How to gain a pricing advantage with futures markets

The launch later this year of a freight futures market will give industry participants better insight into rate management

For the initiated, future markets can be a daunting topic. The concept of buying and selling something at a future date can be confusing to many. In fact, there are many professional traders that avoid futures markets altogether.

Whether you are a futures trader or not, though, the futures markets play a critical role in the physical marketplace. Take oil, for instance. There is a physical marketplace of both consumers of oil and producers of oil. Oil’s price is influenced by a number of physical factors including consumption, production and inventory.

There is also an oil futures market where traders buy and sell oil based on projected price. Oil futures contracts typically mirror the physical market’s attributes and the expectation of those attributes at set periods in time, i.e., 3 months, 6 months, 1 year, etc. But, as the U.S. Energy Information Agency explains, when futures prices are not aligned with real-world prices, market forces intervene.

“If market expectations indicate a change toward relatively stronger future demand or lower future supply, prices for futures contracts will tend to increase, encouraging inventory builds to satisfy the otherwise tightening future balance,” EIA notes. “On the other hand, a sharp loss of current production or unexpected increase in current consumption will tend to push up spot prices relative to futures prices and encourage inventory draw downs to meet the current demand.”

In other words, a futures market will react to the underlying fundamentals of its physical market because in the end, the futures price is linked to the physical market. In this case, there is a physical commodity being exchanged to settle those futures contracts – barrels of oil. Many futures contracts, though, do not involve a physical commodity changing hands. That is true of the upcoming freight futures contracts being launched later this year by TransFX.

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Freight futures contracts are strictly financial instruments with no physical delivery of capacity. The way they will work is that the rates along major freight shipping lanes in the U.S., for example Chicago-Dallas, will become a commodity that is traded on a futures exchange. The contract will be financially settled using data from DAT Solutions that TransFX will incorporate into its TransRisk product.

Using an example from the airline industry, NerdWallet explains how a futures transaction takes place.

“An airline company may want to hedge its bets against an unexpected increase in jet fuel prices. Its traders will therefore seek to enter into a futures contract to lock in a purchase price closer to today’s prices for jet fuel. So they may buy a futures contract agreeing to buy 1 million gallons of JP-8 fuel, taking delivery 90 days in the future, at a price of 3 dollars per gallon. Someone else naturally wants to ensure they have a steady market for fuel. They also want to protect themselves against an unexpected decline in fuel prices, so they will gladly enter into a futures contract.”

As noted, in the freight futures market, there is no exchange of trailer capacity. But, just like in the airline and oil examples, the futures contract can be used by brokers, carriers and shippers to set a firm price for lane rates.

For instance, if the futures contract along the Chicago-Dallas lane is selling for $2 per mile on Sept. 30, that can become a starting point for negotiations on a rate contract even if neither participant is involved in the futures market. A carrier may choose to offer a slight discount to secure capacity, or a shipper may offer a slight premium to secure trailer space, but because there is a financial instrument in place that is reflecting expected market prices, it removes the guesswork – and dispute – from setting competitive, market-based rates.

Either way, because the futures contract is based on proven, trusted data from DAT, each party is ensured that the rate, while maybe not exactly $2 per mile on Sept. 30, was based on a good-faith effort using market fundamentals.

While the futures market should have no bearing on what the physical market rate is, it is influenced the same way as the physical market is, with prices moving for the same reasons - weather, fuel prices, etc. The role of the futures contract is simply to add a level of price management for market participants through transparency.

All parties can also use this data for planning purposes. For instance, if futures prices are trending up in a lane, it could be because there is a need for more capacity in that lane and a proactive carrier might shift more trucks into the area to take advantage. This is information that would not have been available previously. Instead of being reactionary, carriers and shippers can now be proactive, potentially leading to an increase in revenue even without participating in the futures market; the market simply set the stage for more sound business practices.

Third-party logistics (3PLs) providers can also take advantage of the futures market without participating in it. Contracts could be written based on the futures market settlement rate on the date of actual delivery, something that is called spot market assessment contracts. Brokers can also use this information when settling contracts if the contract utilizes the futures market to set a settlement price.

Whether you are a carrier, broker or shipper, utilizing freight futures contracts as a basis to develop rates can lead to more transparency and provides another financial weapon in improving operational insight and cash flow management.