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I was reading Trading Commodities and Financial Futures by Kleinman, I saw this excerpt:

When you buy or sell a futures contract, you don’t actually sign a contract drawn up by a lawyer. Instead, you enter into a contractual obligation that can be met in only one of two ways. The first method is by making or taking delivery of the actual commodity. This is by far the exception, not the rule. Fewer than 1% of all futures contracts are concluded with an actual delivery. The other way to meet this obligation, which is the method you will be using, is termed offset. Very simply, offset is making the opposite (or offsetting) sale or purchase of the same number of contracts bought or sold sometime prior to the expiration date of the contract. Because futures contracts are standardized, this is accomplished easily.

My question is if 1% of contracts are fullfilled, how does this market work? Why would producers create contracts that they would not fullfill?

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  • $\begingroup$ The contracts settle in cash. $\endgroup$ – pyCthon Mar 5 '16 at 18:38
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Because they are hedging their commodity price exposure, not their ability to deliver/receive said commodity.

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  • $\begingroup$ Okay - so let's say I am producing corn, I want to "lock" a price at $6 per bushel, for 5,000 bushels it is worth 30,000. Well, if this corn will never delivered, why would I want to create this contract, and lock a price? $\endgroup$ – user616 Mar 3 '16 at 8:43
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    $\begingroup$ You have two options at expiry of your futures contract: 1. Physical delivery for 6 per bushel. 2. Cash settlement at 6 - x and delivery to market at x. x is the spot price at expiry. Both options produce the same outcome for the producer. The 2nd one is usually preferred, some reasons here Cash settlement $\endgroup$ – KarolisR Mar 3 '16 at 9:46
  • $\begingroup$ I see; I understand the motivation for the buyer now (the airline example, cast settlement was informative). The producer can also cash settle, and sell the corn to someone else. Is that why only 1% of contracts result in actual delivery? This also suggests producers would never create contracts they would not / could not fullfil, right? $\endgroup$ – user616 Mar 3 '16 at 10:15
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    $\begingroup$ Pretty much, yes. At least in energy utility space the power producers typically have a rolling hedging schedule. For example they will have hedged 90% of next year, 60% of 2nd year etc. Whatever is left, they sell at spot. If they see that they will produce less than they hedged, they can close out the hedges before delivery. $\endgroup$ – KarolisR Mar 3 '16 at 14:35
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Lets say we have 3 kind of players/trades: Hedge, arbitrage and speculative. In theory just hedges would be interest in delivery/receive in some case. But as the name say usually it's for hedge market only. When producers go to futures market it's not to sell/buy products it's only to protection this prices. You have other kind of instruments to sell/buy physical. And of course arbitrage and speculative traders is usually the great majority of players and sure they don't want delivery/receive nothing.

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  • $\begingroup$ Form what I understand so far, producers go to futures market for price protection, but this protection must be in proportion to what they produce otherwise it's not protection. With my question I was interested in understanding the production / contract size relationship; The delivery need not necessarily be through the futures contracts, but it happens elsewhere. $\endgroup$ – user616 Mar 4 '16 at 9:44

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