Commodities trading is based on forward contracts and delivery. Forwards, swaps, and futures constitute the basic underlying tradables primarily because most market participants do not have access to storage facilities in which to carry the commodity forward in time. A bond or an equity can be purchased at any time to cover a short position sometime in the future. This involves paying funding costs but does not require elaborate infrastructure, in contrast to most commodities. As a consequence, most trading and hedging in commodities occur in the forward markets. A closely related fact is that one cannot readily infer forward prices from spot prices in energy. For equities, bonds, or even gold, market participants are able to make reliable estimates of the funding costs and other components of carry, such as dividends and warehouse storage, in order to calculate the cost of getting the commodity from now (spot) to a later (forward) delivery time. For energy, and consumption commodities more broadly, carry costs can be inferred only through forward prices. This renders forward prices as the natural underlying price variables.

Forwards, Futures, and Swaps

We have already encountered forward pricing in Figure 1.4, which showed the natural gas forward curve on a particular date. Figure 2.1 shows the forward curve for West Texas Intermediate (WTI). Each point on the plot represents the price for WTI crude oil delivered in subsequent months as of January 15, 2009.