An explanation of the futures market

There are those who say that speculation in the futures markets should be ended to bring down fuel and food prices.

If you think so, do you actually know what a futures market does?

Like all human creations, there's a good side and a bad side to commodities futures. A Businessweek article tells a short story about a baker whose business brings in $200m of revenues. Commodity prices fluctuate, sometimes by a lot. He can use the futures market to lock in prices for key ingredients.

One of the main reasons why Southwest Airlines has been so successful recently is because they hedged their fuel supply at prices far below today's. It was a combination of skill and luck. Don't worry, though, those hedges will expire. How it works is you buy a contract for a set quantity of whatever, for delivery on a certain date. When Southwest runs out of fuel hedges, they pay the market price, unless they can find contracts at lower prices. I've heard it said that airlines are not designed to operate with oil at $140. If it stays that high, Soutwest will eventually meet the same fate as everyone else.

To some extent, speculators merely provide liquidity to the market. If they are jumping in and out of the market, they merely generate trading activity. That makes it harder for one player to manipulate the market. There are stock markets, for example in some Middle Eastern countries, where trading is thin, and insiders can manipulate prices. In fact, pump and dump schemes occur in the US with small stocks which only trade a few hundred shares a day. A scammer sends faxes and emails touting some penny stock no one's ever heard of. People buy. The scammer sells. The buyers eventually lose their shirts.

I'm not saying that speculation in the energy and food markets shouldn't be contained. In fact, governments have intervened in the past to restrict trading activity. For example, the US Federal Reserve can (I think) change margin requirements, essentially meaning that traders have to put up more cash as collateral to buy the contracts on margin (i.e. on borrowed money). We should not, however, be looking to eliminate trading in commodities entirely.