Commodity Futures Contract

What is a ‘Commodity Futures Contract’

A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future. Buyers use such contracts to avoid the risks associated with the price fluctuations of a futures’ underlying product or raw material. Sellers use futures contracts to lock in guaranteed prices for their products.

BREAKING DOWN ‘Commodity Futures Contract’

Besides hedgers, which are all financial markets, speculators can use commodities futures contracts to make directional price bets on raw materials. Trading in commodity futures contracts can be very risky for the inexperienced. One cause of this risk is the high amount of leverage involved in holding futures contracts. For example, for an initial margin of about $3,700, an investor can enter into a futures contract for 1,000 barrels of oil valued at $45,000 (with oil priced at $45 per barrel). Given this large amount of leverage, a very small move in the price of a commodity could result in large gains or losses compared to the initial margin. Unlike options, futures are the obligation of the purchase or sale of the underlying asset. Simply not closing an existing position could result in an inexperienced investor taking delivery of a large quantity of an unwanted commodity. Speculation using short positions in futures can lead to unlimited losses.

Commodity Futures Hedging Example

Buyers and sellers can use commodity futures contracts to lock in the purchase of sale prices weeks, months or years in advance. For example, assume that a farmer is expecting to produce 1,000,000 bushels of soybeans in the next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels. If the farmer’s break-even point on a bushel of soybeans is $10 per bushel and he sees that one-year futures contracts for soybeans are currently priced at $15 per bushel, it might be wise for him to lock in the $15 sales price per bushel by selling enough one-year soybean contracts to cover his harvest. In this example, that is (1,000,000 / 5,000 = 200 contracts).

One year later, regardless of price, the farmer delivers the 1,000,000 bushels and receives $15 x 200 x 5000, or $15,000,000. This price is locked in. But unless soybeans are priced at $15 per bushel in the spot market that day, the farmer has either received less than he could have or more. If soybean were priced at $13 per bushel, the farmer receives a $2 per bushel benefit from hedging, or $2,000,000. Likewise, if the beans were priced at $17 per bushels, the farmer misses out on an additional $2 per bushel profit.

A sample commodity futures contract for coffee is shown in the following table.

Coffee Contract Specifications
Ticker Symbol Open Outcry: KC (ICE)
Electronic: EKC (ICE)
Contract Size 37,500 pounds
Deliverable Grades Arabica Coffee: A Notice of Certification is issued based on testing the grade of the beans and by cup testing for flavor. The exchange uses certain coffees to establish the “basis.” Coffees judged superior are at a premium; those judged inferior are discounted.
Contract Months March, May, July, Sept, Dec
Trading Hours Intercontinental Exchange (ICE): Monday-Friday
Last Trading Day One business day prior to last notice day
Last Notice Day Seven business days prior to the last business day of the delivery month
Price Quote Cents and hundredths of a cent up to two decimal places
Tick Size .05 cent/pound = $18.75 per contract
Daily Price Limit
(Not applicable in electronic markets)
None

Understanding Coffee Contracts
Like every commodity, coffee has its own ticker symbol, contract value and margin requirements. To successfully trade a commodity, you must be aware of these key components and understand how to use them to calculate your potential profits and loss.

For instance, if you buy or sell a coffee futures contract, you would see an entry that looks like this:

KC8U @ 129.50

This is just like saying “Coffee (KC) 2008 (8) September (U) at $1.295/pound.” (It is standard pricing convention to see the prices of futures such as copper, coffee, sugar and orange juice quoted in cents per pound. In this case, $129.50 is equal to $1,295 per pound.) A trader buys or sells a coffee contract according to this type of quotation.

Depending on the quoted price, the value of a commodities contract is based on the current price of the market multiplied by the actual value of the contract itself. In this instance, the coffee contract equals the equivalent of 37,500 troy ounces multiplied by our hypothetical price of $129.50, as in:

$1.295 x 37,500 pounds = $48,562.50

Commodities are traded based on margin and the margin changes based on the market volatility and the current face value of the contract. For example, a coffee contract on the Intercontinental Exchange could require a margin of $4,900, which is approximately 10% of the face value ($4,900/$48,562.50), Maintaining the minimum amount of margin required by the broker, which in this case equals $4,900, gives an investor the ability to control a sizable position despite a relatively small capital outlay. (For more on how markets work for this type of commodity, see The Sweet Life Of Soft Markets.)

Calculating a Change in Price
Because commodity contracts are customized, every price movement has its own distinct value. In a coffee contract, a .0005 cent move is equal to $18.75. When determining ICE’s coffee profit and loss figures, you calculate the difference between the contract price and the exit price, and then multiply the result by $18.75. For example, if prices move from $129.50 to $140.20, you divide the difference, which is $10.70, by five to get $214, and then multiply $214 by $18.75 to yield a contract value change of $4,012.50.

Buy Sell Total Value
Coffee Contract Price (.0005 cent move = $18.75) $1.295 $1.4020 0.1070 cents or $4,012.50



Coffee Exchanges
The futures contract for coffee is traded at the Brazilian Mercantile and Futures Exchange (BM&F), Intercontinental Exchange (ICE), Kansai Commodities Exchange (KEX), Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), Singapore Commodity Exchange (SICOM), Tokyo Grain Exchange (TGE) and NYSE Euronext.

Facts About Production
While coffee production occurs around the world, primary production is dominated by countries such as Brazil, Vietnam, Indonesia and Colombia. Each of these countries has built a thriving business based on exporting coffee around the world. In 2005, Brazil produced 2 million metric tons of coffee beans, which is over twice as much as Vietnam, its nearest competitor.

The two types of coffee beans are Arabica and Robusta. Arabica beans are considered the most flavorful and in turn command a premium in the market place. Robusta beans tend to be more bitter and less palatable, but they have a 50% higher concentration of caffeine than Arabica beans.

Coffee beans come from a small evergreen bush. When they reach maturity, which takes anywhere from three to five years, the bushes blossom and the coffee berry, which starts out as a small green pod, can be picked and dried. The seeds are removed and roasted. The roasting process is what gives coffee its distinctive taste and attributes. Coffee beans that are lightly roasted tend to be more acidic and bitter tasting, but they also have more caffeine. Coffee beans that are dark roasted have a smoother taste because they have less acid and more sugars resulting from the heating process.

Factors That Influence Coffee’s Price
The price is influenced by the following factors:

  • Arabica beans are primarily grown in Central and South America. These are higher quality beans that command a higher price, which has helped Brazil to become the largest coffee exporting nation in the world. At the same time, it has left Brazil exposed to competition from the cheaper coffee bean, Robusta. This Achilles heel has allowed Vietnam to develop a strong coffee industry around the cheaper Robusta bean, putting Vietnam second in the world in coffee exports.
  • Four major corporations dominate the Robusta coffee world. Kraft, Nestle, Proctor & Gamble and Sara Lee account for more than 50% of all Robusta coffee bean purchases, preferring Robusta beans to Arabica beans solely because of their price. On average, Robusta beans are 70% cheaper than Arabica beans, allowing for greater mass production uses.
  • Fair trade coffee is slowly gaining popularity. Fair trade guarantees coffee growers a set price prior to harvest. This has led to more privately negotiated deals with coffee co-ops around the world. In 2004, it represented 24,222 metric tons, according to the Max Havelaar Foundation, and 33,991 metric tons in 2005.
  • Numerous studies have found that drinking coffee might help reduce the risk of diseases such as Alzheimer’s, cirrhosis of the liver, gout and others, significantly outweighing some of coffee’s known health risks. Scientists are still attempting to determine all of the applications that coffee may have, which is good news for the millions of coffee drinkers worldwide.
  • Coffee is a key cash crop in various developing countries. Coffee accounts for 60% of Ethiopia’s exports. The current belief is that more than 100 million people in these countries depend on coffee as their primary source of income.

Conclusion
Millions upon millions of cups of coffee are consumed throughout the world each year. From its origins in the ninth century to its humble commercial beginnings at the Kiva Han to its mega-star status in today’s modern arena, coffee has cemented its position as an essential traded commodity.

Read more: Commodities: Coffee http://www.investopedia.com/university/commodities/commodities2.asp#ixzz4hoVJrTtT
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