It should be easier to get an insight into futures markets, and so I will start with a recent announcement about the natural gas futures market.

On the New York Mercantile Exchange, natural gas for delivery in November hit an intraday low of $2.410 per million British thermal units (Btu), before ending the day at $2.430, down 2.3 cents, or 0.94%.

That statement is what I call special! I have published and lectured in many countries on oil ‘futures’ (= oil futures markets), where the amounts being bought (going long) and sold (going short) were barrels. My first lectures on this subject though were on copper, where the buying and selling was also in physical units. But here the trading is in HEATING UNITS (or millions of Btu of natural gas). If that is too rich for your blood, as it once was for me, let me suggest that you examine the appendix to this contribution, or better, a short and non-technical discussion in my book ENERGY AND ECONOMIC THEORY involving two young finance geniuses called Millicent and Condi, who are going long in oil futures after unexpectedly receiving some very special private information – the kind of information that enables people to become rich.

In any event, futures trading is centuries old. John Cary has described the “disposal” of brandy on the Amsterdam market in 1695 via a scheme that did not require the commodity to be delivered, while it is said that during the Middle Ages techniques were developed in Japan designed to guarantee the forward delivery of silk at previously agreed on prices. Although such conveniences as clearing houses for the settlement of contracts do not seem to have been a part of the Japanese experience, it is very possible that the mechanics of these transactions were akin to those employed on modern futures exchanges.

(OBSERVE: A clearinghouse is a ‘non-profit’ entity affiliated with a futures or options exchange. It monitors/supervises clerical activities associated with buying and selling, paying particular attention to transactions that have to do with the offsetting (i.e. reversing)of ‘open’ futures positions, since these ‘close out’ those positions. If necessary, the clearinghouse makes sure that the commodity in question is delivered to or shipped from the official delivery point, and if contracts are settled by cash instead of delivery, it might do some of the necessary accounting.)

Futures markets operate as follows. Against a background of speculators ‘betting’ on the direction and size of commodity price movements by buying and selling futures contracts, an impersonal agency can be created which permits producers, consumers, inventory holders and various traders in physical products to reduce (i.e. hedge) undesired price risk. This process will be described below.

The success of a futures market is dependent on the satisfaction of a number of well-defined criteria. Among the most important are that the commodity in question can be traded in bulk, is susceptible to grading, is relatively imperishable, attracts a lot of attention from market actors, and almost as important as the last item, the physical commodity is bought and sold in circumstances that cause its price to fluctuate in a random or non-systematic manner. Without this latter provision, speculators are unlikely to be attracted to the commodity, and without considerable speculation (i.e. the provision of liquidity), futures markets will not function properly. This observation deserves repeating: without considerable speculation (i.e. the provision of liquidity), futures markets will not function properly.Put another way, transactors in a physical commodity (e.g. buyers and sellers of physical crude oil and natural gas) can employ futures markets to reduce price risk only if other traders and/or speculators are willing to accept this risk.

The social gain from futures trading derives from the voluntary redistribution of risk between speculators and risk-averse dealers in physical products. The belief here is that in the oil market this gain is considerable, and everyone is made better off by the presence of e.g. oil derivatives markets, and as far as I can tell, this applies to the futures market for natural gas. (OBSERVE: A derivatives market – where price is derived from what takes place in another market – can be based on organized exchanges, or over-the-counter arrangements. The price of derivatives – e.g. futures and options –is ultimately derived from the price of the underlying – e.g. of natural gas or oil. The underlying is also called ‘actuals’.) Exchange traded derivatives are standardized assets whose trading is characterized by margin requirements (which ensure payments to and from buyers and sellers) while over-the-counter derivatives – which are often encountered for options and swaps – are privately negotiated bilateral agreements that are independent of organized exchanges and their ‘transparent’ prices.)

Now we can look at some aspects of hedging. As already noted, if a speculator believes that the price of a commodity is going to rise, she buys futures contracts – goes long. These contracts are referred to a certain delivery month, and often the first day of that month, in which case we can speak of the expiry month or expiry date.In a very liquid market, before the contract matures, this ‘long’position canbe easily offset – i.e. reversed – by the sale of futures for the same delivery date or month. When this is done, the position of Ms Speculator is registered as closed.If the sale price of the contracts is higher than that at which they were bought, then she has made a profit.

 One measure of liquidity is Open Interest! This is the total number of open contracts, long or short – but not both – in a given market. A transaction involving a buyer and seller that is not a reversing trade will increase the open interest by one contract – note, one and not two contracts! Open interest can be regarded as a measure of liquidity, and the greater the open interest, the easier it should be to open or close a position. This is because there are a large number of (open)contracts – both long and short –that are candidates for a reversing transaction.

Similarly, if she had begun by selling contracts – going short – and (taking into consideration brokerage costs) the price at which she made an offsetting transaction (a buy or going long)was lower than the original sale price, she has also made a profit. This is also what the hedging of oil and gas prices that was mentioned earlier is all about. The trick, however, is to hedge before the fall in price takes place, and not after.

Something that is often forgotten or ignored is that the maturity of these contracts is for the most part less than six months. The talk about futures contracts for oil or oil products with a maturity of three or four years does not deserve much credibility, because there is inadequate liquidity for contracts of that maturity.(OBSERVE: A semi-formal definition of liquidity might be the ability of individuals to obtain cash with minimal delay by selling an asset.Market liquidity means that large sales and purchases can take place without unduly moving market prices.In a ‘thin’ market dramatic price movements can .)

If this is clear, the mechanics of hedging can be considered. Hedgers also buy and sell futures contracts, depending upon whether they want to guard against price rises or price falls. Consider, for example, someone who has contracted for a given quantity of natural gas or crude oil, but does not know the price at which this oil will be delivered because the seller insists that buyers will be charged the price prevailing on the spot market at the time of delivery. The buyer thus faces considerable price risk in that the price of the commodity might rise sharply; however a risk-averting buyer can ‘lock in’ a price in this situation by buying futures contracts at or around the same time they contract for the underlying (e.g. physical oil). These futures (i.e. paper) contracts should have a maturity (expiry) date at or close to the date on which the oil will be delivered. Then, around the time that the oil is delivered, they make an offsetting (i.e. reversing) sale of futures. If the spot (i.e. market) price of the oil rises, this transactor takes a loss on the physical transaction, however compensation will be gained on the sale of the futures.

Note also that even if no contract is signed between a specific buyer and seller, for someone who is going to buy a commodity in the future, a resort to futures might be judged wise. If both physical and paper prices for a commodity rise at roughly the same average rate, which generally tends to happen, the loss on the physical purchase will be (partially or totally) compensated for by the gain on the futures transaction. What about sellers of natural gas? If they are afraid of a price fall they sell futures (i.e. go short). If the price of physical gas falls the price of paper gas should also fall, with the loss on the physical transaction being compensated for by the gain on the futures contracts. (This is worth understanding, because there is considerable talk at the present time about the price of oil and gas in the near future!)

One thing remains to be done in this section, which is to provide a brief discussion of the convergence of physical and futures prices. This topic is discussed at considerable length in my textbooks, however readers should make an effort to comprehend the following.

Formally, the proposition that is being put forward is that in the delivery month or date specified on a futures contract, the futures price and the physical market price of the commodity (e.g. oil) must be very close. If this is not the case, arbitrage comes into the picture! If there was a discrepancy between the two prices, either buyers or sellers of the contract would become involved with delivering or taking delivery of the commodity, as well as buying or selling on the physical market. (OBSERVE: Arbitrage can be explicitly tied to the law of one price: there cannot be different prices in the same market for identical goods! Stockholm and Uppsala are essentially in the same market for certain goods. If the price of a designer shirt is higher in Uppsala than in Stockholm, then I might travel to Stockholm and buy the shirt, which I sell in Uppsala.)

Suppose, for example, that the price of oil on a futures contract was posted as $75/b, while the price of oil in the physical (spot) market was $80/b.Someone who has bought a futures contract perceives this difference, and does not make an offsetting (i.e. reversing) sale. Instead they accept delivery on the contract, and immediately sell it on the spot market. This yields a profit of $5/b. Arbitrage of this nature – i.e. taking delivery and selling the commodity will tend to drive down its spot price. There will also be an increased demand for futures (in order to take advantage of this arbitrage situation) which should raise their price. In a very short time the futures and spot prices should be very close.

Deliveries are not common in the oil futures market, and cash-settlement of course reduces deliveries even more. The detailed mechanics of cash settlement will not be taken up in this exposition because this is really a simple matter. If cash settlement prevails in a market, and a ‘player’ decides not to or forgets to close out his or her (open) long or short position, then at what was defined as the expiry date of the contract, the player’s broker would receive whatever he or she had gained on that transaction – assuming that it was a gain.The price employed to calculate gains or losses was either the market price or a price close to the market price and specified (or authorized) by the clearing house.Moreover, cash-settlement reduces transaction costs because it is unnecessary to be concerned with moving and storing a physical commodity such as natural gas or oil.