How do growers, warehouses, and other market participants efficiently allocate a crop produced one time per year, but consumed and utilized through the entire year?
Market participants utilize calendar spreads in the grain and oilseed futures markets to discover prices and manage their risk associated with growing and storing grains.
Look at Corn futures to see how calendar spreads encourage storage when supplies are plentiful, and encourage the movement of supplies to the commercial users that value them most when supplies are tight.
Corn futures expire in September, December, March, May and July. A market participant holding a long December Corn futures contract until delivery would receive a delivery certificate representing 5,000 bushels of corn.
Therefore, the price at any given time for a:
A calendar spread is buying a futures contract that expires in one month, while simultaneously selling a futures contract for the same commodity that expires in a different contract month.
The price of a calendar spread is the price difference at a given point in time between the two futures contract expiration months; the December - March calendar spread would be the difference in price between the December futures contract and the March futures contract.
Assume you manage a grain warehouse. It costs you money to store grain in your warehouse. You pay the electric company to elevate grain into your warehouse, you pay the insurance company to guard against fire and flood and you pay the chemical company for insecticide to keep bugs out.
Each day you have to make a decision about every ton of grain in your warehouse: do I sell that ton of grain today in the cash market OR do I continue to store it until tomorrow?
Because it costs money to store grain in your warehouse, the only way you would make the decision to store is if you expect to receive a higher price in the future to compensate you for these costs.
That is what futures spreads represent –the December futures price represents prices expected in December; the March futures price represents prices expected in March. Thus, the spread between December futures and March futures represents what the market is offering to store grain from December to March.
Around harvest, when supplies of grain are plentiful, the spreads become wider, which encourages storage. Warehouse managers continually adjust their inventory based on signals received in the spread market.
If the spreads are too narrow, and the market is not paying enough to store the grain, warehouse managers start selling grain today, which depresses the nearby futures price.
Less inventory will be available in the future, so the deferred futures price rises. This will continue until the buyers in the market get exactly the amount of grain that they want today, and the rest of the grain is stored for tomorrow.
Late in the crop year, when supplies of grain become short, the spreads narrows to discourage storage.
For example, if the spreads are too wide and supplies are short, users of grain bid up the nearby price, which narrows the spread, and encourages the selling of grain out of storage.
In extreme cases, the supplies of grain can get so short, that the futures prices “invert” meaning that the nearby price is greater than the deferred price.
In this case, the market is not paying anything to the warehouse manager to store; in fact, it is charging the warehouse to store.
When this happens, no warehouse wants to store. But users of the grain, be it millers, or exporters, or feeders do not want to be forced to shut down their businesses because they run out of grain. They are willing to store grain at a loss to avoid running out and having to close down their business.
In review, in addition to providing producers and users with price discovery and risk management tools, grain and oilseed futures provide those that store grain the correct market signals to assure that a commodity that is produced once per year is efficiently allocated throughout an entire calendar year.
Because of this, consumers can count on their favorite products being available regardless of the time of year.