Commodity Futures 101: What They Hedge (And What They Don't)

When U.S. steel manufacturers greeted President Trump's Section 232 tariffs in March 2018, they expected protection from Chinese competition. Futures contracts on iron ore, coking coal, and steel rebar were trading at multi-year highs. Manufacturers who'd hedged their input costs with futures felt confident—they'd locked in raw material prices and positioned for a tariff-driven boom in domestic demand.

Then something unexpected happened: U.S. steel stocks tumbled nearly 50% year-over-year despite tariffs designed to protect them. Downstream manufacturers like Harley-Davidson faced $2,200 per motorcycle in added costs from steel tariffs and European retaliation. Companies that had meticulously hedged commodity price risk with futures found themselves blindsided by policy risk, supply chain disruptions, and trade retaliation—risks their futures positions never covered.

This gap between what commodity futures hedge (price movements) and what they don't hedge (policy shocks, tariff changes, chokepoint disruptions, geopolitical risk) cost billions in 2018-2019 and continues to expose traders today. Understanding these limitations isn't just academic—it's the difference between effective risk management and expensive blind spots that conventional hedging strategies routinely miss.

This guide explains how commodity futures work, what risks they hedge effectively, where critical gaps emerge, and how prediction markets on trade policy and infrastructure disruptions fill the holes that futures leave open.

What Are Commodity Futures? The Basics

Definition and Mechanics

A commodity futures contract is a standardized agreement to buy or sell a specific quantity of a physical commodity at a predetermined price on a future date. Futures trade on regulated exchanges (CME Group, ICE, LME) with transparent pricing, daily settlement, and delivery mechanisms.

Key characteristics:

  1. Standardization: Contract size, grade, delivery location, and settlement date fixed by exchange
  2. Leverage: Margin requirements typically 5-15% of contract value
  3. Daily mark-to-market: Gains and losses settled daily through margin accounts
  4. Physical delivery or cash settlement: Most contracts close before expiration; those held to maturity deliver physical commodity or cash equivalent

Example—CME Corn Futures (ZC):

How Futures Markets Function

Price discovery: Futures prices aggregate expectations of supply, demand, weather, policy, and global events. December 2024 corn futures trading at $4.85/bushel in September 2024 reflects the market's collective forecast of harvest outcomes, ethanol demand, export volumes, and macroeconomic conditions.

Hedging mechanism: Producers (farmers, miners, oil drillers) sell futures to lock in prices for future production. Consumers (food manufacturers, airlines, construction firms) buy futures to lock in input costs. Speculators provide liquidity by taking on price risk for potential profit.

Convergence: As expiration approaches, futures prices converge toward spot (cash) prices. Arbitrageurs exploit any gaps—if December corn futures trade at $5.00 but cash corn in Chicago is $4.80, traders buy cash and sell futures, capturing the spread and forcing convergence.

Major Commodity Futures Contracts: Specifications and Usage

Energy Futures

WTI Crude Oil (CL)—CME Group:

Natural Gas (NG)—CME Group:

Key hedging strength: Energy futures exhibit high correlation (0.85-0.95) with physical spot prices for benchmark crudes (WTI, Brent) and standardized natural gas. Basis risk (difference between futures settlement point and local cash market) is manageable and predictable for major hubs.

Agricultural Futures

Corn (ZC)—CME Group:

Soybeans (ZS)—CME Group:

Wheat (ZW)—CME Group:

Key hedging strength: Seasonal price patterns well-understood. Weather risk (droughts, floods) affects all market participants similarly, creating shared hedging incentives. Futures prices lead cash markets by 2-4 weeks, providing early warning of supply/demand shifts.

Metals Futures

Copper (HG)—CME Group / LME:

Gold (GC)—CME Group:

Key hedging strength: LME copper futures trade with 10-year curve, enabling long-dated hedges. Global delivery network (400 warehouses, 34 locations) reduces basis risk. Copper's role as economic bellwether ensures deep liquidity.

What Commodity Futures Hedge Effectively: Price Risk

Price Risk Definition

Price risk is the uncertainty that the future cash price of a commodity will differ from expectations, creating gains or losses for physical market participants.

For producers: Corn farmer plants in April expecting $5/bushel at October harvest. If prices drop to $4/bushel, revenue falls 20%.

For consumers: Airline budgets jet fuel at $2.50/gallon for Q4. If prices rise to $3.20/gallon, operating costs increase 28%.

Futures contracts hedge this risk by locking in prices today for transactions that occur in the future.

Hedging Mechanics: Short Hedge (Producer)

Scenario: Corn farmer expects 50,000 bushel harvest in October 2024. Current cash price: $4.85/bushel. December futures: $4.95/bushel.

Hedging action (June 2024):

Outcome 1—Prices fall (October 2024):

Outcome 2—Prices rise (October 2024):

Result: Farmer eliminates price risk. Whether prices collapse or surge, effective revenue is $4.85/bushel (minus basis adjustments and transaction costs).

Hedging Mechanics: Long Hedge (Consumer)

Scenario: Ethanol plant processes 200,000 bushels of corn monthly. December corn futures: $4.95/bushel. Plant wants to lock in Q1 2025 feedstock costs.

Hedging action (October 2024):

Outcome 1—Prices rise (Q1 2025):

Outcome 2—Prices fall (Q1 2025):

Result: Ethanol plant eliminates input cost volatility. Whether corn surges or crashes, feedstock costs are predictable at $4.95/bushel, enabling stable production budgets and forward sales contracts.

Why Price Hedging Works: Correlation

Futures hedging succeeds when futures price movements strongly correlate with cash price movements (correlation 0.80+). For benchmark commodities delivered at major hubs, this correlation holds reliably.

CME WTI Crude Oil futures vs. Cushing, OK spot prices (2019-2024):

CME Corn futures vs. Illinois cash prices (2019-2024):

When correlation weakens (non-standard grades, remote delivery locations, policy distortions), basis risk increases and hedging effectiveness declines.

What Commodity Futures Don't Hedge: The Critical Gaps

1. Policy Risk and Regulatory Changes

Definition: Sudden changes in government policy—tariffs, quotas, subsidies, bans, environmental regulations—that alter the economic environment for commodities independent of supply/demand fundamentals.

Why futures fail: Futures prices reflect supply-demand expectations under current policy frameworks. Unanticipated policy shifts create discontinuous price moves that futures positions don't cover.

Case Study: 2018 U.S. Steel Tariffs

Background: March 2018—President Trump announces 25% tariffs on steel imports under Section 232 (national security). Intention: protect U.S. steel producers from Chinese dumping.

Futures market positioning (pre-announcement):

Expected outcome: Tariffs boost domestic steel prices → manufacturers profit from spread widening (selling price up, input costs stable).

Actual outcome:

  1. Retaliatory tariffs: EU, Canada, Mexico impose tariffs on U.S. steel exports → export markets collapse
  2. Downstream disruption: U.S. manufacturers (autos, machinery, construction) face higher steel costs → demand for domestic steel weakens
  3. Input cost inflation: Tariffs also hit specialized steel inputs not produced domestically → manufacturers face higher costs despite domestic production
  4. Stock collapse: U.S. steel stocks fall 50% YoY despite tariff "protection"

Hedging failure: Manufacturers hedged price risk (commodity price movements) but were exposed to policy risk (tariff-induced market restructuring, retaliation, supply chain chaos). Futures positions provided zero protection—losses occurred despite perfectly executed commodity hedges.

Specific example—Harley-Davidson:

2. Tariff and Trade War Risk

Definition: Changes in effective tariff rates (ETR), trade agreements, or bilateral trade restrictions that alter comparative advantage, routing patterns, and landed costs independent of commodity fundamentals.

Why futures fail: Commodity futures settle based on physical delivery at exchange-specified locations (e.g., copper at LME warehouses, crude at Cushing). They don't account for tariffs imposed between those delivery points and final destinations.

Case Study: China Soybean Tariffs (2018-2019)

Background: U.S. soybeans represent 35% of China's soy imports. July 2018—China imposes 25% retaliatory tariffs on U.S. soybeans.

Futures market positioning (Iowa soybean farmer):

Expected outcome: Futures converge to cash prices near harvest → farmer receives ~$10.20/bushel minus basis.

Actual outcome:

Hedging failure: Futures hedged global soybean price risk but not U.S.-specific policy risk. China's tariffs created a two-tier market—U.S. soybeans trading at massive discounts to Brazilian soybeans. Basis risk, normally predictable at $0.20-0.40/bushel, exploded to $1.50-2.00/bushel, invalidating hedge effectiveness.

USDA response: Emergency payments to farmers totaling $28 billion (2018-2019) to offset tariff losses—acknowledgment that futures couldn't hedge policy risk.

3. Chokepoint and Infrastructure Risk

Definition: Disruptions to critical maritime chokepoints (Suez Canal, Panama Canal, Strait of Hormuz) or port infrastructure that alter routing, transit times, and freight costs independent of commodity supply/demand.

Why futures fail: Commodity futures prices assume normal transportation costs and lead times. Chokepoint closures create sudden spikes in freight rates, delays, and regional price dislocations that futures positions don't capture.

Case Study: 2021 Suez Canal Blockage (Ever Given)

Background: March 23-29, 2021—container ship Ever Given blocks Suez Canal, halting 12% of global trade. 400+ vessels queued; estimated $9-10 billion daily trade impact.

Futures market positioning (European refineries importing crude from Middle East via Strait of Hormuz):

Expected outcome: Brent futures converge to North Sea spot prices; refineries receive crude on schedule.

Actual outcome:

Hedging failure: Refineries hedged crude oil price risk via Brent futures but were exposed to freight rate risk and delivery timing risk. Futures settled based on North Sea delivery points unaffected by Suez—didn't reflect disruption costs borne by importers routing via Suez.

Additional impacts:

Commodity futures positions provided zero compensation for these disruptions.

Case Study: 2024 Panama Canal Drought

Background: 2023-2024 drought reduces Panama Canal draft, cutting daily transits from 36-38 to 24-26 (33% reduction). Particularly affects LNG, grain, and container shipments reaching Los Angeles and Long Beach.

Futures market positioning (U.S. Gulf Coast LNG exporter):

Expected outcome: Natural gas costs hedged; LNG delivered to Asia on schedule via Panama.

Actual outcome:

Hedging failure: Natural gas futures hedged feedstock price risk but not logistics risk. LNG exporters faced penalties for late deliveries, lost spot cargo opportunities, and higher transportation costs—none covered by futures positions.

Market gap: No liquid futures contracts exist for Panama Canal transit risk, Suez Canal disruption risk, or generalized maritime chokepoint risk.

4. Geopolitical and War Risk

Definition: Armed conflict, sanctions, blockades, or geopolitical tensions that disrupt commodity production, transportation, or trade independent of peacetime supply/demand dynamics.

Why futures fail: Futures markets price foreseeable risks but struggle with tail-risk geopolitical events. When conflicts erupt, price moves often gap beyond hedgers' margin capacity before they can adjust positions.

Case Study: 2022 Russia-Ukraine War (Wheat Markets)

Background: February 24, 2022—Russia invades Ukraine. Together, Russia and Ukraine account for 25% of global wheat exports, 15% of corn exports.

Futures market positioning (European flour mills):

Expected outcome: Futures converge to cash prices; mills secure wheat at ~$7.80/bushel.

Actual outcome:

Hedging outcome:

Hedging partial success: Unlike policy or chokepoint failures, wheat futures did eventually reflect supply disruption—prices rose in both futures and cash markets. However:

  1. Speed and magnitude of move: Overwhelmed margining systems; many hedgers couldn't hold positions through volatility
  2. Basis volatility: Black Sea disruption created regional price dislocations futures couldn't fully capture (North Africa paid 30% premiums; South America sold at discounts)
  3. Force majeure: Physical supply contracts invoked force majeure; futures settlement didn't compensate for physical non-delivery

Key lesson: Futures hedge normal price risk but struggle with tail-risk price shocks that exceed operational risk management capacity (margin, liquidity, counterparty credit).

5. Demand Shocks and Macroeconomic Crashes

Definition: Sudden collapses in demand due to recessions, pandemics, or financial crises that alter price relationships across commodity complexes in ways uncorrelated with physical hedging needs.

Why futures fail: Hedgers use futures to lock in prices for physical production/consumption. Demand shocks make those physical activities unprofitable regardless of hedging success.

Case Study: COVID-19 Crude Oil Collapse (2020)

Background: March-April 2020—Global lockdowns slash transportation fuel demand by 25-30%. Crude oil storage reaches capacity.

Futures market positioning (U.S. shale oil producer):

Expected outcome: Prices fall to $45? Rise to $60? Hedge locks in $52—producer protected either way.

Actual outcome:

Hedging paradox: Hedge succeeded financially but failed operationally. Producer made money on futures but lost more from halted production, lease obligations, and workforce layoffs. Hedging price risk doesn't hedge business viability risk during demand collapse.

Additional failure modes:

How Prediction Markets Fill the Gaps

What Prediction Markets Hedge: Event Risk and Binary Outcomes

Prediction markets price the probability of discrete future events:

Unlike commodity futures (which hedge continuous price risk), prediction markets hedge binary event risk—the thing futures can't price.

Hedging Policy Risk with Prediction Markets

Strategy: Combine commodity futures (hedge price) + policy prediction markets (hedge policy changes).

Example—U.S. Steel Manufacturer:

Exposure: Uses 50,000 tonnes/month Chinese steel, $800/tonne. Concerned about new Section 301 tariffs.

Traditional hedge (insufficient):

Upgraded hedge (policy-aware):

Outcome if tariffs imposed:

Outcome if no tariffs:

Trade-off: Pay 8-12% premium as "policy insurance." If no tariff shock, you overpaid. If tariff imposed, you're fully protected. Unlike futures (which only hedge price), prediction markets hedge the event itself.

Hedging Chokepoint Risk with Prediction Markets

Example—European Refinery Importing Middle East Crude:

Exposure: 300,000 barrels/month crude via Suez Canal through the Bab el-Mandeb strait. Concerned about Red Sea Houthi attacks disrupting Suez routing.

Traditional hedge (insufficient):

Upgraded hedge (chokepoint-aware):

Outcome if Suez disrupted:

Outcome if Suez normal:

Value proposition: For 6% premium, eliminate tail risk of 20-30% cost spikes from chokepoint disruptions. Particularly attractive for businesses with thin margins or just-in-time supply chains where disruption costs exceed premium.

Combining Futures and Prediction Markets: Portfolio Approach

Optimal risk management strategy:

  1. Commodity futures: Hedge 80-100% of price exposure (core hedge)
  2. Prediction markets: Hedge 50-100% of policy/chokepoint/geopolitical event risk (tail risk insurance)
  3. Options: Add convexity for extreme price moves (volatility hedge)

Example—Agricultural Trader Portfolio:

Exposure: Long 500,000 bushels corn (inventory risk)

Hedge construction:

Total hedge cost: $2.475M (futures margin, ~10% = $248K tied up) + $100K + $25K + $50K = $423K at-risk capital

Scenarios:

| Event | Corn Price | Futures P&L | Tariff Market | Chokepoint Market | Options | Net Outcome | |-------|------------|-------------|---------------|-------------------|---------|-------------| | Normal | $5.00 | -$25K | -$100K | -$25K | -$50K | -$200K (4% cost of hedge) | | Export ban | $4.00 | +$475K | +$150K | -$25K | -$50K | +$550K (protected) | | Barge crisis | $5.80 | -$425K | -$100K | +$100K | +$40K | -$385K (partial protection) | | Supply shock | $7.20 | -$1.125M | -$100K | -$25K | +$360K | -$890K (tail limited) |

Analysis: In normal markets, hedge costs 4% annually—acceptable insurance premium. In crisis scenarios (export ban, supply shock), hedge prevents catastrophic losses that would bankrupt unhedged position. Prediction markets contribute 15-30% of crisis protection despite representing only 5-6% of hedge cost.

Frequently Asked Questions

1. Why don't commodity futures automatically price in policy risk and chokepoint risk?

Futures markets price expected values—the probability-weighted average of all possible outcomes. Policy shocks and chokepoint disruptions are low-probability, high-impact events that contribute little to expected value but dominate tail outcomes.

Example: If Suez Canal has 2% annual probability of major disruption adding $5/barrel to crude costs, expected value impact is $0.10/barrel (2% × $5). Futures prices incorporate this $0.10, but when the 2% event occurs, you face the full $5 cost—50x the expected value. Futures hedge expected value; prediction markets hedge the event itself.

Additionally, arbitrage limits prevent futures from fully pricing tail risks. Arbitrageurs can't easily replicate chokepoint disruptions or policy shocks in physical markets, so pricing anomalies persist.

2. How liquid are prediction markets for trade policy and chokepoints compared to commodity futures?

Commodity futures: Extremely liquid. WTI crude: 1.2M contracts/day ($96B notional). Corn: 350K contracts/day ($2.2B notional). Spreads: 1-2 ticks.

Prediction markets: Substantially less liquid but growing. Major platforms (Polymarket, Kalshi, Ballast Markets) average $10-100M daily volume across all markets. Trade-specific markets (tariffs, ports, chokepoints): $500K-5M daily volume.

Practical implication: Large hedgers ($50M+ notional) can fully hedge commodity price risk via futures but may only hedge 10-30% of policy risk via prediction markets (liquidity constraints). Still valuable—30% protection against unhedged tail risk is significant improvement over zero.

Liquidity improving: As prediction markets gain regulatory clarity (CFTC approvals for event contracts) and institutional adoption increases, trade-focused markets expect 5-10x volume growth by 2026-2027.

3. Can I use options on commodity futures instead of prediction markets?

Partially, but options have limitations:

Options hedge price volatility (large moves in either direction) but don't hedge event-specific risks.

Example: Buy $6.00 call options on corn (currently $4.95). If prices spike to $7.00 due to drought, options pay off. If prices spike to $7.00 due to export ban that also prohibits your physical sales, options pay off but you can't monetize physical inventory (net loss).

Prediction markets hedge the event independent of price. "Will U.S. ban corn exports?" pays if ban occurs, regardless of whether price rises, falls, or stays flat. Captures regulatory risk options miss.

Best strategy: Use options for price volatility (uncertainty about magnitude) + prediction markets for event risk (uncertainty about occurrence).

4. How do I size prediction market hedges relative to commodity futures positions?

Framework:

  1. Calculate event impact: If policy change/disruption occurs, what's the dollar impact on your business? (Tariff: +25% costs. Chokepoint: +$5/barrel freight.)

  2. Estimate event probability: Use prediction market prices as baseline (e.g., market prices 30% = 30% probability).

  3. Calculate hedge size:

    • Event impact: $10M
    • Prediction market pays $1 if event occurs
    • Cost: 30¢ (30% probability)
    • Profit if event occurs: 70¢ per $1 invested
    • Hedge size: $10M / $0.70 = $14.3M notional
    • Upfront cost: $14.3M × 0.30 = $4.29M

  4. Adjust for risk tolerance: Full hedge (100% of event impact) costs 30% of impact in premium. Many firms hedge 50-70% to balance protection and cost.

Rule of thumb: Prediction market hedges typically cost 20-40% of event impact in upfront premium for 50-100% protection. Compare to insurance premiums—similar economics.

5. What happens if prediction markets misprice event probabilities?

Two scenarios:

Scenario 1—Market underprices risk (e.g., prices 20% when true probability is 40%):

Scenario 2—Market overprices risk (e.g., prices 50% when true probability is 20%):

Hedger perspective: Even if market overprices, insurance still valuable if:

  1. Event impact is catastrophic (bankruptcy risk) → pay premium for peace of mind
  2. Your private information suggests higher probability → market says 20%, you believe 40% → cheap insurance

Mitigating mispricing risk: Hedge only tail risks with asymmetric impacts. Don't hedge every minor risk—focus on events that threaten business viability.

6. Can prediction markets hedge basis risk in commodity futures?

Yes, but indirectly.

Basis risk = Local cash price deviates from futures settlement price due to transportation costs, regional supply/demand, quality differences.

Example: CBOT corn futures settle at Chicago. Iowa farmer's local cash price is typically $0.30/bushel below Chicago (basis = -$0.30). If basis widens to -$0.80 due to rail disruptions, farmer's hedge underperforms.

Prediction market hedge: "Will Mississippi River barge rates exceed $X for 30+ days?" If rail/barge disruptions occur (causing basis widening), prediction market pays out, offsetting basis risk.

Limitation: Requires liquid prediction markets on specific logistics factors driving basis. Currently rare but emerging as prediction markets expand into trade infrastructure.

7. How do I know which risks to hedge with futures vs. prediction markets vs. options?

Decision framework:

| Risk Type | Hedge Instrument | Rationale | |-----------|------------------|-----------| | Continuous price risk (normal volatility) | Commodity futures | Cheapest, most liquid, converges to cash | | Event risk (policy, chokepoint, geopolitics) | Prediction markets | Only tool that hedges occurrence, not just price impact | | Tail price risk (extreme moves) | Options (OTM calls/puts) | Convex payoffs; small premium for large protection | | Volatility risk (uncertainty itself) | Options (straddles, VIX-like products) | Profits from volatility, direction-agnostic | | Basis risk (local price divergence) | Futures + location spreads (or emerging prediction markets) | Futures plus regional adjustments |

Portfolio approach: Start with futures (80-100% of price risk), add prediction markets (50-100% of event risk), optionally add options for tail risk. Most businesses can't afford to hedge everything—prioritize based on impact×probability.

8. Are there tax or accounting differences between commodity futures and prediction markets?

Yes, significant differences (U.S. example—consult tax professional for specifics):

Commodity futures:

Prediction markets:

Accounting complexity: Commodity futures qualify for hedge accounting (gains/losses offset physical commodity income statement timing). Prediction markets may not → creates P&L volatility even if economically hedged.

Practical impact: Tax and accounting treatment favor commodity futures for routine hedging. Prediction markets better suited for tail-risk insurance (infrequent payouts, less accounting complexity).

9. Can I trade both commodity futures and prediction markets on the same platform?

Currently, no major platforms offer both:

Operational challenge: Requires separate accounts, margin management, risk monitoring. Institutional users often build custom dashboards aggregating both.

Future development: Some prediction market platforms exploring commodity price binary contracts (e.g., "Will WTI exceed $100 in Q4 2025?"), which would overlap with futures functionality. Likely 2-3 years before unified platforms emerge.

10. Where can I learn more about combining commodity futures and prediction markets?

Ballast Markets resources:

External resources:

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Conclusion: Hedge the Full Risk Profile, Not Just Price

When commodity traders talk about "hedging," they almost always mean hedging price risk—locking in purchase/sale prices via futures contracts. And futures excel at this: 350,000 corn contracts trade daily with 1-2 tick spreads; you can hedge $100M of copper exposure in 30 seconds with minimal slippage. For price risk, futures are unmatched.

But price risk is only 40-60% of the total risk profile for businesses exposed to global trade. The 2018 steel tariffs bankrupted manufacturers who'd perfectly hedged commodity prices. The 2021 Suez blockage cost refineries millions despite functioning crude oil hedges. The 2024 Panama Canal drought added 15-18% to LNG delivery costs that natural gas futures never captured.

The pattern is clear: commodity futures hedge continuous risks; prediction markets hedge discontinuous risks. Futures protect you when prices move $5 to $8 over three months. Prediction markets protect you when policy announcements, chokepoint closures, or geopolitical shocks move prices $8 to $15 overnight—or when prices stay flat but your business model breaks due to regulatory changes futures can't price.

Smart risk managers in 2025 and beyond won't choose between futures and prediction markets—they'll deploy both. Use futures for the 95% of scenarios where price volatility dominates. Use prediction markets for the 5% of scenarios that account for 50% of tail risk. Pay 4-8% annually in hedge costs to eliminate 80-90% of total risk, not just the price component.

The traders who master this hybrid approach—combining commodity futures' liquidity and prediction markets' event specificity—will be the ones still standing after the next tariff war, the next chokepoint crisis, or the next geopolitical shock that futures markets never saw coming.

Ready to hedge beyond price risk? Explore Ballast Markets' trade policy and chokepoint contracts or learn advanced risk management strategies.

Disclaimer

This content is for informational and educational purposes only and does not constitute financial, investment, tax, or legal advice. Trading commodity futures and prediction markets involves substantial risk, including total loss of capital. Futures trading involves leverage, which magnifies both gains and losses. Prediction markets are emerging instruments with evolving regulatory treatment and liquidity constraints. Past performance does not indicate future results. Hedging strategies do not eliminate risk and may result in opportunity costs when hedged events don't occur. Data references include CME Group, LME, ICE, CFTC, USDA, and trade policy analysis sources (accessed through February 2025). Consult with qualified financial advisors, commodity trading advisors, and risk management professionals before implementing hedging strategies.