How commodities trade: futures, spot, CFDs and the roll

The spot market, also called the cash or physical market, is where the material itself changes hands for delivery now. Its users are mostly producers, merchants, refiners and manufacturers. A spot price is always for a stated grade at a stated place, because a barrel at a pipeline hub and a barrel on a ship are not the same thing to a buyer who needs it somewhere.

A futures contract is a standardised agreement, traded on an exchange, to buy or sell a fixed quantity of a stated grade for delivery in a named month. Both sides post margin with the exchange’s clearing house, and gains and losses are settled between them every day. Because every contract for a given month is identical, it can be sold on to anyone, and most are closed before delivery ever comes up.

A contract for difference is an agreement with a provider to exchange the change in a price between the moment a position is opened and the moment it is closed. Nothing is owned and nothing is delivered. The price of a commodity CFD is taken from an underlying market, which is commonly a futures contract and sometimes a spot quotation, and the other party is the provider, not an exchange.

Each delivery month has a price of its own. Set side by side, from the nearest month to the furthest, those prices form the futures curve.

When later months cost more than nearer ones, the market is said to be in contango. It is the shape commonly seen when supply is ample: the gap reflects, in part, what it costs to store, insure and finance the material until the later date, which is called the cost of carry.

When nearer months cost more than later ones, the market is in backwardation. It is commonly seen when the material is scarce today: buyers who need it now pay more than those who can wait.

The curve is not a forecast. A price for delivery in six months is the price at which that delivery can be agreed today, and it changes as often as any other price.

A futures contract expires. Anyone who wants to stay in the market beyond that date must close the expiring month and open a later one. That exchange is the roll.

The two months have different prices, so a chart that joins one contract to the next shows a step on the day of the roll. The step is not a move in the market: it is the gap between two different contracts.

A CFD built on futures meets the same date. The provider changes the underlying contract on a stated day, and the usual practice is a cash adjustment to open positions equal to the difference between the two prices, so that the change of contract neither gives nor takes by itself. Dealing costs still apply.

Over many rolls the shape of the curve tells. In contango a holder who is long keeps leaving a cheaper contract for a dearer one, and if the dearer one then drifts down towards the spot price as its own expiry nears, that drift is a loss. In backwardation the effect runs the other way. This is why the result of holding a futures-based product for a long time can differ from the change in the headline price of the commodity.

A note on the word: in foreign exchange, rollover means carrying a position overnight and the financing that goes with it. That is a different thing from the change of contract described here.

Many commodities are produced or used to a calendar. A crop is planted, grows and is harvested once a year in each hemisphere; the supply arrives within a few weeks and is stored for the rest of the year. Its price is usually most sensitive to weather while the crop is in the ground, when the size of the harvest is still unknown.

Energy has seasons of demand. Natural gas and heating fuels are drawn on in cold months and stockpiled in mild ones; motor fuel is used most in the months when people travel.

Because these patterns are known to everyone, they are already in the curve: it is one of the reasons delivery in one month is priced differently from delivery in another. What moves a price is the season that turns out differently from the one expected, such as a mild winter or a failed harvest. A known season is not, by itself, a reason for a price to rise or fall.

Some futures contracts are settled by delivery: the seller hands over the material, or a document of title to it in an approved warehouse, and the buyer pays. Others are settled in cash against a published reference price, and no material moves.

Either way, the price of a contract is drawn towards the spot price as its expiry approaches. If it were not, a merchant could buy in the cheaper market and deliver into the dearer one.

Most people who trade futures do not want the material. They close or roll their positions before the delivery period, and firms that serve individuals generally require it. The last days of a deliverable contract belong to those who can make or take delivery, and prices then can behave strangely. On 20 April 2020 the expiring United States crude oil contract settled below zero: with storage at the delivery point scarce, holders who could not take delivery paid others to take the contracts from them.