The Flow&Ebb CRPM glossary is intended to help you understand some of the specialized, and sometimes esoteric, concepts used in the world of commodity risk management
Commodities, Hedging and Derivatives
A commodity is any raw material that can be changed easily for any other raw material of the same type. Corn is a commodity because a bushel of corn can be interchanged for another bushel of corn at the same price easily. A car is not a commodity because there are many different types of cars that can not be exchange at the same price.
The price of a commodity seen quoted in news reports is almost always either the price of that commodity for immediate delivery, or the nearest forward delivery price.
Spot or Cash Commodity
A spot commodity is a commodity that can be delivered immediately. The spot price of a commodity is the price paid today for a commodity today. This is sometimes referred to as a cash or actual commodity. The front month is the first futures delivery point. Many commodity prices referred to in news will be this first delivery month price and this front month contract tends to be the most highly traded.
This refers to the practise of leaving the price of a commodity ‘to float’ rather than the buyer and seller fixing the price of a commodity. For example instead of fixing the price of wheat for a delivery month a buyer can elect to pay the daily spot price for that commodity when it is delivered.
Any agreement between a buyer and seller of a commodity for forward delivery of a commodity. Terms of these agreements can be more flexible and personalised than exchange traded futures contracts. Often price is fixed when the agreement is made but price can also be left floating.
Long Term Contracts
Traditionally company’s that were not directly involved in commodity trade such but whose cost of goods sold was significantly impacted by commodity prices would use long term fixed price contracts with suppliers. This would provide budget certainty whilst being easier to manage. Annually or over a longer period prices would be readjusted to match commodity price changes. This method of hedging often led to sudden price changes when new contracts prices were set. Or it would mean a buying company would lose out on a market dip or pay higher prices than their competitors. It also leaves companies at risk of their counterparties failing and losing hedges.
Supplier fixations allow buyers of commodities or commodity derived goods to choose either ask their suppliers to provide a fixed commodity price for a forward delivery or a floating price for a forward delivery. This gives a company more flexibility and greater exposure to commodity markets. But it comes with the same counterparty risk as long term contracts. Also if fixing decisions are made poorly a company may also face higher cost of goods sold versus their competitors.
Future, Swaps & Options
A commodity derivative is a type of financial derivative that’s price is derived from an underlying cash commodity price. Commodity futures, swaps and options fall into this category. These derivatives and bought and sold by hedgers from brokers. They are used to the same effect as fixing commodity prices with suppliers but are more flexible and come with substantially reduced counterparty risk.
Futures contracts are forward contracts traded on a centralised commodity exchange with contract terms set by the commodity exchange. They are traded in lots - which are pre-defined volumes of commodities - and they have a limited number of delivery locations. Commodity exchanges will enforce contract terms onto market participants and most of those participants access these exchange through brokers. Most futures contract trading for hedging is done to manage commodity risk instead of marketing/procuring commodities. Only a small minority of market participants use futures contracts to take exchange physical commodities.
A swap is an agreement to exchange cash flows based on the price of an underlying commodity price. The swap buyer will receive cash from the seller if the commodity price is higher than the swap price or pay cash if it is below. The cash the buyer receives for the swap should be balanced out by the higher price the buyer will pay for the underlying commodity. Commodity swaps provide the same financial risk management function as commodity futures but do not provide guaranteed delivery.
Options come either put or call forms. A buyer of a put option gains the right to sell a futures or swap contract at a strike price. For that right the buyer pays an option premium. The buyer of a call option gains the right to buy a futures or swap contract at a strike price. Options are used as a more flexibility way hedging commodity risk than futures or swaps. For example the buyer of a call option will effectively pay the floating price for a commodity below the call option strike price and, if their option is exercised, they will not pay a higher price than the strike price. Put and call options can also be combined to provide hedgers with price bands. The closer an options strike price is to the current market price the higher the option premium will be.
Over-the-Counter & Exchange Traded
Futures, swaps and options can either be traded between two entities or at a centralised exchange. The former is called over-the-counter trading or OTC. It is more prevalent in the swap market.
Hedging accounting is a financial accounting method that defers the gains and losses of owning a financial derivative until the opposite gain or loss on the commodity requirement being hedged is recognised in a company’s books. This allows a company to reduce income statement volatility. Auditor requirements for deploying hedge accounting can be onerous.
When entering into a commodity supply or delivery agreement a company is at risk of the other side of the contract not living up to the agreement. This is counterparty risk and any company that enters a fixed price commodity agreement takes on this risk.
For a commodity with a futures market there typically multiple forward delivery months available. A forward curve is all the currently traded futures contracts for future delivery. At any given time a buyer or seller can estimate the future delivery price of a commodity based on its forward curve. The prices for forward delivery will move together as market conditions change but the spread (price differential) between different delivery months can be valuable for speculators and hedgers.
The difference between the spot or cash price of a commodity against the futures price of a commodity. Futures contracts have a limited number of delivery locations and commodities are traded in many more locations. Because of this the price of a commodity for local use is typically sold at a premium or discount to the futures prices. WTI for delivery in Texas will often trade at a discount to the futures price in Chicago, whilst WTI in New York will trade at a premium due to delivery costs. Basis prices can be highly volatile and represent a risk to firms with tight margins.
The word ‘premium’ has three main uses in commodity markets. First its used in options trading to refer to the price of an option. Second its used to refer to the additional cost of a higher quality commodity vs. the standardised futures contract commodity. Third metals markets use the term ‘premium’ in place of ‘basis’.
An offer to buy.
An offer to sell.
The act of buying a future or swap contract. A natural long is consumer of commodities.
The act of selling a future or swap contract. A natural short is seller of commodities. Naked short selling is the act of selling a futures contract without buying a futures contract to sell.
A bull believes a commodity price will increase.
A bear believes a commodity price will decrease.
Contango & Backwardation
When commodity futures prices further into the future are lower than the cash price or nearest term future price or both the market is considered to be in backwardation. When the opposite is true market is considered to be in contango. Most commodity markets will naturally be in contango as the cost of storing a commodity means that future price should be higher. A market in backwardation may suggest that current supplies may be tight but the market expects the forward supply and demand situation to be more balanced.
Fundamentals & Technicals
Fundamentals are a commodity’s underlying demand and supply dynamics. Technicals are mathematical and visual conversions of price, open interest and volume data for a commodity. Both are used to predict future price movements. Analysts will use a combination of both to understand markets.
There are many forms of commodity exchanges from sophisticated intercontinental, entirely digital operations to small scale rural meeting places. But ultimately they all serve one purpose – for buyers and sellers to meet and exchange commodities. Some exchanges purely act as a meeting place whilst others act as a central counterparty between buyers and sellers. These more sophisticated operations will be the buy futures contracts from sellers and sell to buyers, enforce contract terms, ensure exchange members are fit and proper, and often sell exchange data. Because no central counterparty exchange has gone bankrupt in the modern history of commodity exchanges they superior counterparties to individual buyers and sellers.
Most commodity exchanges will only allow exchange members to trade on their floors. Most market participants will access these exchanges via brokers who are either members or have a relationship with members.
Hedgers, Speculators & Brokerages
Typically, there are three categories of commodity exchange participants. Hedgers who use exchanges to manage price risk (or rarely to procure or market commodities), speculators who use exchanges to earn income from price changes, and brokerages who earn income from facilitating trade. The involvement of speculators in commodity exchanges has a long and controversial history. Speculative trading can vastly outweigh commercial hedging activity. Physical buyers and sellers have time and time again accused speculators of causing price bubbles and collapses. Governments and exchanges have often acted to cool speculation through higher fees or legislation. But current mainstream thought on the role of speculators sees them as providing a necessary boost to market liquidity benefiting hedging activity.
A commodity’s liquidity is how easy it is to trade that commodity without affecting price. If we can buy 1,000 barrels of Dec-18 Brent crude oil with little change in market price then that market is considered liquid. Generally, commodities are more liquid markets than say art pieces or CDOs. However, some commodities can be illiquid especially for delivery months far in the future. If we sell 1,000 tonnes of Jan-19 UK Feed Wheat and the market price moves noticeably then that market is considered illiquid. Commodity price risk management can be limited by market liquidity due to regulatory and practical constraints.
Volume in commodity markets is how many lots are traded. Daily volume is how many lots are traded in a day.
Settlement & Closing Prices
At the end of each trading day exchanges publish a closing and settlement price. The closing price or the last trade price is the last bid or ask price of each trading day. The settlement price can be the same as the closing prices, however, most commodity exchanges use formulas to weight multiple trades or monthly spreads or both to publish a settlement price more indicative of market prices. Settlement prices are used to in a wide variety of contracting arrangements by market participants and by the exchanges themselves for clearing and margin calculation activity.
The total number of long or short futures contracts that are outstanding for a commodity and delivery month on a commodity exchange.
Commitment of Traders
A report by commodity exchanges breaking down the amount of open interest held by different categories of market participants.
Large scale commodity exchanges act as a central clearing party between buyers and sellers of commodity derivatives. When someone buys a commodity future they will buy it from the exchange, and vice versa for sales. As commodity exchanges are well capitalized and supported by industry and governments they are excellent counterparties.
Planning, Forecasting & Commodity Prices
Integral to a company’s planning is forecasting how much it will ned to buy to produce goods to sell in the future. All company’s face some sort of market risk where the future prices of inputs cannot be known without fixing these prices in some way. Those company’s whose margins are heavily impacted commodity prices face a more acute market risk problem than others. Geopolitics, weather, technological change and economic growth make commodity prices excessively volatile in comparison to other inputs. Even highly liquid commodity markets can change by 30% year-on-year. Being able to embed commodity price risk into planning and forecasting activity, and having methods to manage that risk is a key part of these company’s strategies.
Volatility is how rapidly and unpredictable a commodities prices are changing. All market prices are inherently volatile but to varying degrees. Commodity markets tend to be more volatile than other asset classes especially during extreme geopolitical or environmental events. Furthermore the availability of hedging tools such as futures markets and increased liquidity tends to make markets less volatile.
Value-at-Risk is a statistical method that firms use to measure potential loss on their commodity exposures. Using recent market returns VaR measures the probability of extreme market movements in the future causing losses. VaR will estimate a greater probability of these extreme market movements if recent market volatility has been high.
Traditionally a business’s procurement team managed commodity hedging. However, with increasingly onerous regulation, more shareholder awareness of commodity market impacts and greater possibilities for hedging companies are implementing a cross-department commodity risk model. Commodity Price Risk Management is a modern method that combines both the procurement functions desire to get the best commodity input prices, the treasury functions desire to minimise market risk and accounting functions need for strong audit trails and good data.