Shutterstock 187920503

A Guide to Commodity Derivatives

ChAI
Published by ChAI
May 15 2024
Share

A Guide to Commodity Derivatives

Commodity derivatives are financial instruments whose value is based on underlying commodities, such as oil, gas, metals, agricultural products, and minerals. They are used to hedge against price volatility in commodities markets or to speculate on price movements by traders, investors, and companies.

Here we provide a high-level guide to understand commodity derivatives and the different types of derivatives.

The main types of commodity derivatives are:

  1. Futures: Contracts to buy or sell a given commodity at a predetermined price and time in the future. Traded on exchanges and standardised.
  2. Options: Contracts that give the buyer the right, but not the obligation, to buy or sell a given commodity at a predetermined price within a specific timeframe.
  3. Swaps: Contracts to exchange cash flows in the future at predetermined prices - effectively fixing the price of the commodity.

As mentioned before, the use cases for commodity derivatives are typically hedging and speculation. Hedging involves using a derivative to offset a potential loss from an existing position in the underlying commodity, typically used by the physical community (manufacturers etc) while speculation aims to profit from price changes, typically used by the financial community (traders etc).

Some key benefits of commodity derivatives include:

  • Price Risk Management: Protecting business against adverse price movements.
  • Facilitating price discovery: Setting benchmark prices.
  • Providing liquidity and trading opportunities: A venue to buy and sell commodities efficiently.

However, they can be complex instruments that require expertise to use effectively.

There are risks associated with commodity derivatives, including:

  • Market Risk: The potential for loss due to the volatile nature of commodity prices and unfavourable market movements.
  • Credit Risk: The risk of counterparty default in Over The Counter (OTC) contracts.
  • Liquidity Risk: The risk of not being able to close positions due to low market liquidity.
  • Operational Risk: Errors, system failures, or fraud that can cause losses.

Commodity derivatives are regulated by exchanges and governments to prevent market abuse, ensuring orderly trading. This includes position limits, reporting requirements, and other controls.

Why do Manufacturers use Commodity Derivatives?

Manufacturers use commodity derivatives primarily to hedge against price volatility in raw materials they use to make their end products. The key reasons are:

  • Risk Management: Derivatives enable manufacturers to lock in prices for the raw materials they need to purchase in the future. This avoids the impact of price changes.
  • Cost Certainty: Fixing future costs helps manufacturers better plan their budgets and operations. It helps them protect profit margins and stay competitive.
  • Avoiding Supply Disruptions: Assists manufacturers in securing supply and avoid disruptions that could occur due to price volatility in the physical markets.

It is evident that the use of different types of derivatives is a key risk management strategy that helps manufacturers operate more efficiently and effectively in the face of volatile commodity markets.

Alternatives to Commodity Derivatives

As stated in a previous article Commodity Price Risk Management some other strategies to risk management include:

Physical hedging:

  • Long term price fixing arrangement with suppliers
    • Manufacturers and their suppliers agree to transact on a known volume of a raw material at a predetermined price at a future date. Often manufacturers are paying a premium to remove the uncertainty around price rises.
  • Strategic buying (stockpiling)
    • Stockpile materials when prices are low, and burn through the stockpile when prices are high.This requires proactive management and the ability to store the raw material can be expensive.

Passing costs through:

  • Manufacturers may be able to pass the increased costs straight through to their consumers. This can impact competitive advantage and brand loyalty.
  • This tends to not work as well in cases where demand is elastic.

Insurance

  • There are some specialty insurance companies that are able to offer a commodity price risk insurance product on demand.
  • ChAI is one such organisation - please see below for more details about its product ChAI Protect.

ChAI Protect

Tailor a price protection product around their exact raw material needs, be it packaging materials or any materials that are benchmarked against an index price.

The protection is designed to be similar to a bull call spread (or bear put spread) option. A premium is charged up front at inception of the policy to protect your raw material costs. Choose coverage start and stop ranges of interest. On the settlement date, ChAI evaluates if the prevailing raw material price falls within the client’s coverage range. If it does, the client's policy pays out the excess of their losses.

As it is insurance, there are no minimum volumes, and no margin calls. You can also use simplified mark-to-market accounting. Inclusions & exclusions can be seen here.

Related market insights

Hands
Cta protect bg

Commodity coverage

ChAI provides price forecasts and market intelligence for a range of commodities across Metals, Energies, Plastics and Agricultural.

Request List
CTA mockup steel new desigm

Talk to one of our experts about the power of ChAI

Talk to us