Commodity Derivatives

Markets and Applications

Neil C. Schofield

• Publisher: Wiley
• Year: 2021
• ISBN:
  9781119349259
• Edition: 2
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Commodity Derivatives

In the newly revised Second Edition of Commodity Derivatives: Markets and Applications, expert trading educator and author Neil Schofield delivers a comprehensive overview of a wide variety of commodities and derivatives. Beginning with discussions of commodity markets generally before moving on to derivative valuation and risk management, the author then dives into individual commodity markets, like gold, base metals, crude oil, natural gas, electricity, and more.

Schofield relies on his extensive experience at Barclays Investment Bank to offer readers detailed examinations of commodity finance and the use of commodities within a wider investmentportfolio.

The second edition includes discussions of critical new topics like dual curve swap valuation, optionvaluation within a negative price environment using the Bachelier model, volatility skews, smiles, smirks, term structures for major commodities, and more. You'll find case studies on corporate failures linked to improper commodity risk management, as well as explorations of issues like the impact of growing interest in electric vehicles on commodity markets.

The text of the original edition has been updated and expanded and new example transactions are included to help the reader understand the concepts discussed within. Each chapter follows a uniform structure, with typical demand and supply patterns following a non-­technical description of the commodity at issue. Discussions of the physical markets in each commodity and the main exchange-traded and over-the-counter products conclude each chapter.

Perfect for commodity and derivatives traders, analysts, and risk managers, the Second Edition of Commodity Derivatives: Markets and Applications will also earn a place in the libraries of students and academics studying finance and the graduate intake in financial institutions.

A one-stop resource for the main commodity markets and their associated derivatives

Finance professionals seeking a single volume that fully describes the major commodity markets and their derivatives will find everything they need in the latest edition of Commodity Derivatives: Markets and Applications. Former Global Head of Financial Markets Training at Barclays Investment Bank Neil Schofield delivers a rigorous and authoritative reference on a crucial, but often overlooked, subject.

Completely revised and greatly expanded, the Second Edition of this essential text offers finance professionals and students coverage on every major class of commodities, including gold, steel, ethanol, crude oil, and more. You'll also find discussions of derivative valuation, risk management, commodity finance, and the use of commodities within an investment portfolio.

Non-technical descriptions of major commodity classes ensure the material is accessible to everyone while still in-depth and rigorous enough to deliver key information on an area central to global finance.

Ideal for students and academics in finance, Commodity Derivatives is an indispensable guide for commodity and derivatives traders, analysts, and risk managers who seek a one-volume resource on foundational and advanced topics in commodity markets and their associated derivatives.

CHAPTER 1
Fundamentals of Commodities and Derivatives

After the publication of the first edition of this text, many of the author's friends not involved with financial markets often asked, ‘what are commodities’? Like many innocent questions, they are often very difficult to answer. In one sense, they are largely unprocessed or semi‐processed goods, which are either consumed or can be processed and then resold. However, this definition will not always universally apply; for example, freight and carbon emission markets do not easily fall within this category.

In general terms, commodities can be classified under different headings:

Energy markets

• Crude oil and refined products (e.g. WTI/Brent, gasoline)
• Power and natural gas
• Natural gas liquids (e.g. propane and butane)
• Coal

Industrial metals

• Copper, aluminium

Precious metals

• Gold, silver

Agricultural products

• Grains
• Softs (e.g. coffee)
• Livestock

‘Specialty’ markets

• Forest products (e.g. pulp and recovered paper)
• Carbon emissions
• Weather
• Freight

1.1 MARKET OVERVIEW

Figure 1.1 is a ‘big picture’ overview of commodity markets.

In this diagram there are two main segments, the physical and the financial markets. The diagram was designed without a specific product in mind, but if the reader prefers some context, it may be helpful to think of a popular commodity such as crude oil. Within the physical side of the market there will be three main participants: producers, refiners, and consumers. In addition, trading houses will perform a variety of tasks, which are detailed in a subsequent section. The financial side of the market will incorporate those entities offering financing and risk management services as well as investors seeking to earn a return from the asset class. One aspect that is central to commodities is price discovery, and so the role of futures exchanges is key.

To get a sense of the generic market flows associated outlined in Figure 1.1, consider the following issues faced by market participants:

• Commodities are not homogeneous – it is not particularly helpful to speak in general terms about commodities. For example, the phrase ‘crude oil’ is meaningless as the chemical properties of crude extracted in one location will vary from those in a different location. Trafigura (2016) argues that over 150 types of crude oil are traded worldwide.

  

  FIGURE 1.1 Commodity market overview.

• Commodities need to be transformed into consumer goods – for example, oil needs to be refined to produce gasoline.
• Benchmarks help participants agree on a price for non‐homogeneous products – so with respect to crude oil, a particular grade of oil could be priced relative to an agreed benchmark such as a futures contract that references Brent Blend.
• Production and consumption may not take place in the same geographical location – this means that there is a need for transportation. The mode of this transportation can vary for a single commodity. For example, in the USA, crude oil is typically moved by pipeline or train. In other areas such as Europe, sea‐borne transport may be more common.
• Consumption and production may not occur simultaneously – a consumer may not need to take immediate delivery of a commodity, therefore storage and inventories are key factors. When there is a geographic element to the issue, it takes time for a commodity to be transported.

1.2 MARKET PARTICIPANTS

Market participants are able to manage the respective price risks using derivatives. Although risk management will be considered in greater detail in Chapter 3, it is worth considering some related motivations.

Participants can:

• Avoid risk,
• Retain risk,
• Transfer risk,
• Reduce risk,
• Increase risk.

One of the key roles of derivatives is that they allow different market participants with different risk profiles and objectives to obtain a desired risk exposure. With respect to commodity derivatives the main participants will be physical market participants, price reporting agencies (PRAs), investment banks, commodity trading houses, hedge funds, or ‘real’ money accounts.

1.2.1 Physical market participants

Individual product supply chains will be considered in the respective chapter. In general terms, the commodity will need to be produced, refined, and then transformed into a product that can be consumed by the end user. Admittedly this general description does not capture all the different types of commodity supply chains, but the key point is that the participant will typically have some form of price risk at most points along the supply chain

In simple terms, producers will be exposed to falling prices, consumers will be exposed to rising prices, and refiners, processors, and utilities will be exposed to margins (e.g. the income generated from selling gasoline less the cost of buying crude oil). These participants are also faced with a variety of other risks which include:

• Credit, i.e. the unwillingness or inability of a customer to pay their debts.
• Logistical risks surrounding the movement of the commodity.
• Sourcing the right quality of commodity.
• Being able to finance day‐to‐day operations.

1.2.2 Price reporting agencies (PRAs)

One of the problems faced by various commodity markets over the years is one of price discovery. How does a market participant know if they are achieving fair market value? Consider the following quote from a market participant in 2011 with respect to the metal Rhodium, which was about to be used in the creation of an exchange traded fund aimed at the retail market:

‘With no futures benchmark…all the spot price transparency of molasses…and a risk reward with which only a supremely knowledgeable professional or those wet behind the ears would be comfortable…guess the target audience?’

(Financial Times, 2011)

Since commodities are heterogeneous products, establishing a fair price has always been a challenge for market participants and the main conventions used either involve exchange traded prices (where available) or index values determined by PRAs. IOSCO (2012) defines a PRA as:

‘Publishers and information providers who report prices transacted in physical and some derivative markets and give informed assessment of price levels at distinct points in time’.

They defined a crude oil assessment as:

‘The process of applying a methodology and/or judgement to market data and other information to reach a conclusion about the price of oil’.

In...