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Why would a company enter into a futures contract to sell more of a commodity than it expects to produce?

Oct 21, 2014 by John from Tulsa, OK in  |  Flag
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John Essigman Level 17

Hi John,

The other side of your question is why would someone enter into a contract to buy something that has not yet been produced? In business, why does anyone buy or sell anything? In anticipation of a profit or to limit losses.

In the case of futures, it gets even weirder in that very few contracts actually end up with an actual purchase, delivery or sale of the actual commodity. The seller of the contract does not need to have possession of the commodity and the buyer may have no intention of taking possession of the commodity. A futures contract is an agreement to deliver a specific quantity of a commodity at a future date at a set price.

A producer growing soybeans today might have a 4 month lead-time from planting to harvest. If a farmer is planting soybeans today and currently selling for $10 a bushel there is a very high risk that the price will change by the time to harvest. A soybean farmer can protect his position by offering a futures contract on that harvest. So if the price of soybeans goes down, he must sell his product at the prevailing price but will recoup the difference on the futures contract by buying back his contracts for less than what he sold them for. If the price of soybeans is higher he will make a higher profit than anticipated on the soybeans but must buy back the futures contract at a higher price.

It is one thing for a producer to do this to protect themselves. It is yet another thing to speculate on the price of some commodity in the future. You might be better off going to Vegas… and a lot more fun.

Comment   |  Flag   |  Oct 22, 2014 from Cleveland, GA

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Hi John,

As John Essigman pointed out above, commodities producers often "hedge" their production proceeds by purchasing futures contracts. As you imply, they often lock in the price of their crops via futures contracts. Thus, if the market price of their crop falls they still command the contract price.

To answer your question, I think two things often happen with commodities producers. First, the producers are not entirely sure how much they'll produce in a given time frame. It's therefore likely that they sell more than they expect to produce just to be conservative. A "better safe than sorry" approach.

Secondly, many large commodities producers are very active in the futures markets as previously described. British Petroleum, Chevron, and other oil companies have massive commodities trading operations. I think as they become more engaged in the futures markets, their confidence grows, and they are more likely to speculate on the price of their own crops. Thus the first trade may be a traditional hedge, while the excess constitutes a speculative bet.

Hope this helps.

Comment   |  Flag   |  Oct 30, 2014 from Lake Oswego, OR

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