What Is a Spot Commodity?
In finance, the term “spot commodity” refers to a commodity that is being sold with the intention of being delivered to the buyer fairly immediately -- either presently or within only a few days. As their name suggests, spot commodities are commodities that trade on the spot market. Likewise, a spot commodity's price is known as its spot price.
By contrast, commodity futures or forwards markets entail delivery of the commodity at a future point in time.
- A spot commodity is a commodity that is traded on its cash market as opposed to a derivatives market.
- Spot markets are those in which the transactions are settled within just a few days.
- Market participants often use a combination of spot and futures markets for trading commodities, as hedgers or as speculators.
How Spot Commodities Work
Spot commodities are an important part of the financial markets, allowing companies, traders, and intermediaries to purchase a wide range of commodities on short notice. Today’s spot commodity markets include energy commodities such as oil, coal, and electricity; agricultural commodities such as corn, wheat, and soya beans; metals such as gold, silver, and steel; and many others.
Generally speaking, there are two major types of buyers in the spot commodities market: commercial customers and speculators. For commercial customers, the commodities they purchase are essential inputs into their business operations. For instance, airlines such as Delta Airlines Inc. (DAL) require a large amount of jet fuel to operate their aircraft; while a company such as Starbucks Corp. (SBUX) requires vast quantities of coffee beans as part of their coffee roasting and production lines. Speculators on the other hand use the commodities market as a way to profit from anticipated rises or falls in commodity prices and do not intend to take physical delivery of the commodities they buy.
Typically, speculators will use the spot market as a way to close out a position they have previously entered into through the commodity futures market. For example, a speculator who purchased coffee bean futures contracts might close out that position by selling those contracts to a commercial buyer in the spot market once that futures contract has reached its settlement date. Since the value of a commodity futures contract is based on the value of its underlying commodity, the price of a given futures contract will trend toward the spot price of that commodity as the futures contract approaches its settlement date.
Real World Example of a Spot Commodity
Often, commodity market participants will use both the spot and futures commodity markets. For example, consider the case of an airline that needs to secure its supply of jet fuel for the following year. In October 2020, the spot price of US Gulf Coast kerosene-type jet fuel was just over $1 per gallon. By contrast, that same commodity cost roughly $1.85 per gallon in October 2019.
Looking at these prices, an airline company might be happy to purchase its jet fuel in the spot market, taking physical delivery within a few days of purchasing the fuel. However, it might also want to purchase jet fuel futures contracts in order to “lock in” the low price several months into the future. The price of the futures contracts would then reflect not only the spot price of the commodity today but also the anticipated future direction of spot prices.
Spot Price, Futures Price, and Basis
The basis is the difference between the spot price of a deliverable commodity and the price of the futures contract for the earliest available date. Basis is used by commodities traders to determine the best time to buy or sell a commodity. Traders buy or sell based on whether the basis is strengthening or weakening.
Basis is a crucial concept for portfolio managers and traders because this relationship between cash and futures prices affects the value of the contracts used in hedging. As an example for basis in futures contracts, assume the spot price for crude oil is $50 per barrel and the futures price for crude oil deliverable in two months' time is $54. The basis is $4, or $54 - $50.