In reading the coverage of the recent move in Natural Gas, I have noticed what I think is a significant misconception about how commodity markets function. Commodity futures contracts (The front month being what most people are referring to when they say the “price” of a particular commodity) do not represent the price of the commodity “In general” or “in the long run”. Commodity contracts represent the supply/demand for the commodity to be delivered at a specific time and place. For example, here is the contract specification page for the CME Natural Gas contract.
Let’s consider an analogy. Water “in general” is free or nearly free to most people. We could analyze the supply/demand for water going out for years and say, “there is plenty of it, it will continue to be cheap”. Now imagine you are stranded in the desert (A specific time and place where there is great urgency and limited supply). How much would a gallon of water be worth in these circumstances? Water available immediately would be worth tremendously more than water that only became available next week or next month, or next year. In other words, trapped in the desert, you could price out a forward curve of what you would be willing to pay for a gallon of water. If might look like this:
Commodity pricing can at times be the same way. The immediate to deliver contract represents what is available in the short run – And do to things like severe weather and depleting reserves in storage, supply/demand over the short run can at times be completely different from what the long term fundamentals suggest. Here is the forward curve chart for Natural Gas that I posted a few days ago:
It is a (far) less extreme version of my “man lost in the desert” forward curve. We read so much about “bubbles” and supposed “market failures” that too many people lose sight of the fact that the great majority of the time, futures markets and forward pricing work very effectively to allocate scares resources over time – and speculators play a critical role in this process. By the way – if you are interested in trading strategies, you might like the articles on this page.
There is much more to consider on this topic. For example, in my opinion the failure to understand the implications of what a futures contract actually is results in investment products being created that make little economic sense. Just to hint at what I am referring too, I am a strong critic of the notion of investing in “commodity indexes”. I am convinced that over time, commodity index investments will result in significant investor losses.