"To understand commodity futures prices, you need to understand the production and consumption of  the commodity in question."

Field crops operate on an annual supply schedule and a variable demand schedule. Field crops include the following commodity futures markets: Cotton, Sugar, Cocoa, Orange Juice, and Coffee. Though the production of these commodities has become a world operation during the last ten to twenty years, the bulk of the supply is usually available at the time of harvest for the major producing regions. Demand, on the other hand, is fairly evenly spread throughout the year, though certain periods, such as the spring and early summer, tend to see increase grain demand. This sets up a unique feature in the market where price acts as a rationing device for annually produced commodities, as consumers and producers cycle through being gripped by the forces of fear and greed.

When a market has annual production, or supply is replenished once a year, this supply must be rationed or spread out over the rest of the year. The market mechanism for rationing supply is price. When prices are high, consumers are discouraged from consumption to some degree and the supply will last longer. When prices are low, consumers are encouraged to use the product to a certain extent and the supply is used up. But price also acts as a stimulus for supply. When prices are high, producers are encouraged to increase production to increase profits. However, when prices are low, producers tend to decrease production since profit margins are not as great. This type of market behavior sets up a paradox, in which low prices discourage production, and high prices encourage production, but producer reactions to prices cannot occur until the following year. As such, swings in annually produced commodities, especially when supplies are currently tight, tend to be exaggerated when the crop is vulnerable to damage.

Risk Premiums and Commodity Futures

The exaggerations of price are often referred to as building a "risk premium" into the crop. Since price will ultimately ration the supply that when a crop is feared to be in limited supply prices tend to rise to spread out supply. Annually produced commodities tend to go through cycles of building risk premium and destroying risk premium as the crop goes through its various stages of production. Risk premiums are built when consumers fear limited supply and producers have an economic motive to with hold supply from the market place. So during potentially tight supply times, consumers tend to pay higher prices for fear of not being able secure supply, while producers must be encouraged to sell at these higher prices to satisfy their profit motive, or greed.

However, as the consumers meet their current demand needs they tend to be motivated to find alternate sources of supply or will use other products in substitution (greed) while producers fear missing the higher prices and tend to open the flood gates of supply. As such, when the crop is in danger of potential damage, fear grips the consumer and greed the producer. Prices then rise as the market place builds the risk premium into the crop to ensure supply at a later date.

As the crop matures and supply looks more probable in the future, the producer now removes the risk premium from the market. There is fear of missing the attractive higher prices of selling their product to consumers who have now met their demand with alternate sources and supplies. Hence, as a crop goes through its natural planting, maturating, and harvesting cycle, the risk premium is built and destroyed depending upon the forces of nature as well as the emotional forces of fear and greed.

Conclusion

This process of building and removing of risk premiums is key to understanding the rationality of grain prices. Because fear and greed are important in building and removing of risk premiums, markets tend to move much farther than would be thought, and can stay at emotional levels longer than most people would anticipate. It is this factor which makes the markets, especially the grains and field crops, difficult to analyze since they are constantly being buoyed by this "irrational exuberance", to quote the Chairman of the Federal Reserve.

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