Taking physical delivery and hedging are not one and the same. It’s entirely possible to use a cash settled future to hedge against market movements; the farmer sells at a steep loss, but their cash settled wheat futures offset a large percentage of the loss on a cash basis.
The distinction you’re looking for here is those who are speculating on market prices, vs. those who are hedging against market prices. If you use or sell oil in large amounts, it makes sense to use futures to stabilize your downside risk, even if those futures are cash settled.
That being said, I think that cash settled futures make purely speculative trading much easier, so you’d have a good point if that’s what you were heading towards.
That is the point I was trying to make. Basically if you're in the business of producing or buying and selling the commodity the futures are for you. If you're just speculating how does that help anybody? I guess you could make the argument that having more eyes on the market means there is more information so the price is a better reflection of the true value.
It's a good question. Most markets have (or at least used to; I've been out of this a long time) a special class of speculator called a market-maker; they get discounted fees in exchange for providing liquidity. That way a seller doesn't have to wait around for a buyer.
Speculators in theory also provide liquidity, and in theory also contribute to keeping the prices "correct" (meaning at levels that reflect what's known). But it's not like any given speculator personally cares about that; they're just looking to gamble and win. Last I heard there was reasonable evidence that more gets spent on speculation than is delivered in benefits to the economy. So you suspicion is not unwarranted.
But there's another class of people who neither create nor consume the product, but have some financial interest in something related. E.g., suppose you sell farm equipment. You know that if wheat farmers have a bad year, you'll have a bad year, because they will put off buying your new tractors. To even things out, you can use wheat derivatives to essentially buy insurance on wheat prices. If wheat prices are normal, you lose a little money. But if they fall through the floor, you make money, hopefully counterbalancing the income from lost sales.
When this activity is significant enough, it can lead to the creation of synthetic commodities. E.g., if you are in the snowplowing business, maybe you want to insure against winters being abnormally snowy. You could maybe do something with a fuel oil future. But that's kinda tenuous. Instead now you can just trade weather futures: https://www.cmegroup.com/trading/weather/
Minor nit: market makers typically aren’t there to speculate, they’re there to provide liquidity and make small profits per trade doing so. Most market makers try their best to trade down to no position overnight, since they don’t want to be long or short in anything.
Thanks! Maybe the market maker I worked for was atypical. We definitely had opinions on where the market was going and made good money from that, especially in times of high volatility.
It's hard to make money by pure market-making, so it's common for market-makers to also do some amount of speculation.
After 2008, banks were banned from speculating (ish) [1], but were allowed to do market-making. It's common for market-making desks to do speculative trades under cover of market-making activity. It's hard to conclusively prove that any given trade is speculation rather than market-making (which involves hedging), so they generally get away with it.
Ah, yes. We were purely a proprietary trading firm. As my boss explained it, the traders who started the company brought a pile of money with them, and it was our job to make it a bigger pile of money. It was in some ways very pure; for my first year there we didn't even have the company name on the door. We already knew where the place was, and money spent on frivolities just meant less money to trade with.
If you only had farmers and individuals purchasing their goods allowed to trade futures, there is direct incentive for either party to manipulate the physical market through their actions, in ways that they only could, that wouldn't necessarily make any economic sense and could have spillover effects into the real economy. By having a more open market for futures, you theoretically have a more efficient market for all participants which you mention in your last sentence.
The standard answer is that speculators provide liquidity.
People that want to buy or sell a commodity typically only want to do a certain number of transactions. What happens if they can’t find someone to take the other side of a trade? It would be annoying to have to wait a week until someone else is interested. Moreover, they may want a different quantity than you do, or they may want a different delivery date.
There is also price discovery as you allude to. A farmer selling pork doesn’t necessarily want to have to track the details of the Chinese economy and the weather patterns in Europe just to get a fair price for their goods. Speculators help with that.
You may hedge your risk of prices of a different but related product.
E.g. a bread manufacturer wants stability on their cost of goods, so they may buy wheat futures even though they don't ever want to receive direct shipment of wheat, they're dealing with specific regional flour suppliers but the wheat futures at a major location are a good proxy for that price.
You might want to invest in oil futures without taking delivery because you the thing you want to buy in volume doesn't have a contract, but is highly correlated. Airlines and jet fuel for example, though I think that has a market now.
The distinction you’re looking for here is those who are speculating on market prices, vs. those who are hedging against market prices. If you use or sell oil in large amounts, it makes sense to use futures to stabilize your downside risk, even if those futures are cash settled.
That being said, I think that cash settled futures make purely speculative trading much easier, so you’d have a good point if that’s what you were heading towards.