What is a Spot Commodity
A spot commodity is a commodity up for immediate trade, as opposed to a commodity under contract for trade at a future date. A commodity is a necessary good which is used in commerce that is interchangeable with other commodities of the same type.
Spot commodities traded on the spot market with an expectation of delivery at settlement. In contrast, commodities traded on the futures market have a delivery set at a future date.
BREAKING DOWN Spot Commodity
Spot commodities must be ready for immediate sale and delivery, as most trades typically settle within two days. Because of this, the price of a spot commodity has more exposure to supply and demand pressures within the market than futures contracts. Future contracts will specify a price for delivery of a certain quantity of a commodity at a later date.
The perishability of a commodity also factors into the volatility of its spot price. During periods of excess supply, the cost of spoilage eventually outweighs the cost of holding the commodity.
Spot Commodities Compared to Futures Contracts
Futures contracts initially involved providing a hedging mechanism for buyers and producers. When farmers plan to grow crops or raise animals for the agriculture industry, futures contracts provide them with some certainty around their financial return at harvest or slaughter. The price is locked in, despite what may happen to market prices in the intervening period. For buyers expecting to take physical delivery of a commodity at settlement, a futures contract protects a spike in prices. As an example, airlines will partake in fuel hedging and purchase futures in airline fuel to establish a capped or fixed cost.
By contrast, commodities speculators use futures contracts to profit on price volatility in commodities markets. Speculators do not intend to take delivery of a commodity at settlement, instead of buying and selling the contracts themselves on an exchange.
Backwardation and Contango
Since the value of a commodity futures contract derives from the value of the underlying commodity, it’s reasonable to expect the price of the futures contract to trend toward the spot price of a commodity as the futures contract approaches its settlement date.
Typically, the price of a futures contract for a commodity moves higher, toward the expected spot price, as the futures contract settlement date nears. This process is known as normal backwardation. Economists believe the higher rates on futures contracts factor in the risk of a shortage of the commodity in the spot market.
The opposite situation is known as contango. Contango is when futures contracts trade below the expected spot price of a commodity at settlement.
For example, hog markets can experience supply and demand shortages when animals are affected by illness or by weather fluctuations. In a typical year, one might expect the price of a futures contract to be higher than the expected spot price. Investors will hedge the risk of trouble which might constrict supply or demand.
If a combination of bad weather and infection decimated the hog population, spot prices would be expected to rise due to the unexpectedly constrained supply. The rise in spot prices could then push the market into contango as futures contracts adjust to match the increase in expected spot market prices.