23/04/2024, 17:41 Fundamental Analysis - Futures Supply and Demand - CME Group

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LESSONS

 9 MIN LESSON 3 OF 9

Fundamental Analysis - Futures

Supply and Demand

Supply and demand is a key economic concept that attempts to explain what the
market is willing to pay for a given product, where the quantity produced is equal to
the quantity demanded. This interaction is key to the analysis of the price of a futures
contract.

Fundamental analysts will use their knowledge of supply and demand factors to
create their opinion of whether the futures contract is fairly valued, and if price will
increase or decrease.

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The factors that affect supply and demand are numerous and highly interrelated, the
behavior of the markets is complex. Traders must focus on the key variables they feel
are most the important price influencers for each commodity.

Some of these factors include:

Unique factors for a specific market

Interactions with other interconnected markets

Interactions with the broad economy

Natural cycles

Spot and futures pricing

Unique Market Factors

Some markets have factors that will affect supply and demand uniquely for that
market, and have little to no effect on another market.

For example, weather plays a very important role on the supply side of agricultural
commodities, like soybeans, but may not be as relevant for markets like gold or equity
indices. Traders will become familiar with the specific factors that impact their
industry, and keep track of these factors as they trade.

Crops have a few key times during their growing cycle where weather can have a
major effect on harvest yields; planting, growing and harvesting. If the climate is too
wet or too dry during these times, supply might be adversely affected. But if
conditions are favorable through the entire cycle, yields might increase. In some years
there might be excess supply and in some years there might be low supply.

On the other end of the spectrum, weather will play less of a role in the supply of gold,
or crude oil, where mining and drilling activities are less affected by weather.

But gold is much more impacted by changes in inflation than soybeans.

Interconnected Markets

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Supply and demand can also be connected; there are times when one futures contract
might represent an input for another. The futures markets are interrelated and this
relationship that can be calculated and analyzed by the fundamental analyst.

For example, corn can be used as livestock feed and in the production of ethanol. A
corn trader might look at the corn market and its relationship to cattle, as well as its
relationship to ethanol.

Another example is Crude Oil and Gasoline futures. Where the price of Gasoline
futures can be influenced by supply and demand for gasoline and the price of the
input commodity.

If a trader only focuses on supply and demand for one market, they might miss an
important effect from a related market.

Economic Variables
Economic variables are also very important to the pricing of futures contracts.

Economic data is released at regular intervals and can have a dramatic effect on
prices in one sector. There are dozens of economic data reports released daily, with
calendars available online. Most of the data will not directly impact the market when
it is released but some data releases have the potential to move the market with every
release. Announcements like the unemployment rate, GDP and FOMC interest rate
decisions are powerful market movers and are watched closely by traders.

Traders should be aware of economic release dates and its related market impact, as
not all data will always have the same impact. It is important to understand how the
data fits in to the current economic landscape and whether the market has
determined that it is important or not.

At times, certain data will have more of an effect on the markets than at other times.
When Crude Oil was around $100, Crude Oil Inventory Reports effected, not only on
Crude, but also the S&P 500. If we look at the current impact of the reports, it is
limited to the energy market, making the report less important to traders of other
markets.

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Housing is also an indicator that has varied effects. As the economy pulled out of the
market downturn of 2008, housing statistics were very important, as mortgages and
credit were a large factor in the downturn. For a long time after 2008 traders eagerly
anticipated the release of the newest housing data, which influenced the broad
market. Now that mortgages and credit are less of an issue, housing numbers have a
limited effect on the broad market.

All futures contracts will have an economic release that is specific to their sector.

For example, USDA crop reports are specific to agricultural futures, and detail plating
conditions, progression of growth and harvest results. They are updated through the
agricultural season, and futures prices react to the data, moving up if forecast crop
yields are down and moving down if crop yields are higher than expected.

Another unique report for agricultural traders are weather reports, as overly wet or dry
conditions can impact crop yields and ultimately price.

Natural Cycles
Since many futures represent commodities that do not have a continuous, supply like
corn, or commodities that are in higher demand at certain time of the year, like
heating oil, these seasonal patterns of supply and demand create natural cycles that
influence the price of futures contracts.

For example, crops are grown and harvested during specific months of the year, once
harvested, supply will not increase until next harvest.

Fuel-related commodities, like heating oil, have a naturally higher demand at certain
times of the year. During the winter months, heating oil has more demand because
many homeowners use the fuel to heat their homes.

Spot and Futures Pricing

Another unique variable in pricing futures, is the fact that they price a market at a
certain time in the future, whereas spot prices refer to the price you pay if you want to
buy a commodity today.

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The futures market is priced based on delivery at a certain point in the future. This
means the spot price and the futures price will be different over the life of the futures
contract and only converge at expiration of the futures contract. Futures and spot
prices will converge and diverge over time.

Contango and Backwardation

There are natural relationships to the spot price that form in the futures markets. For
example, Crude Oil futures have a different relationship to spot price than Soybean
futures. Futures and spot markets can have two kinds of relationships: contango and
backwardation.

Contango is the most common relationship, where the futures price is higher than the
spot price. While some futures will trade in backwardation, this is a relationship where
the spot price of a commodity is higher than its futures price.

The fundamental analyst will determine if the relation between spot and futures prices
are in their normal relation or not. This will have an impact on how prices will move in
the future.

For example, non-agricultural products typically trade in contango, where the futures
price is higher than the spot price. This is typically due to the carry cost of buying at
the spot price now, storing the commodity, like copper, and selling it in the future. The
holder of the physical commodity would have to be compensated for the costs.
Therefore, the futures price is higher; if not, there would be arbitrage opportunities.

Agricultural products, however, typically trade in backwardation, where the futures

price is less than the spot price. The reasoning behind backwardation is because once
harvested, supply can only decrease until the next harvest, creating a situation where
spot prices can be higher nearing the end of the supply cycle. Futures contracts that
expire after the next harvest can be cheaper since supply will be higher after the next
crop is harvested.

The trader will want to know the typical situation for the futures contact they are
trading and pay attention if the contract shifts from contango to backwardation or
vice versa.

Conclusion
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Each futures market will have its own supply and demand factors, a trader will want to
determine the most important factors and carefully piece together the data to build
their analysis and trading decisions.

Each Futures market has direct variables affecting its supply and de

True

False

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