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Demand Uncertainty and Excess Supply in Commodity Contracting

Author

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  • Dana G. Popescu

    (Department of Technology and Operations Management, INSEAD, Singapore 138676)

  • Sridhar Seshadri

    (Department of Information, Risk and Operations Management, McCombs School of Business, University of Texas at Austin, Austin, Texas 78712)

Abstract

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.

Suggested Citation

  • Dana G. Popescu & Sridhar Seshadri, 2013. "Demand Uncertainty and Excess Supply in Commodity Contracting," Management Science, INFORMS, vol. 59(9), pages 2135-2152, September.
    • Handle: RePEc:inm:ormnsc:v:59:y:2013:i:9:p:2135-2152
    DOI: 10.1287/mnsc.1120.1679
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    3. Falbo, Paolo & Ruiz, Carlos, 2019. "Optimal sales-mix and generation plan in a two-stage electricity market," Energy Economics, Elsevier, vol. 78(C), pages 598-614.
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    5. Paolo Falbo & Carlos Ruiz, 2021. "Joint optimization of sales-mix and generation plan for a large electricity producer," Papers 2110.02016, arXiv.org.
    6. ap Gwilym, Rhys & Ebrahim, M. Shahid & El Alaoui, Abdelkader O. & Rahman, Hamid & Taamouti, Abderrahim, 2020. "Financial frictions and the futures pricing puzzle," Economic Modelling, Elsevier, vol. 87(C), pages 358-371.
    7. Sébastien Mitraille & Henry Thille, 2020. "Strategic advance sales, demand uncertainty and overcommitment," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 69(3), pages 789-828, April.
    8. Jhang, Shih-Sian (Sherwin) & Ogden, Joseph P. & Suresh, Nallan C., 2019. "Operational and financial configurations contingent on market power status," Omega, Elsevier, vol. 88(C), pages 91-109.
    9. Lusheng Shao & Derui Wang & Xiaole Wu, 2022. "Competitive trading in forward and spot markets under yield uncertainty," Production and Operations Management, Production and Operations Management Society, vol. 31(9), pages 3400-3418, September.
    10. Bolandifar, Ehsan & Chen, Zhong, 2020. "Hedging through index-based price contracts in commodity-based supply chains," Omega, Elsevier, vol. 90(C).
    11. Falbo, Paolo & Ruiz, Carlos, 2023. "Joint optimization of sales-mix and generation plan for a large electricity producer," Energy Economics, Elsevier, vol. 120(C).
    12. Zhanwen Shi & Erbao Cao, 2020. "Contract farming problems and games under yield uncertainty," Australian Journal of Agricultural and Resource Economics, Australian Agricultural and Resource Economics Society, vol. 64(4), pages 1210-1238, October.
    13. Amar Sapra & Peter L. Jackson, 2022. "Integration of long‐ and short‐term contracts in a market for capacity," Production and Operations Management, Production and Operations Management Society, vol. 31(7), pages 2872-2890, July.

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