops are grown and harvested during specific months of the year, once harvested, supply will not increase until next harvest.
Fuel-related commodities, like heating oil, have a naturally higher demand at certain times of the year. During the winter months, heating oil has more demand because many homeowners use the fuel to heat their homes.
Spot and Futures Pricing
Another unique variable in pricing futures, is the fact that they price a market at a certain time in the future, whereas spot prices refer to the price you pay if you want to buy a commodity today.
The futures market is priced based on delivery at a certain point in the future. This means the spot price and the futures price will be different over the life of the futures contract and only converge at expiration of the futures contract. Futures and spot prices will converge and diverge over time.
Contango and Backwardation
There are natural relationships to the spot price that form in the futures markets. For example, Crude Oil futures have a different relationship to spot price than Soybean futures. Futures and spot markets can have two kinds of relationships: contango and backwardation.
Contango is the most common relationship, where the futures price is higher than the spot price. While some futures will trade in backwardation, this is a relationship where the spot price of a commodity is higher than its futures price.
The fundamental analyst will determine if the relation between spot and futures prices are in their normal relation or not. This will have an impact on how prices will move in the future.
For example, non-agricultural products typically trade in contango, where the futures price is higher than the spot price. This is typically due to the carry cost of buying at the spot price now, storing the commodity, like copper, and selling it in the future. The holder of the physical commodity would have to be compensated for the costs. Therefore, the futures price is higher; if not, there would be arbitrage opportunities.
Agricultural products, however, typically trade in backwardation, where the futures price is less than the spot price. The reasoning behind backwardation is because once harvested, supply can only decrease until the next harvest, creating a situation where spot prices can be higher nearing the end of the supply cycle. Futures contracts that expire after the next harvest can be cheaper since supply will be higher after the next crop is harvested.
The trader will want to know the typical situation for the futures contact they are trading and pay attention if the contract shifts from contango to backwardation or vice versa.
Each futures market will have its own supply and demand factors, a trader will want to determine the most important factors and carefully piece together the data to build their analysis and trading decisions.
Peter Knight Advisor