Demand Uncertainty and Excess Supply in Commodity Contracting

We examine how different characteristics of product demand and market impact the relative sales volume in the forward and spot markets for a commodity whose aggregate demand is uncertain. In a setting where either the forward contracts are binding quantity commitments between buyers and suppliers or the forward production takes place before the uncertainty in demand is resolved, we find that a combination of factors that include market concentration, demand risk, and price elasticity of demand will determine whether a commodity will be sold mainly through forward contracts or in the spot market. Previous findings in the literature show that when participants are risk neutral, the ratio of forward sales to spot sales is a function of market concentration alone; also, the lower the concentration, the higher this ratio. These findings hold under the assumption that demand is either deterministic or, if demand is uncertain, all production takes place after uncertainty is fully resolved and production plans can be altered instantaneously and costlessly. In our setting, however, we find that even a low level of demand risk can reverse the nature of supply in a highly competitive (low concentration) market, by shifting it from predominantly forward-driven to predominantly spot-driven supply. In markets with high concentration, the price elasticity of demand will determine whether the supply will be predominantly spot-driven or forward-driven. Our analysis suggests various new hypotheses on the structure of supply in commodity markets. This paper was accepted by Martin Lariviere, operations management.