In 2005, Southwest Airlines bought future contracts to purchase oil at $50 per barrel two years later. After it bought those contracts, oil prices shot to $100 or so per barrel such that the value of those contracts doubled, earning Southwest additional income. Why did Southwest buy those contracts? Or alternatively, why didn’t other airlines take such a risk?
Usually one assumes futures markets are about speculators like Long Term Capital Management L.P., which lost billions in 1998 using the famous Black–Scholes mathematical model for financial derivatives. The Federal Reserve actually stepped in to run the company to quell the financial chaos Long Term Capital Management’s demise would have created. Such situations, though, mask the rather mundane actions of purchasing futures: think boring insurance policy, not slick Wall Street speculation.
To understand how futures contracts work, consider gold mining or agriculture. The original Chicago Board of Trade was in fact a futures market set up for farmers. But gold miners, too, could benefit from futures contracts, and no one knows gold like Alaskans.
Say you are a gold miner and you want to borrow money to initiate your summer mining seasoning in a remote location where you won’t be able to get out again until the next fall to sell your nuggets. The idea is that you borrow money from a bank in the late spring to pay for starting up your mine; then you pay back your loan in the fall after most of your gold is finally processed and able to be sold.
Consider that the price for your gold can vary by the time you sell your nuggets. If gold is $1,000 per ounce now, will it go up to $1,500 per ounce, or will it go down to $500 per ounce? Maybe you are confident you can extract 100 ounces by the fall, but will you get $100,000, $150,000 or $50,000 out of it, when your costs could be tens of thousands of dollars? If you only get $50,000, you may end up losing money and have some difficulty paying back the loan. So what can you do today about it?
Well, you can obtain a futures contract for a fee, and based on sound advice, where you can guarantee receiving a set future price. On the market, the miner buys a contract for a $1,000 per ounce value in six months. If the price goes down to $500 per ounce, the miner still gets $1000; if the price goes up to $1,500, he will only get the $1,000 contracted. Nevertheless, the futures contract guarantees him a future price of $1,000. This type of contract for a miner is termed “going short.” A short seller makes money if the price falls and losses money if the price increases. But this could be a good deal, if you need what is basically insurance, i.e. a guaranteed price, for your fall output. You repay the loan and hopefully have seed money for next year.
In fact the contract can just be a paper deal, where you receive money if gold prices decline or pay money if gold prices increase. In the later case, there is no problem: the prices have increased, so you can now sell your product for more money in order to pay off the short contract and cover your other costs. In the former case, you are assured a set payment to cover your losses.
Going long is the opposite. Think of an electronics company who uses small amounts of gold in producing complex computer chips. The company would set up a futures contract to bring in extra cash if gold prices go up. This will help them cover a higher price for the gold they purchase for inputs. However, if prices go down, the contract requires a payment of money. But the electronic company should be covered because, after all, the low gold prices negate gold feedstock costs and the company can now afford to pay for the future’s loss.
Theoretically, farmers could use oil price futures to lock in low fuel prices, i.e. going long on oil when oil prices are low. When oil prices rise, and in turn the harvesting costs affected by oil prices rise, the farmer gains money to compensate for those increased costs, the opposite happens for lower oil prices. It depends on how vulnerable a farmer is to fuel costs.
So futures are a handy tool if you need to guarantee a certain price and keep your expense from being so volatile from season to season.
Doug Reynolds is a professor of Economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at firstname.lastname@example.org. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.