Forecasting Commodity Price with Futures Contract Prices

The basis ratio of cash/futures prices provides a good forecast about the future ... since the procedure is very quick and easy, these forecasts, if nothing more, can provide a check over the forecasts generated by complex statistical models... uses heating oil price as a proxy for diesel fuel price. Accurate cost budgets are essential for setting up business plans. Often, price forecasts for commodity-related products are a crucial ingredient in formulating budgets for manufacturing and transportation companies. For instance, a national trucking company must budget diesel fuel costs when planning their fiscal year. A number of alternative methods are available for making commodity price forecasts. However, research has shown that the price of a futures contract is often a more accurate price forecast than the one produced by government experts. A futures contract price also tends to be more accurate than the one derived with statistical techniques. Futures contracts are traded by commercial users of the commodity and speculators in a public market. As such, futures prices reflect the market collective expectations about future commodity prices. Since futures prices are widely reported in the media, forecasts based on them are relatively inexpensive to prepare and easy to update. In this article, we illustrate how we can forecast the Department of Energy's on-highway diesel price by using publicly available futures prices. FUTURES PRICES: A PROXY FOR FUTURE FORECASTS Futures contract trades are governed and regulated by public exchanges such as New York Mercantile Exchange (NYMEX). They reflect the price of a specific commodity. For instance, the NYMEX heating oil contract represents the price of No. 2 fuel oil delivered in the New York Harbor between the fifth and last business day of the delivery month. For the NYMEX heating oil contract, futures trading is conducted for 18 consecutive months out. If we are in December 30, 2003, futures trading will occur in all months from January 2004 through June 2005. For the NYMEX heating oil contract, future delivery months correspond with calendar months. Table 1 gives the actual futures prices for the January 2004 through December 2004 delivery months as of December 30, 2003. The June 2004 futures price of 0.7936, for example, can be interpreted as the expected price of the specific commodity, heating oil in this case, for delivery in June 2004. Producers, processors, consumers and speculators buy and sell futures contracts. In so doing, the market participants indirectly reveal their price expectations. As prices adjust to equate supply and demand, an equilibrium price is formed that reflects the market's expected price of the commodity for the future delivery date. In many regards, the futures price is a consensus forecast of all the futures market participants, who undoubtedly use a number of different methods for arriving at their own forecasts. So, the key step here is to first establish the relationship between the futures price and the commodity price under consideration, and then use that relationship to prepare a forecast. BASIS RATIOS The relationship between a specific cash price and the futures price is referred to as the basis. The basis can either be expressed as a difference, basis = cash - futures, or as a ratio, basis = cash/futures. In either case, the basis serves as the connector between the futures price and the cash commodity price being forecast. A direct method for estimating the basis is to simply look at the historical average basis. It is important to do this on a monthly interval to capture any seasonality in the cash/futures relationship. As an example, consider the price of retail diesel fuel as represented by the Department of Energy's national on-highway diesel fuel price. The on-highway price is a common benchmark that evokes price escalator and deescalator clauses in distribution contracts, and represents the relevant price faced by national trucking firms. …