Commodity futures are standardised, exchange-traded futures contracts whose underlying reference is a commodity, such as an energy product, metal or agricultural good. Their contract specifications determine the quantity, quote units, expiry and final settlement arrangements. They let a producer, buyer or investor take commodity-price exposure without making an immediate purchase of physical inventory.
That separation is useful for hedging, but it creates a practical cash-flow problem: a future can require cash today while the offsetting benefit from the physical business arrives later.
Which commodity, where, and when?
“Long oil” is not a complete position description. A commodity future refers to a particular contract and expiry. Before translating its quoted price into a dollar exposure, check:
- Quantity and quotation: underlying units per contract, currency per quoted unit, tick size and tick value. A price quoted in cents must be converted consistently before calculating dollar gains.
- Physical reference: the eligible grade or quality, delivery location and any permitted substitutions or price adjustments.
- Dates and final settlement: the last trading day, notice and delivery deadlines where applicable, and whether settlement involves physical delivery or cash against a defined reference price.
An exchange standardises these terms; it does not standardise every commodity future into the same instrument. Even two contracts referring to the same broad commodity can differ materially. CME’s contract introduction explains why quantity, quality and delivery terms belong to the contract specification.
One quote, three different dollar amounts
Consider a fictional linear contract, quoted in USD per unit, representing 100 units per contract. A buyer enters one long contract at 50 USD per unit and later closes it at 55. There are no fees, interest or funding costs, and the position remains open throughout the stated path.
Its initial notional amount is . This measures price exposure. It is neither an initial margin requirement nor a USD 5,000 cash purchase of the commodity.
For this contract, the cumulative trading gain is
The same position taken short would lose USD 500. Actual contract multipliers and settlement calculations must come from the relevant exchange specifications, including any rounding rules.
Initial margin is collateral supporting the position. Daily settlement variation pays the trading gains and losses as prices change. Neither implies that the trader has paid for, or already owns, physical inventory. Margin requirements can change, additional cash can be required, and the amount initially posted is not a maximum loss.
Suppose the fictional price first settles at 47 before reaching 55. The long pays USD 300 on the first move and receives USD 800 on the second, for the same net USD 500 gain. On the closing day, assume the offsetting trade occurs at that day’s settlement price. The USD 500 is the sum of transfers across the holding period, not an additional payment to add to them.
Original fictional ledger. Futures prices are observations of the same contract over time. The physical purchase is separate; the illustration assumes zero basis at purchase and excludes costs. The initial notional is USD 5,000, while initial margin is unspecified.
The earlier USD 300 payment still needs funding. The later gain cannot retroactively supply that cash. Collateral balances, collection deadlines and broker rules determine whether more money must be deposited; no particular margin-call threshold is assumed here. CME’s mark-to-market explanation describes daily settlement and the risk of liquidation when required funds are unavailable.
A hedge joins the futures account to the business
A buyer expecting to purchase a commodity is exposed to rising input prices, so a long hedge can provide an offset. A producer expecting to sell is exposed to falling sale prices, so a short hedge can provide an offset. Judge the combined physical and futures cash flows, rather than demanding that the futures position itself always make money.
For the fictional buyer above, assume it needs exactly 100 physical units and buys them when the future closes. If the physical purchase price is also 55 USD per unit, the invoice is USD 5,500. Deducting the cumulative USD 500 futures gain gives USD 5,000, or 50 USD per unit, before costs.
This exact offset depends on the assumptions. The buyer must obtain the right grade at the right location and time; its actual purchase price may differ from the futures price. Basis risk is the risk that those prices fail to move together as required by the hedge. Financing the interim settlement payments also affects the full economic result.
For a broader worked introduction to long and short hedges and cash-flow timing, Forwards and Futures is available with a free signed-in account.
Closing, rolling and taking delivery
An equal opposite trade in the same contract and expiry offsets an open position. Buying another expiry does not close a short in the original expiry. A roll closes one expiry and opens another, with a new entry price and exposure.
Daily cash settlement of gains and losses does not mean the contract is cash-settled at expiry. A physically delivered contract still carries delivery obligations if it enters the relevant process. A cash-settled contract instead follows its final reference-price rules. Notice deadlines, delivery periods and broker cutoffs deserve attention before the last trading day. CME’s expiration and roll guide explains these distinct exit routes.
Finally, a commodity forward curve compares different expiries at one time. The ledger above follows one expiry across time. A curve’s shape is not the future price path, and it does not guarantee a profit from holding or rolling a commodity future.
Sources
- John C. Hull, Options, Futures, and Other Derivatives, ninth Global Edition, Pearson, 2018, §§2.1–2.4, pp. 46–53, and §3.1, pp. 71–73: contract specifications, offsetting, daily settlement, and long and short hedges. Numerical examples here are original and fictional.
- CME Group: Definition of a Futures Contract: exchange standardisation and commodity contract terms.
- CME Group: Mark-to-Market: daily settlement prices and settlement cash flows.
- CME Group: Understanding Futures Expiration & Contract Roll: offsetting, rolling and final settlement.