Commodity Derivatives

A Guide for Future Practitioners

Paul E. Peterson

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781317512974
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Commodity Derivatives: A Guide for Future Practitioners describes the origins and uses of these important markets. Commodities are often used as inputs in the production of other products, and commodity prices are notoriously volatile. Derivatives include forwards, futures, options, and swaps; all are types of contracts that allow buyers and sellers to establish the price at one time and exchange the commodity at another.

These contracts can be used to establish a price now for a purchase or sale that will occur later, or establish a price later for a purchase or sale now. This book provides detailed examples for using derivatives to manage prices by hedging, using futures, options, and swaps. It also presents strategies for using derivatives to speculate on price levels, relationships, volatility, and the passage of time. Finally, because the relationship between a commodity price and a derivative price is not constant, this book examines the impact of basis behaviour on hedging results, and shows how the basis can be bought and sold like a commodity.

The material in this book is based on the author's 30-year career in commodity derivatives, and is essential reading for students planning careers as commodity merchandisers, traders, and related industry positions. Not only does it provide them with the necessary theoretical background, it also covers the practical applications that employers expect new hires to understand. Examples are coordinated across chapters using consistent prices and formats, and industry terminology is used so students can become familiar with standard terms and concepts. This book is organized into 18 chapters, corresponding to approximately one chapter per week for courses on the semester system.

1 Introduction

The title of this book is Commodity Derivatives: A Guide for Future Practitioners. But what is a commodity, and what are derivatives?

What is a Commodity?

Undifferentiated vs. Branded Products

Commodities are undifferentiated products including tangible physical items such as wheat, gold, or crude oil. By “undifferentiated” we mean that every bushel of wheat, or bar of gold, or barrel of crude oil, is just like every other every bushel of wheat, or bar of gold, or barrel of crude oil with the same quality specifications. In contrast, most consumer goods are branded, which implies the presence of additional qualities – real or imagined – that set a product apart from similar but competing products, and typically allows them to command a higher price. For example, coffee is a commodity, but Starbucks coffee definitely is not. Most commodities are inputs used in the production of various other products, while most consumer goods are final or near-final products sold to end users.

By being undifferentiated, the same commodity from different sources can be commingled or combined. For example, wheat from multiple individuals can be combined in the same storage bin. If any of the individual owners want to remove “their” wheat at some later date, it is not necessary for them to receive the exact same kernels they put into storage. Instead, any wheat with the same quality, and therefore the same value, will be acceptable. Stated differently, commodities are fungible, so every unit of a commodity having a particular set of qualities is perfectly substitutable with every other unit of the same commodity. Because the underlying commodities are fungible, many of the exchange-traded derivatives based on those commodities – particularly futures and options on futures – also are fungible, so they can be bought and sold easily. Each exchange-traded contract is completely interchangeable, so it is not necessary for buyers and sellers to find their original trading partners to liquidate positions from previous transactions.

Perfect Competition Model

Commodities differ from most other products because price and quantity are determined by the market as a whole, through the forces of supply and demand. Consequently, commodity markets resemble the perfect competition model, which requires large numbers of buyers and sellers with no individual large enough to influence the market, homogeneous products, low barriers to entry and exit, and all decisions driven by profit maximization. This is in contrast to the branded products described above – for example, Starbucks coffee – in which the seller sets the price and then uses various marketing tools to create additional qualities to justify that price. If a commodity seller attempted to do this and demanded a higher price based on claims of some type of intangible benefit, potential buyers would simply buy the commodity at a lower price from someone else. Similarly, if a commodity buyer attempted to do this and offered a lower price, potential sellers would simply sell the commodity at a higher price to someone else.

One consequence of the perfect competition model is zero long-run economic profits. This does not imply that producers and consumers in commodity markets do not earn profits. Instead, it means that over the long run, they earn returns to capital, labor, management, and other inputs, but no consistent, above-market returns over an extended period of time. From basic economics, recall that the cost curve defines the supply curve, so a low-cost producer of a commodity has a definite advantage over its competitors. In fact, cost control is the only tool that commodity producers have to obtain higher profits. From history, we also know that commodity prices are characterized by boom-and-bust cycles and volatile prices which can be disruptive to buyers and sellers alike. Reducing this inherent price volatility is precisely the reason why commodity derivatives were developed.

Inelastic Supply and Demand

Another characteristic of commodities is inelastic supply and/or inelastic demand, where small changes in the quantity supplied and/or quantity demanded can produce large changes in the price. Most commodities are economic necessities in the production of other products, and have few close substitutes that can be used when shortages arise. When a commodity shortage occurs as the result of crop failures, labor strikes, transportation disruptions, or various other events, the market allocates the limited supplies of the commodity by increasing the price. Conversely, when a commodity surplus occurs, the market encourages increased consumption by decreasing the price. Commodity markets are particularly susceptible to supply shocks that can cause prices to spike higher or lower. Demand shocks also can occur in commodity markets, but tend to be less common. Most demand changes occur gradually over a period of years, but sudden shifts in government policies such as taxes or import/ export restrictions are the most common examples of demand shocks that can affect commodity prices.

What is a Derivative?

Price Stability and Certainty

Derivatives include forward contracts, futures contracts, options, and swaps. They are called “derivatives” because their values are derived from the price of the underlying commodity – wheat or gold or crude oil, from our examples at the beginning of this chapter.

In a typical transaction for a physical commodity – and for most of the things we buy and sell in everyday life – a buyer and a seller agree to exchange a product today for a price established today. In most situations, and particularly for frequent transactions involving relatively small quantities of a product and relatively small amounts of money – for example, filling up your car with gasoline once a week – this simultaneous exchange of goods for money at the current market price is acceptable, because the price risk is manageable.

However, when transactions become large and/or infrequent – for example, a farmer who harvests and sells a crop once a year and needs the selling price to cover their costs, or an airline that needs to price its fuel needs so it knows how much to charge its customers for tickets, the risk of an unfavorable price can be devastating to the individual or firm. In these situations it becomes important to establish the commodity price before the goods and money are exchanged. The importance of stable, predictable prices typically increases as businesses become larger, and planning and budgeting activities become more formalized.

Separating the Pricing and Exchange Functions

Forward Contracts

Markets for physical commodities are designed for the simultaneous exchange of goods for money at the current market price. In contrast, establishing the price in advance of the actual transaction is beyond the capabilities of a regular market, because it requires the exchange of goods for money to occur at one time and the price to be established at another. However, the separation of the exchange of goods from the pricing of those goods can be accomplished with a derivative.

The simplest and most common type of derivative is a forward contract, commonly referred to simply as a forward. A forward contract is a legally binding agreement between buyer and seller to exchange a product later, or “forward” in time, for a price established now. A forward contract eliminates uncertainty about the price at the later date; it does not eliminate buyer’s remorse or seller’s remorse when the price at the time of the exchange turns out to be better (i.e., lower for buyers or higher for sellers) than the agreed-upon price. Forward contracts may be created for any product, not just commodities, and may include any terms to which the buyer and seller agree. Consequently, the market for forward contracts is both large and non-homogeneous, reflecting the high degree of customization and flexibility that is possible with forwards.

One version of a forward contract known as a price-later contract reverses the timing of the two components described above. As the name suggests, it is an agreement between buyer and seller to exchange a product now for a price established later. A price-later contract removes uncertainty about the availability of the commodity for the buyer, and allows the seller to select the market price at some later date as the price for the commodity they deliver today.

Futures Contracts

A futures contract is a more formalized version of a forward contract. Like forwards, futures are legally binding agreements between buyer and seller. Unlike forwards, which are completely customizable, futures are standardized in terms of the underlying commodity being traded, the quality and quantity of the underlying commodity, and the time, location, and other details for final settlement of the contract. Because all terms and conditions for a futures contract except the price are established beforehand, the price is the only feature to be negotiated between the buyer and seller.

This high degree of standardization, with price as the only variable, makes futures contracts fungible. Consequently, someone who initially buys or sells a futures contract and later wishes to liquidate it does not need to find their trading partner from the initial transaction and then try to negotiate an exit at some price. Instead, the initial buyer or seller can make an offsetting trade with anyone who is willing to sell or buy at that particular point in time. Standardization also allows futures contracts to be traded on an exchange, which is a centralized marketplace that brings together buyers and sellers. This concentration of buyer and sellers enhances liquidity, or the ability to buy or sell quickly and easily with little or no impact on the price.

The world’s first futures contract was created in the 1700s at the Dojima Rice Market in Osaka, Japan (this market closed in the 1930s). The first commodity futures markets in the United States were created in the mid-1800s for corn, wheat, and oats, making them the oldest continuously-traded futures markets still in existence. Other crop and crop-based futures contracts, including those on oilseeds and the so-called soft or tropical commodities, were added over the subsequent decades. Among other physical commodities, livestock futures and precious metals futures were introduced in the 1960s, and energy futures first appeared in the 1970s.

Today, corn is the largest of the three original US futures commodities in terms of physical production, value of physical production, and volume of futures trading. Given its long history and importance in the development of futures markets on other commodities, all numerical examples in this book will use corn-level prices, and the examples will be coordinated to allow easy comparison across chapters. However, the principles presented in this book apply equally to all commodities, so the reader can easily convert these examples into any other commodity by simply re-scaling the prices.

Options

From the descriptions above, both forwards and futures require the buyer to provide the agreed-upon funds and the seller to provide the agreed-upon goods at the termination of the contract. In contrast, an option replaces the buyer’s obligation with the right to buy a specific commodity or futures contract at a specific price – known as a call – or the right to sell a specific commodity or futures contract at a specific price – known as a put. An option may be on a physical commodity, known as an option on actual, or on a futures contract, known as an option on futures. Our focus in this book will be on options on futures, which in the US were introduced in the 1980s.

If the price specified in the option is favorable to the option buyer – relative to the market price at some date or over some period of time – the buyer may exercise the option. Upon exercise the option buyer receives a futures contract at the specified price, and the option seller is assigned the opposite position in the same futures contract. If the specified price is unfavorable, the option buyer can simply abandon the option without any penalty. In return for this right to exercise or abandon, the option buyer pays the option seller a premium at the outset of the option. Similar to futures contracts, options on futures are traded on an exchange. All terms and conditions of the option are standardized except the premium, which is negotiated between the buyer and seller in the same manner as futures prices.

Swaps

Swaps are similar to forward contracts in many respects, beginning with the fact that swaps are traded off-exchange, so they may be created for any product and may include any terms to which the buyer and seller agree. Also like forward contracts, the market for swaps is both large and non-homogeneous, reflecting a high degree of customization and flexibility. The first swap was created in the 1980s.

As the name suggests, a swap requires the buyer and seller to exchange or “swap” cash flows from two forward contracts on the same commodity. While a forward contract has a single payment, a swap typically has multiple payments, so a swap can be described as a series of forward contracts with different maturities.

Organization of this Book

This book is organized into three parts. The first part focuses on futures, the second part on options on futures, and the third part on swaps. Each part will describe how the particular derivative and its market infrastructure operates, how it can be used for risk management purposes, and how it can be used for speculative or investment purposes. There is no section on forwards, largely due to the close similarities between forwards and futures and the duplication that would result from a discussion of both types of derivatives.

Forwards, Futures, and Price Discovery

As noted earlier, forward contracts may be created for any product and for any terms to which the buyer and seller agree. This means forwards are very flexible, but the unique nature of each transaction means that the price for one forward contract may not be a reliable indicator of the price for other forward contracts, or for the underlying commodity itself.

Each term and condition of a forward contract must be negotiated by the buyer and seller, so reaching an agreement can be a time-consuming process. Because there is no centralized market or other authority to monitor trading activity, enforcement of those terms and conditions is the responsibility of the buyer and seller, and resolving disputes can be time consuming and costly. Each party faces the risk of default, or non-performance by the counterparty, or other party in the agreement. On the agreed-upon day for exchanging goods for money to fulfill the contract, the buyer may not be able to provide the funds, and/or the seller may not be able to provide the specified quality or quantity of the commodity at the specified location within the specified time frame. Finally, there is no mechanism to disseminate the price, quantity, and other details of the transaction. Although some buyers and sellers might prefer to keep these details confidential, information about previous transactions can be useful to other market participants when negotiating new transactions and can make the market more efficient, even when the terms and conditions of previous transactions are substantially different from those being negotiated.

In contrast, futures are highly standardized, so futures can be traded rapidly and in large volumes because only the price must be negotiated, and the prices of all transactions are publicly available on a real-time basis. The exchange enforces terms and conditions of the contracts, provides facilities for rapidly resolving disputes, and provides financial guarantees against default, all of which facilitate additional trading activity.

An important side benefit of futures trading is price discovery, in which the forces of suppl...