Commodity Markets for Dummies (or the Left)

While following a Twitter Conversation last night between one individual who self identifies with conservative viewpoints and an individual who obviously identifies with the left, the conversation turned to the subject of the Commodities/Futures Market.  Of course the gut reaction of the leftist individual was to condemn it and supported increased regulations which would lead to their elimination.  The conservative/constitutionist, who was obviously well educated on why the Commodities Markets exist and how they work, supported the need for the markets and generally a hands off approach.

The standard left line about the Commodities Markets is that the speculators are evil because speculation drives up the price of the commodity and in turn increases the cost to the consumer and therefore no benefit to society.  This may be true in some cases but usually those effects are short lived and prices do return to levels supported by the current supply and demand.  Also speculation tends to be a zero sum game with the money lost equalling the money gained within the market itself unlike the stock market where wealth is generated and increases over time are due to better production methods and higher efficiency.

So if the expected outcome within the Commodities Markets is actually equal to zero why do people speculate and why does the market exist.  It exists for one reason and one reason only.  It exists to provide a certain amount of economic stability to the producers and consumers of commodities.

Lets look at the following example for Farmer Brown.

First the facts:  Farmer Brown has a farm with 5,000 workable acres.
                         Due to soil and location he can grow Corn or Soybeans.
                         Decision for Crop Type occurs 1 April.
                         Planting usually occurs in early May
                         Harvest occurs in late August
                         Crop is available for delivery in September

Farmer Brown notes that his expected profit based on the 1 April prices is about the same for both crops so he decides to grow Soybeans since there are some rumors going around that there is going to be a shortage of Soybeans come September when his crop will be available for delivery.  Futures markets do not exist for Farmer Brown so he has no way to hedge his decision.  Come September he finds out that everyone grew Soybeans and the price drops by 50% causing an actual loss.  He can no longer pay his mortgage and he is foreclosed and is thrown out into the street.

Farmer Smith has the same size farm and the same decision to make only that in his country he has a Commodities/Futures market which allows him to lock in his price today for delivery later on.  Whether the price goes up or down he has a set price, and a set profit which he uses to pay off his mortgage, send his kids to college, and not be a drag on society.

But how does this Commodities Market mumbo jumbo work?  Farmer Smith has chosen to grow Corn since he has seen a bit of downward pressure on the price of Soybeans for September delivery and an uptick in Corn for the same month indicating there may be higher demand for corn.

Based on 180 Bushels/Acre for Corn Production he is expecting to produce 900,000 bushels of corn. Corn Contracts are normally written 5,000 bushels per contract so Farmer Smith decides to lock in the current futures price of corn at $5 per bushel for September delivery and sells 180 contracts.  This is a short position therefore a drop in price will cause him to profit in his Futures Contracts but that in turn will be eaten up by his losses with regards to the actual corn he sells.  Lets say at delivery the price per bushel has fallen to $4 per bushel.  Because of his short position he has profited $900,000 in his futures contract but in turn he will receive $900,000 less than he originally expected for his crop that he produced.  He has successfully hedged his risk and he locked in the price with little to no risk.  It allowed him to successfully plan his business for the year by transferring his risk to the speculators.

The commodities market will also give indication of anticipated future supply.  The producers are selling futures to hedge their risk.  If there is a drop in the futures price it indicates that the commodity may be overproduced and the market self corrects by driving the producers to under produced products.  Adam Smiths "invisible hand" which directs Market Capitalism is evidently displayed within the Commodity Markets everyday. Laissez Faire at its best.

Commodity Markets ensure that supply and demand are properly met and allows for future economic planning.  Elimination of the commodity markets is possible but that leads to two things.  Starvation for the entire nation or a Command Economy.  A Command Economy usually takes the form of State Socialism, Communism, or Facism.  So next time you hear a leftist state that commodity markets should be eliminated ask them what will take the place of the markets and who will set the prices?