Commodities, Buying the Future

Let’s do something different. I want to dig a little deeper into what we mean when we make commodities into things that vary in a single dimension, and some implications for time-space, financial engineering, and scholastic philosophy.

Space

Put your arms out in front of you forming a “V”. I want you to picture this as space, say the country as a whole. Now slowly bring your arms together, and picture the experience of space collapsing.

One generalized notion of modernity is that it involves a collapse of space. One way to approach this involves specific technologies which increases one’s ability to travel across space (see this David Harvey chart). But it also involves a homogenization of commodities across space. You experience this today in the generic complaint that there are the same stores everywhere, the same goods, the same food. But the origins go back further.

One of the big innovations in this process was the mail-order catalog, pioneered by the Sears, Roebuck and Co in 1888. A problem that this catalog had to overcome was that people had to know what they were getting. The commodities that were mailed out had to have a basic level of quality implied through the catalog since people would not experience the good until after it was paid for across a fair amount of spatial distance – you wouldn’t look a shopkeeper in his eye, shake his hand and get his word. So advertising, marketing, educating the consumer (who was now a term you could detach from location), started to come into practice.

Time

Now put one arm in front of you, and the other arm straight in the air, so you look like an “L” from the side. I want you to think of this as the time dimension, and I want you to think of the futures market as a collapse of this dimension. The futures market allows us to collapse the top arm down.

I’ll just kick it to wikipedia for a definition of a contract: “Futures contract, in finance, refers to a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price).” Here is the market price for live cattle in the future. There are several prices, and they only vary on one dimension (more on this in a second), and that is the time of delivery. So you can get a price for cattle in April 2011 or December 2010, and the only thing that should be different is that one is delievered 4 months later. It should function the same way an interest rate curve works – the only difference when your identical money get paid is that one is a few months later.

You can go ahead and thank Chicago for this collapse in time/space as well. The first forward contract on corn was signed in Chicago on March 13th, 1851. It was for 3,000 bushels of corn to be consigned in June of 1852. Here’s what the commodities market looks like today in Chicago:

So, to go back to the question above, we have this same problem – you are buying from someone you won’t meet. You also have an additional problem – if you buy a dress from the Sears Catalog, chances are there’s a warehouse with thousands of these dress. With this form of correspondence buying across time (as opposed to the correspondence buying across space in the catalog), the commodity hasn’t even been created yet. And these commodities are often living things often, plants and animals, not standardized like a toaster. So we need to get into the business of standardizing them.

Not only did Chicago, and this market, redefined the act of selling, but it has also redefined the terms of what it sells: cattle, meat, wheat, and lumber. These goods needed to be turned into a form of currency, something that is completely fungible. Remember the futures contract is a claim on a future good, but this only aggregates market information if people can bid it up and down. So the information contained in cattle or wood has to be agreeable to all parties as a baseline, just like a form of currency. In the same way you and I can’t argue that since your $20 bill has a bit of the corner torn off it is less than $20 – all bills are the same – we need all cattle to be the same in order for us to bid on the prices.

And we do this in the contract. Take a look at a contract for Live Cattle Futures.

Par Delivery Unit. A par delivery unit is 40,000 pounds of USDA estimated Yield Grade 3, 55% Choice, 45% Select quality grade live steers, with no individual animal weighing less than 1,050 pounds or more than 1,475 pounds deliverable at par…

No cattle showing a predominance of dairy breeding or showing a prominent hump on the forepart of the body shall be deliverable. Such determinations shall be made by the grader and shall be binding on all parties…

Steers weighing more than 1,475 pounds but less than or equal to 1,550 pounds shall be deliverable at an adjustment equal to 950-1000 lbs Factor described in Rule 10103.A., multiplied by the average live weight of the delivery unit…

Cattles who are too large (over 1,475 pounds) or too small (under 1,050 pounds), won’t qualified to be sold as a commodity. There are many, many rules in that manual and the other manuals it alludes to, all of which creates the Ideal Cattle, the only cattle which can find a buyer in this market. It goes on. Here’s Butter Futures:

A par delivery unit is 40,000 pounds of Grade AA salted butter. The entire unit shall be exclusively frozen butter at temperatures not to exceed 0 degrees Fahrenheit at the time of delivery. The entire unit shall be uniform in color, salt content and weight. Grade A butter shall not be deliverable.

Butter shall be packaged to conform to the packaging specifications of the Commodity Credit Corporation for bulk butter in force on the date of manufacture, as contained in “Announcement Dairy-6, Purchase of Bulk Dairy Products”, as amended, or in such other document or an announcement as may supersede this publication.

Also check out Random Length Lumber Futures:

The lumber shall be double end trimmed, surfaced four sides, eased edge and of minimum dressed dimensions, as specified in Voluntary Product Standard 20-94, American Softwood Lumber Standard, published by the United States Department of Commerce, or any subsequent revisions (hereinafter referred to as PS 20)….

The lumber shall meet the requirements of PS 20 and shall comply with the requirements for inspection and reinspection of an agency recognized by the American Lumber Standards committee and/or Canadian Lumber Standards Committee.

The moisture content of each piece shall not exceed 19% as determined by moisture meter readings in accordance with the “Standard Method of Tests for Moisture Content of Wood,” Section 9, Method B of the American Society for Testing Material Standard, D2016-65.

It even mandates the level of moisture that is needed to qualify as being lumber. This standardization process is one of the bigger workhorses of modernity. Think of nuts and bolts you can buy from a dozen different hardware stores that work with each other regardless of where you buy them. The futures commodity market requires cash and these commodities to work the same exact way.

The philosophical implication are immediate. I’m going to outsource the conclusion to Marco d’Eramo, from his book The Pig and the Skyscraper: Chicago: A History of Our Future:

Without knowing it, the futures market confronts, and in its own way resolves, the debate of the Middle Ages between nominalists and realists. That debate addresses a question of universals, with scholastic philosophers trying to decide whether the names of things resulted purely from convention, whether ideas actually corresponded to the objective reality of their physical examples – or whether ideas possessed a reality independent of who thought them or of the objects that appeared to correspond to them. To buy or sell a cattle future, the market needed first to define “the ideal cow”, “the idea of cattle.” Once this idea had been defined and a set of standards fixed, the living cows actually had to live up to that reality if they were to find a market…

In this sense, althought it may originally be the result of purely arbitrary convention, the name of a thing produces the thing itself. Furthermore, the name itself defines the essence – the quidditas – of an object and excludes everything that does not fall under its definition…The apple’s quidditas (its “appleness” is defined by color, consistency, dimensions – in short, by form – but not by flavor.

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8 Responses to Commodities, Buying the Future

  1. Matt Frost says:

    That was good, but all I remember is “something something, 40,000 pounds of Grade AA salted butter, something something.”

  2. financeguy says:

    Interesting stuff, philosophically. I think d’Eramo could have stated his conclusion with a bit more bite: when you commoditize something, the apple (or whatever the product) will then start to become whatever the heavy hand of the market says it should be. It would be interesting to compare our image of a typical apple today with one from 400 years ago. Today: bright red, nicely formed. 400 years ago: not as red and maybe a little lumpy, probably with a few blemish spots.

    Anyway not to hijack your train and send it in a different direction but commoditization has a curious application to the swamp of toxic financial assets out there. One problem confronted early on was how to dispose of bad assets. One solution: a reverse auction (instead of the one seller, many buyers model, a one buyer (fed. government), many sellers model). The trouble is, these securities were too unique — not commoditized enough — for this to work. A given security might be effectively sui generis. And so (and I blogged about why this wouldn’t work), sure enough … the idea just kinda died.

  3. Matt Frost says:

    For further discussion: replace “lumber,” “butter,” or “cattle” with “labor.”

  4. Jared says:

    Great post, Mike.

  5. Mike says:

    Matt: Isn’t it great to imagine Enron-style hard-hitting type A future traders getting in each other’s faces over the butter market? And now that you are mentioning it, I have to take on shop class as soulcraft with this idea of commodification of labor in the background.

    financeguy: I’m thinking a lot about the heterogenity of debt as bundles of consumer debt, instead of the more Fordist way debt was an extension of a production economy (collateralized in inventory and factories and goods), is one of the changes in the nature of rated debt that caused the question of the quality to become so difficult.

    Jared: Thanks!

  6. Not the Mike You're Looking For says:

    With regard to standardization, here’s a more interesting example: In the Chicago grain market, sometimes the price of a lower-quality grade of wheat would rise to a level where it became profitable for sellers to dump gravel into higher-grade wheat and sell it as the lower grade (at the increased weight). You can find it in William Cronon, _Nature’s Metropolis_.

    By the way, I find d’Eramo’s last paragraph really obscure. “The name of a thing produces the thing itself” is one of those annoying turns of phrase that cultural studies professors say to sound profound. More to the point, it’s wrong. The conclusion I see is that the ideal, commodified version of lumber or cattle is a social achievement, a product that requires countless hours of labor, not to mention the active intervention of a third-party authority (which may or may not be the government).

  7. “The apple’s quidditas (its “appleness” is defined by color, consistency, dimensions – in short, by form – but not by flavor.”)

    Perhaps that’s why economists have screwed things up so royally. Marco D’Eramo may know everything about the futures market and pigs and Chicago, but he knows nothing about apples.

    Go to any farmer’s market, and you’ll discover that the flavor of the apple is often the only thing that makes the apple worth buying (unless you’re looking to turn a quick buck in the futures market.) And for those passionate souls engaged in creating that most American dish of all, the apple pie, flavor is absolutely essential when picking the apples that will be used. If you’re gonna talk apples, know what’s important to the people who consume them – and it’s flavor, not form.

    In America today, I think we’ve seen from the mortgage market that the name of a thing – the “thingness” of the thing – is less relevant than whether or not there’s a short term profit to be made on whatever anyone is selling. The “quidditas” of such endeavors is rather dreary and lacking good taste, though rife with money – until the exceptionally poor business practices take down the economy.

  8. Paul Delima says:

    While I may agree with your thesis, I disagree with the examples used to derive it. Commodities are by their nature a fairly broad category, and the the Chicago constraints are:
    a) not really broad enough to define the space
    b) can be used an benchmarks for non-conforming products.

    Take the lumber for example, 19% moisture is actually fairly high. You would have trouble using that lumber for construction if moisture were to hit 20% meaning a fifth of the weight of lumber is water. Hence the Chicago definition of the lumber product constrains the product to what buyers would use in the real world. Lumber producers are welcome to produce other specifications of lumber, but they would have to work just a little harder to find a buyer.

    Secondly, non-conforming products can be benchmarked against the Chicago product. For example lumber of moisture content 20% -25% can be sold at 10% discount to Chicago standard. This is actually how most commodities in the world are sold, as a very small number of commodities conform to the actual exchange specification physically, and an even smaller number are actually delivered to Chicago warehouses which is what the futures contract specifies.

    So in short, you would be right, that the specifications end up defining the product, except that in the real world buyers and sellers use the futures specifications merely as benchmarks to actually price their real commodities with all the variations inherent in a real product.

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