Investing in commodities is different from the stock, bond, mutual fund, and ETF investing that most investors do. Because commodities involve physical goods trading hands, it's important to understand the logistics involved in making investment decisions. In particular, the difference between the spot price of a commodity and the price of futures contracts covering the same commodity plays a major role in defining how a particular commodity market behaves. Let's take a closer look at what a spot price is and why it's important in the commodity futures markets.
Understanding the spot price
The commodities markets are more complicated than many people realize, but the concept of the spot price is one of the simplest to understand in the industry. Put simply, if you want to buy a commodity on the spot -- rather than waiting until some point in the future -- then the spot price is what you'll pay right now to obtain that commodity.
As you can imagine, spot prices change all the time. They react to changes in supply and demand of the commodity in question, rising when supply constraints cut the available amount of a good or when customers want more of that good, and falling when available supplies soar or demand disappears.
Why spot prices are important
Looking at the interplay between commodities markets and futures contracts highlights the importance of the spot price. Many producers of goods sell futures contracts in order to lock in prices for future production, and many purchasers of goods buy futures contracts to have a predictable cost structure for the commodities that they'll need. Yet because it's typically impossible to predict with certainty exactly how much of a commodity you'll have to buy or sell, the spot market makes it possible for buyers and sellers to meet unanticipated needs or deal with unexpected surpluses beyond what they expected to have.
Moreover, spot prices help determine futures prices. Buyers who need a certain amount of a nonperishable commodity in the future always have two choices. They can buy a futures contract to take delivery of the commodity at that future date. Alternatively, they can buy the commodity now at the spot price and then store it until it's needed. If futures prices are higher than what it would cost to buy the good now and pay any storage-related costs, then investors will go to the spot market rather than buying futures. That in turn will reduce demand for futures contracts, bringing their price down to more reasonable levels.
Most investors don't participate in the commodities markets, and those who do typically use futures contracts rather than trading actual physical commodities. Nevertheless, understanding what spot prices are and why they're important will help you invest better in the companies that do rely on commodities markets for their success.
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