In a discussion of physical commodity markets such as oil, natural gas, wheat, gold, etc., there are two main players involved in determining the market price. Generally speaking, you are either an actual Producer (or somehow involved in the actual product, such as a distributor), or a Speculator. An oil company, like Exxon that actually risks its' own capital to explore for oil, is an example of a Producer. A trader on the Futures Exchange or an investor at home wanting to make money somehow in the oil markets are Speculators. The two of these, combined with the Futures Exchanges, are integral to the functioning of our Financial Markets and are one of the main reasons our Capitalistic system works so well at allocating resources and determining fair market prices.

If you are a Producer of a product, the price of the particular product such as oil will usually be very different from when you actually started the exploration process versus when you are able to sell it. If the prices rise you stand to make a greater profit, but if the price drops you may actually lose money as you have already paid all of the upfront costs associated with production. This is a huge risk to the Producer and has been the cause of many companies going out of business. Wouldn't it be nice if a Producer could somehow "lock-in" their selling price so as to guarantee at least a minimum profit?

They can, and this is where Speculators and Exchanges come into play. A Commodity Exchange is where Producers and Speculators come together to "do business". Producers are interested in being able to sell their products at a particular price or range whereas Speculators just want to make money. A Producer can hedge their risk of a price fluctuation by "transferring" that risk to a Speculator. The process of transferring risk is known as buying or selling a Futures Contract.

For illustration purposes let's say that it costs Exxon $60 per barrel to get the oil out of the ground but they need a minimum selling price of $75 per barrel to show an adequate return for their shareholders. Exxon can sell a Futures Contract that allows the buyer, the Speculator, to buy the oil from them at $75, locking in Exxons' needed profit. A Speculator who feels that oil prices are going to continue to rise in the near term to say, $90, might find this an attractive investment opportunity. If the price does in fact rise, Exxon makes money, not as much as if they didn't hedge, but still at least a profit and the Speculator also makes money. If the price drops Exxon is protected on the downside and the Speculator losses money. Oh well, that is why they are called Speculators and the real ones understand the risks involved.

This is a simplistic explanation and there are numerous variations and nuances involved. However, the bottom line is that the Producers and Speculators need each other. It is a symbiotic relationship and neither can really prosper without the other. As consumers, we benefit because the Producers are able to stay in business and we get their product. The market, supply and demand, and the interaction between Producers and Speculators ultimately determines the end price.