Forget about new agriculture futures contracts; Focus on agriculture competition if you want to trade commodities

A new CME pork cutout futures contract is coming in early November. Why should a commodity investor care?  Most new futures contracts fail. We have not seen a new successful agriculture futures contract for some time. Most investors will not be an active user until volume and open interest rise to some minimum level to sustain speculative trading. 

What is important for the success of a futures contract is the underlying structure in agriculture markets and price discovery cane be facilitated through futures. An industry that is too concentrated cannot sustain active futures contracts. When there is a power imbalance between buyers and sellers, the dominant player will drive contract decisions and pricing and will generally not support open discovery of prices. A poor functioning cash market because of extremes in market power will spill over to a poorly functioning futures market. 

A less competitive market means that traders are not able to see or be part of price discovery and futures prices are not closely linked to fundamentals. Even a trend-follower who focuses just on prices does not benefit from markets dominated by larger players or a market where price discovery is not present. 

Agricultural markets are becoming increasingly dominated by large product buyers which impact speculation, hedging, and overall prices. Grain markets are also dominated by a few players in farm production inputs like seeds. One-sided relationships will threaten competition. Yet, there are limited voices for competition given smaller players do not have the ability to influence exchanges or regulators. 

However, the story of competition in the hog market is more complex than a David and Goliath story between large processors and small farmer/producers. Processing has become more concentrated, but hog producers have also become big operations that need stable pricing and contracts. Direct placement over auction is more likely when both parties are large and have a desire for consistent product flow and stable cash flow. The changes in the hog industry is a story of increasing returns to scale with vertical integration to ensure scale economies are exploited. Processors buy or link with producers to create a seamless supply chain. In this world, the needs for a lean hog futures market change. 

There is a desire to switch futures business for pork cutouts over lean hogs because the business has changed. The key firm risk has moved to a different point of the supply chain. The combination of concentration, the evolution or destruction of the cash market, and the value-added at the wholesale market over the risk to farmers all contribute to a need for adaptation in futures contract, but it begs the question of what is happening to agriculture markets.

Concentration has slowly increased over a 40 year period and now is closing in on 70%. The concentration has coincided with the export business for protein which takes greater capital and logistical expertise to be profitable. However, these numbers do not tell the real story because large hog producers are also dominating the business and eliminating the small producer. Direct contracting is dominating the market over a cash spot market. An integrated hog industry changes the need for generalized futures contracts.

There is a dynamic tension between integrated market structure, competition, and futures trading. Futures trading sits in the center of a competitive industry structure. Change the rules and players, and the active contract of today can be a dead market tomorrow. Agricultural futures have now survived for centuries, but its importance in farm marketing and distribution is not guaranteed as the move to industrialized farming moves forward.