How to Predict Commodity Prices With the Futures Market

A physically settled commodity futures contract obligates the buyer to take delivery of a set quantity and quality of a commodity at a future date. The price to be paid at delivery -- the futures price -- is set at the start of the contract. The futures price is a prediction of what the current, or spot, price will be at the delivery date, adjusted for various factors that affect the cost of holding goods until exchange. Some recent research questions the predictive value of futures markets.

Spot vs. Futures Price

In a free economy, supply and demand determine prices. The spot price of a commodity is the price at which buyers and sellers exchange goods for immediate delivery. Futures contracts postpone the exchange and payment but not the pricing. The delay is called the term of the contract and ranges from one month to several years. Normally, contracts with longer terms cost more than do short-term futures or spot prices; this is called a normal market. An inverted market has lower prices for distant contracts, suggesting rising supply or falling demand over time.

Contango vs. Normal Backwardation

Normal and inverted markets refer to a snapshot of different futures prices for different contract terms. However, buyers and sellers want to know how the prices of their contracts will evolve over time. A market is in contango when the futures price is higher than the predicted future spot price. Contango predicts falling prices. A market in normal backwardation involves futures prices that are lower than the expected future spot price, predicting rising prices. The accuracy of predictions based on contango and normal backwardation depends on many factors, including carrying costs, interest rates and changes to supply and demand.

The Role of Arbitrage

In a contango market, buyers are paying a premium to lock in a purchase price over what they would pay on the spot market if they waited to buy. Sellers reap the premium but take on the added costs of carrying the commodity -- such as storage and financing costs -- until the contract’s delivery date. An arbitrageur who saw that the premium exceeded the carrying costs would sell the contracts and buy the commodity, locking in the excess premium as a profit. This would cause futures prices to fall. Similarly, a market in normal backwardation rewards arbitragers who buy the contract and sell the commodity if the discount on the commodity price outweighs the benefits of owning the commodity until the delivery date. Under these circumstances, arbitrage activity would raise the futures prices of commodity contracts. Arbitrageurs help create futures prices that are rational, based upon the costs and benefits of carrying a commodity until delivery.

Reality Check

A 2013 study titled “The Predictive Content of Commodity Futures” by Menzie Chinn and Olivier Coiboin concludes that, since the beginning of the current century, futures prices have not been a reliable predictor of future spot prices. The researchers show that predicted prices of energy and agricultural futures -- for commodities such as coal, oil, wheat and corn -- are relatively unbiased, meaning they are just as likely to be too high as they are to be too low. However, futures prices for metals, both precious and base, were biased and poor predictors. In all cases, the predictive power of futures contracts has declined steadily since the early 2000s. The authors warn policymakers not to depend on futures prices to predict future commodity prices.

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About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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