Key Takeaways
• A small change in my job role and company.
• Commodity derivatives encapsulates both a financial and physical market.
• Price discovery in commodity derivatives plays a major role for the multiple participants in it's supply chain.
A new job and learning chapter..
It's been one year since I last wrote a blog. Since then, I started creating tutorials on the MEAN stack followed by short videos around backend fundamentals. This diversion away from more 'coding' focussed content has come about from a change in job.
In March 2023, I joined the Macquarie group in an opportunity that explores technical infrastructure alongside Java development. This new role will see me work upon the applications used across the bank's commodity desks and through the trade lifecycle.
So with that said, let's take a look at the bare bones of Commodity derivates, before I write deeper upon these topics in the coming months.
Commodity markets
Commodity markets, just like other asset classes, are classified into smaller segments that focus on specific products. What's unique here, is that commodities represent real, tangible products that are used in the world around us. There may be some overlap between markets, however the main ones are as follows:
Energy Markets
Energy markets include the trade of crude oil, refined products, power, natural gas, natural gas liquids and coal.
Crude oil fossil fuels are found between sedimentary rock under the Earth's surface. They are a combination of hydrocarbons (a chemical compound of hydrogen and carbon) formed over millions of years from the remains of animals and plants. Over the years, the remains are covered in layers of sand and rock to create the raw product under heat and pressure.
Crude oil can be transformed into many different refined products after it is extracted. These 'petroleum' products include gasoline, diesel, heating oil, jet fuels, waxes and lubricants.
Power refers to electricity as a tradeable commodity. Electricity is often measured in kilowatt hours, and is interchangeable to how it is generated. For example, electricity can be produced from coal or natural gas, and both of these are measured the same way, through kilowatt hours.
Coal is also a hydrocarbon fossil fuel, found in sedimentary rock. It can be burned to produce fuel or for generating electricity.
Natural gas is a gaseous hydrocarbon, mostly consisting of methane. While it exists in abundance under the Earth's surface, it's gaseous form means it must be transported via pipelines, or converted to a liquid for transportation. This conversion can add to the costs associated with it. Natural gas, once refined, can be used for electrical power generation, residential heating, and industrial production.
Natural gas liquids are components of natural gas that have been separated from the gaseous state. Liquids can be produced in the form of Ethane (used to create plastics), Propane (used for heating), Butane (used for synthetic rubber) and Isobutane (used for aerosols).
Industrial Metals
Industrial metals include copper and aluminium.
Copper is a malleable metal that also acts as an effective conductor of heat and electricity. It is most commonly used for wiring, lighting, motors, cables and electric generators.
Aluminium is one of the most widespread metals on Earth. It is soft and malleable making it useful for a variety of products including foils, window frames, beer kegs and electrical conductors.
Precious Metals
Precious metals include gold and silver. Gold is a durable metal that will not rust or erode with time. Gold is malleable and conductive, making it useful for carrying electrical currents in your smart-phone, but is more commonly used for ornamental objects such as medals and fine jewellery.
Silver is not quite as dense as gold, meaning it will be less durable, but is more malleable. Silver is historically used for photography due to it's ability to reflect natural light. In the modern day, it is used for mirrors, tableware, batteries and alloys amongst many other ornamental objects.
The ownership of these precious metals extend beyond their use to create products, and are also held for hedging against inflation. We will see more on this in a future blog.
Agriculture
Agriculture include 'soft' commodities that are grown, such as grains and coffee, as well as livestock.
Grains are widely consumed and include wheat, corn, soybeans, rice and oats. Livestock includes animals that are grown for meat production, accessory production (such as wool or worm casting) or human consumption (such as dairy products, honey or leather).
Speciality Commodities
The last commodity subdivision captures unique products and derivatives such as forest production, carbon emissions, weather and freight.
Forest production includes pulp and recovered paper. Trees can be used to create wood pulp, that is then used to create paper.
Carbon emissions are government-granted allotments of carbon dioxide outputs that are granted to companies. The carbon credits enable the companies to emit a specific number of emissions, therefore those below their threshold (such as Tesla) are able to sell their credits to enable other companies to manufacture more.
Weather as a derivative is interesting...This can be used to mitigate the risk of unfavourable weather in specific markets. Weather derivatives can be used to value good and bad weather in specific regions. Entities can then trade these to hedge the risk from unfavourable weather to their business.
Lastly, freight derivatives are derived from the current and future value of freight rates. Freight is used to transport commodities and can be used by supply chains to hedge to price volatility risk associated with transport.
What makes commodities unique
The commodities market differentiates itself from other asset classes as they operate in both a physical and financial market. There are financial derivatives for commodities such as options, futures and swaps, however the underlying products represent physical products that must be grown/extracted, transported and stored along an agreed timeline.
The physical market consists of 3 main participants: producers, refiners and consumers. Producers are responsible for sourcing the raw commodity, refiners will transform the commodity into a consumable product (such as transforming oil into gasoline), and the consumers make use of the product. These products, similar to stocks, come in different grades by quality. The supply chain is extended further to include participants for purpose-built storage facilities, and transportation to account for the transfer of ownership for the commodity.
Unlike financial derivatives, commodities cannot be created and placed in a deal book in an instance. There is a timeline for it's creation, production and delivery. This timeline exposes multiple participants to a price risk. For example, the farmer who grows grain will be exposed to future demand and subsequent price volatility. The refiner will be exposed to the cost of delivery and storage to their facility, and the consumer will be exposed to all of these compounded fees.
As a result of the vast number of participants and timeline for product delivery, price discovery plays a major role to all members of the commodities supply-chain.
A common challenge in Commodities
As with all asset classes, commodities presents their own unique challenges for market participants and financial institutions. One challenge I will repeatedly refer to within my blogs are price discovery.
Price discovery is a term that will enable all market participants to understand what a 'fair price' is for the product they are buying. Each participant in the supply chain will be exposed to unique price factors that can influence the value of the commodity as it is extracted, refined and transported. Some factors can include operational costs such as credit protection and transportation and storage fees. As well as the availability of the commodity in the region it is sourced, and also at a grade quality that is expected.
Commodity markets are vast with different qualities of each product, meaning markets are not always liquid enough to provide natural price discovery via an exchange.
A solution to this challenge exists in the form of a price reporting agency (PRA). This is an independent research provider that provides pricing indexes for commodities, thus bringing price transparency to physical commodity markets. The price indexes are available from the agency through a subscription and can be used to understand prices across entire commodity segments.
Popular PRA's include IOSCO and Platts, who are responsible for deriving commodity index markets. These indexes can then be used for commercial contracts and wholesale commodity deals.
Summary
This blog has taken a high level view to the complexities of commodity derivatives; their vast array of products, participants and markets introduces many opportunities for financial services to speculate and hedge risk for their clients and stakeholders.
What makes commodities so valuable to learn about is their representation in real life. The energy sources and raw material that are traded are all around us. This extends to infrastructure, devices, transportation, food and homes; all of which are products of a commodity that has been grown, extracted, refined, transported and stored, all with the help of financial institutions.
I look forward to writing my next blog, where I look at the various roles financial institutions play for commodity market participants, and the difference between traded and non-traded commodities.