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Definition of 'Commodity Swap

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A swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity.

Investopedia explains 'Commodity Swap'
The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index). On the other side, if a producer of oil wishes to fix its income, it would agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity

Commodity swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (For example: Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries) A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. How do Commodity Swaps work? For example, consider a commodity swap involving a notional principal of 1,00,000 barrels of crude oil. One party agrees to... make fixed semi-annual payments at a fixed price of Rs 2,500/bbl, and receive floating payments. On the first settlement date, if the spot price of crude oil is Rs 2,400/bbl, the pay-fixed party must pay (Rs 2,500/bbl)*(1, 00,000 bbl) = Rs 2,50,000,000. The pay-fixed party also receives (Rs 2,400/bbl)*(1, 00,000 bbl) =Rs 2,40,000,000. The net payment made (cash out flow for the pay-fixed party) is then Rs 10,000,000. In a different scenario, if the price per barrel will have increased to Rs 2,550/bbl than the pay-fixed party would have received a net inflow of Rs 5,000,000.

Commodity Swap
A swap in which at least one set of payments is based on the price of a commodity, such as oil. The other set of payments can be either fixed or determined by some other floating price or rate. While payments could be made by delivering actual units of the underlying commodity, in practice cash is exchanged instead. Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market. In most interest rate, currency and equity swaps, the variable payment is based on the price or rate on a specific day. However, in oil swaps it is common to base the variable payment on the average value of an oil index over a period of time, which could be weekly, monthly, quarterly, or the entire period between settlements. This feature removes the effects of an unusually volatile single day and ensures that the payment will more accurately represent the value of the index. Average-price payoff structures are also found in other derivatives, particularly options.

Significance
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Different types of commodity swaps have differing significance. For instance, a gas station chain may be an end user of crude oil; the station chain's executive management may want to enter into a swap in order to avoid volatility in the prices of barrels of oil. By contrast, a manager of a fund based on commodities may see an advantage in the difference between oil prices and current money market rates. In addition, both of the above-described situations may offer the chance to "hedge," or limit future risk. The gas station chain sees the opportunity to lock in an oil price at an affordable rate. The fund manager may view a commodity swap as a hedge against future inflation.

Structure
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In addition to the underlying intent, commodity swaps may be structured to suit each party's specific financial needs. Swaps may be arranged as fixed floating agreements, for example. In such a contract, one party will pay a fixed price for the given commodity on the settlement date, while the counterparty will pay a floating price for the same commodity. The agreed-upon price is determined by an exchange, such as the Commodities Research Board Index. A fixed floating contract is also known as a "simple swap." By contrast, a swap can be structured to limit the price paid for the commodity. In these cases, a "cap" or "floor" is placed, meaning that one party pays a specified amount up front, while the counterparty pays the difference by which the price exceeds or falls below the contract price as of the settlement date.

Variations
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Although simple swaps may be the most common type of commodity contract, there are key variations as well. For example, a hedge may involve a commodity price versus a specified money market rate. In this type of contract, called an interest-for-commodity swap, parties are attempting to hedge against movements in interest rates against commodity prices. A commodity producer may

therefore lock in both a price for its product and a hedge against the chance of rising variable rates on the company's debt, for instance. Using varying contract types allows a party to reduce risk (or speculate, in the case of investors) on more than one economic variable at a time.

Considerations
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Commodity swaps have additional costs beyond the potential price paid on the settlement date. For instance, swaps may include brokerage fees as well as risk-analysis and internal administrative costs. In addition, legal ramifications of commodity swaps also affect the type of contract. Creditworthiness of counterparties, security (collateral) available and termination rights of the parties all must be considered. Both additional costs and legal issues can affect management's ultimate choice of commodity swap type.

Commodity swap is becoming increasingly normal in the energy and agricultural industries, where demand and supply are both subject to substantial uncertainty. For instance, heavy users of oil, including airlines, will frequently enter into contracts in which they agree to produce a volume of fixed payments, say every single 6 months for two years, and receive payments on those same dates as found by an oil value index. Computations are frequently depending on a certain volume of tons of oil to be able to lock in the rate the airline pays for a particular series of oil, acquired at steady intervals above the two-year length. On the contrary, the airline will commonly purchase the real oil it needs from the spot marketplace.

In most interest price, currency and equity swaps, the variable payment is depending on the cost or cost on a particular day. Even so, in oil swaps it¶s usual to base the variable payment on the average cost of an oil index above a length of time that could be once a week, once a month, quarterly, or the entire interval amongst settlements. This feature removes the effects of an unusually volatile single day and ensures that the payment will further accurately represent the price of the index. Average-price payoff structures are also determined in other derivatives, particularly options.

How are commodity swaps traded? This article describes the process. A commodity swap is a swap in which exchanged cash flows are dependent on the price of the commodity in question. Commodity swaps can also be said to be a transaction where the two parties to the deal agree to exchange cash flows over a commodity. In essence, the cash flows in commodity swaps are linked to the prices of the underlying commodities. Swaps speak of an exchange; therefore we talk about commodity swaps from the producer side and the consumer¶s side. A consumer of a commodity (such as airlines which use large amounts of aviation fuel, a derivative of crude oil) can use a commodity swap to secure an acceptable price for the commodity which it would consider as a price ceiling, and pay a financial institution this price so as to get payments on the commodity on the prices prevalent in the market. Commodity swaps are used as a hedge against commodity price volatility. A producer of oil may also pay a financial institution the market price in order to receive payments on the commodity as a fixed maximum price.

Types of Commodity Swaps The two types of commodity swaps are the fixed-floating and commodity-for-interestswaps. How Commodity Swaps Work Commodity swaps are used in markets where the demand and supply of a commodity are extremely uncertain, which is why it is very popular in the energy and agricultural commodity markets. A political situation could develop in an oil producing nation, negatively affecting the supply of oil. Similarly, an adverse weather condition or unexpected drought could markedly affect the harvest of a commodity crop. Even political situations could come to play (like in Coted¶Ivoire, the world¶s largest cocoa producer where the post-election crisis cut cocoa exports and sent the product price skyrocketing). In oil swaps, the variable payments which are made on regular intervals over time are based on the average value of an oil index over that period of time. This serves to nullify the effects of hefty intra-day volatility, spreading the risk over time. First Scenario: Drop in commodity price If a swap involves 5,000,000 barrels of crude oil, and a party in the transaction agrees to make fixed semi-annual payments based on a price of $80 per barrel, and to receive floating payments, this is the calculation of the settlement amounts: On settlement date 1, if the spot price of crude oil is $70 per barrel, then the pay fixed party must pay $80 X 5,000,000 = $400 million. The pay fixed party will receive 70 X 5,000,000 = $350 million. The net payment made which corresponds to the cash outflow for the pay-fixed party = $50 million. This is an outflow payment. Second Scenario: Increase in commodity price Assuming the swap involves the same number of barrels of crude oil but the market price rises to $90 as opposed to a fixed maximum price of $80, then the net payment will be 5,000,000 X (90-80) = $50 million. This will be an inflow or a received payment. Trading Commodity Swaps Commodity swaps are usually traded in the Over-the-Counter (OTC) market. They are extremely risky to trade. The basis of trading commodity swaps is to look for price correlations e.g. correlation of the price of heating oil to crude oil, especially in winter. However, correlations do not always work and as is the case with most instruments on the OTC market, prices of commodity swaps are highly unpredictable.

1) A Forward or Swap is always financially settling, meaning that only cash is exchanged, never the physical commodity. Organizations do trade where the actual physical commodity is purchased or sold that trade type isn t called a Swap or Forward that is called a Physical trade. In other words, a Forward or Swap is financially setting by definition.

2) With regard to the timing of the forward/swap trade by definition the exchange of cash and finalizing the prices are done sometime in the future. That is, the trade is done on the current date, so the trade date is today for an exchange to be made at a future point in time. If you did a trade today for delivery today (physical delivery) then the trade would be called a Physical trade (not a forward/swap). Physical trades for immediate settlement are sometimes called cash trades and physical trades for delivery in the next month (after the current month) are sometimes called prompt month trades. 3) In order for one side to pay the financial equivalent of the commodity, you need an objective/impartial third party to publish prices. These are called settle or closing prices when the source of the prices is a commodities exchange. For example, a popular commodities exchange is the NYMEX www.nymex.com. Or the prices might just be called published prices if the source of the prices is not an exchange. A popular source of commodity prices from a non-exchange is Platts. www.platts.com/ 4) A Forward or Swap is always between two counterparties by definition. Trades between two counterparties are called OTC (Over the Counter). An OTC trade is sometimes called a bilateral trade. If a trade with similar attributes is cleared on an exchange then it is called a Futures contract. 5) The typical period is for a month. So for example, you could have a Jan 2012 forward trade. A commodity Swap could be for one month, three months, 12 months or more. A three month swap, e.g., January to March would typically have 3 payments, one for each month. In other words, a Swap is like a series of Forwards. You could alternately have a single payment that is based on the average of the values of three months. Any variation of terms is possible with OTC trades.

Example
One side of the trade, e.g., an oil major (e.g., Shell Oil Company) agrees on Dec 1, 2010 (trade date) to pay the financial equivalent of the price of crude oil each month for 12 months for periods Jan 2011 to Dec 2011. The oil major agrees to pay whatever price is published on the NYMEX the day before the last trade date for the contact (e.g., the Jan-2011 contract). The volume is 5000 BBL (barrels). The other side of the trade, an investment bank will pay a fixed price of $85/BBL, i.e,, 85 dollars per barrel. Note that investment bank is the term in the United States in Europe these kind of firms might be called a merchant bank . For both sides, the payment date will be 5 (five) business days after the date the price is published by the exchange. Notes: 1) Common price setting for the crude oil market could be 1a) Based on the last trading day of the contract, which would be 20-Dec-2010 for the Jan-11 contract. This type of pricing is sometime called exchange lookalike since it mimics the economic characteristics of a futures contract (trade done where one side of the trade is the commodities exchange, e.g., NYMEX). 1b) Based on one business day before the last trading day of the contract, e.g., Friday 17-Dec-2010 for the Jan-11 contract. Why one day before? The volume traded on the very find day of trading tends to be low and low volume means that the final price could be inadvertently skewed one way or another to be too high or too low relative to what people think is a fair value. One day before pricing is commonly called penultimate pricing.

1c) A very common form of pricing would be to take the average price for the calendar month. So, for example, take the settle price for all of the business days in the month of Jan-2011, add them up, and divide by the total number of business days (to get the average price). Observe from the table below that the Jan-11 contract actually expires before the calendar month of January, so for the average of the business days in January (i.e., Jan 1 to Jan 31, business days only) you ll typically get the prices from what is called the first nearby contract , which is the Feb-2011 contract from Jan 1 to Jan 20, 2011, the expiration date of the Feb contract and then you get your daily prices sourced from the March-2010 contract from 21-Jan-2011 to 31-Jan-2011. i.e., Jan 1 to Jan 21 Get the price from the Feb-2011 contract Jan 22 to Jan 31 Get the price from the Mar-2011 contract 1d) Another variation would be to shift the date of the contract roll to be one day earlier. So the pricing would be the average of the daily settlement /closing prices as follows: Jan 1 to Jan 20 Get the price from the Feb-2011 contract Jan 21 to Jan 31 Get the price from the Mar-2011 contract 2) The volume in this example is set to be 5,000 BBL per month. So for the fixed payment, which is $85/BBL we know the exact payment in advance, i.e., we know the payment amount and payment date for the fixed side payer. The payment amount is calculated based on a formula of quantity * price, or 5,000 BBL * $85/BBL = $425,000. For the floating side (also called the index side ) we don t know the amount of the payment as of the trade date but we do know the formula for calculating the payment it is the same as for the fixed side of quantity * price the quantity is the same 5,000 BBL and the price is an unknown as of the trade date it will be determined at a later time based on the agreed to pricing formula. Note that that total volume for this example is 60,000 BBL, which is 5,000 per month * 12 months. 3) This example is sometimes called a fixed for float or fixed price for index price swap because one side is fixed (meaning known in advance, set as of the trade date as part of the terms of the trade). You could also have a float for float swap were both sides of the swap are based on to-bedetermined amounts. For example a float for float swap could be for the price of crude oil versus the price of unleaded gasoline, both expressed in barrels. That particular difference in prices is known as a crack spread , because cracking is the name of one of the popular methods for refining crude oil into unleaded gasoline. Note that any combination of crude oil versus a refined product, such as unleaded gasoline or heating oil) can be called a crack spread 4) Each side of the swap, i.e., the two counterparties in the trade makes a payment with one side payment a fixed price and the other side paying a floating price, meaning unknown as of trade date, though the payment will be finalized/known by the payment date. Oil Major: Pays Floating Payment (volume * floating price) Receives Fixed Payment (volume * fixed price) Investment Bank Receives Floating Payment (volume * floating price) Pays Fixed Payment (volume * fixed price)

The counterparty that is paying the fixed payment is said to be the buyer of the swap and the other side is said to be the seller of the swap. In the above example, the Oil Major is the seller of the swap. It can be confusing to people as to which side is the buyer and which side is the seller since both side make a payment (and both sides receive a payment). To remember how this terminology is used consider a physical trade instead. If the Oil Major were selling oil (the physical commodity) and the other counterparty were paying a fixed price of $85/BBL, then it would be clear that the Oil Major was selling the oil. With the swap example instead of selling the physical oil, the Oil Major is providing the financial equivalent of the oil instead of the physical commodity. 5) For practical purposes, payments in swap transactions tend to be netted such that only one side makes a payment and that payment is the net (meaning difference) between the two prices. So instead of this: Oil Major Pays $90 * 5,000 = $450,000 (assuming the first floating price winds up being $90/BBL) Investment Bank Pays $85 * 5,000 = $425,000 You have this in common practice: Oil Major Pays $5 * 5,000 = $25,000 Investment Bank doesn t pay anything (they just receive the $25,000) 6) Here is a recap of the trade terms as they might commonly be expressed and details on the expected pricing and payment dates. Quantity: 5,000 BBL Fixed Price: $85/BBL Floating Price: NYMEX Crude Oil penultimate single day (non averaging) Start Month: Jan 2011 End Month: Dec 2011 (12 monthly periods) Buyer of the swap (pay fixed): Investment bank
NYMEX Last Trade Date 20-Dec-2010 20-Jan-2011 22-Feb-2011 22-Mar-2011 19-Apr-2011 20-May-2011 21-Jun-2011 20-Jul-2011 22-Aug-2011 20-Sep-2011 20-Oct-2011 18-Nov-2011 Day Before Last Trade Date 17-Dec-2010 19-Jan-2011 21-Feb-2011 21-Mar-2011 18-Apr-2011 19-May-2011 20-Jun-2011 19-Jul-2011 19-Aug-2011 19-Sep-2011 19-Oct-2011 17-Nov-2011 Fixed Payment ($) 425000 425000 425000 425000 425000 425000 425000 425000 425000 425000 425000 425000

Contract Month Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11

Payment Date 22-Dec-2010 24-Jan-2011 28-Feb-2011 28-Mar-2011 25-Apr-2011 24-May-2011 27-Jun-2011 25-Jul-2011 24-Aug-2011 26-Sep-2011 24-Oct-2011 22-Nov-2011

Volume (BBL) 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

Fixed Price ($) 85 85 85 85 85 85 85 85 85 85 85 85

Floating Payment ??? ??? ??? ??? ??? ??? ??? ??? ??? ??? ??? ???

Reason to Buy

By buying a commodity swap, a user of the commodity can lock in prices. E.g., a refiner (an organization that converts crude oil into a refined product such as unleaded gas) can buy a supply of crude oil to use in their refining facilities. With regard to the reason to buy a commodity swap, consider the alternatives for a user of the commodity (e.g., a refiner): 1) They could choose to wait until they need the commodity and then buy it at the market price which could be higher or lower in the future than it is today. Meaning that they buy the commodity they need in the physical market. 2) The organization could lock in the price with a physical trade, i.e., one side pays a payment based on a fixed price and the other side delivers the commodity. Why might an organization want to trade a financially settling trade, a swap , instead of a physical trade? Suppose they are used to buying the physical commodity they need from local distributers. And suppose those local distributers are not equipped to commit in advance to allow their clients to lock in prices, e.g., they don t have the trading and risk management in place to make those kind of trades/commitments. The refinery could buy a financially settling commodity agreeing, as in the above example, to pay $85/BBL. Then if the price rises to $90/BBL they pay the investment bank $85/BLL, get/receive the $90/BBL from the investment bank, and then use the $90 they received to pay their local distributer of crude oil for the physical commodity (in the cash/spot market).

Reason to Sell
As in the above example, where the oil major is selling the swap a reason to sell a swap would be to lock in prices. An oil major will, literally, get crude oil from the ground, from a well. For the oil it expects to get in the future (i.e., expects to get as of today), it has these main choices: a) It can wait until it has pumped the oil and then sell the oil at the market price, i.e., whatever it will be in the future. b) It can lock in a price today for selling the oil. The organization may choose to lock in the prices to avoid losses if the price of oil drops in the future. There are other possibilities for the oil major for the oil the pump c) They can store it (e.g., in tanks on the ground or on ships) d) They can refine it into unleaded gas or other refined products (if they own the refining facilities) The point here is that if the oil major does decide to lock in the price that they can sell their future oil at, then they can do so by selling a commodity swap.

MTM Valuation
To get the present value of a commodity swap 1) List out each payment, e.g., 12 payments, one per month from the example above 2) You ll need to project the prices, i.e., estimate on what the prices will be for the future dates. 3) For each payment date, calculate the discount factor using the appropriate interest rates. 4) Calculate each payment as quantity * price. 5) Then calculate the net payment, i.e., the different between what you are paying versus what you are receiving. 6) Multiply the net payment times the discount factor to calculate the present value for each payment. 7) Sum of the present value of all of the payments to get the MTM (mark to market) of the trade.

For example, the MTM for the below trade is the sum of the values in the final column: $2,675.00 That is from the point of view of the firm paying the floating price. The value would be negative of that, it would be $-2,675.00 from the point of view of the other firm, the firm paying the fixed price.
Projected Floating Price ($/BBL) 85.00 85.10 85.20 85.30 85.20 85.10 85.00 84.90 84.80 84.70 84.60 84.50 Projected Floating Payment ($) 425,000 425,500 426,000 426,500 426,000 425,500 425,000 424,500 424,000 423,500 423,000 422,500

Volume 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

Fixed Price ($/BBL) 85 85 85 85 85 85 85 85 85 85 85 85

Fixed Payment ($) 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000

Net Payment ($) 0.00 (500.00) (1,000.00) (1,500.00) (1,000.00) (500.00) 0.00 500.00 1,000.00 1,500.00 2,000.00 2,500.00

Payment Date 22-Dec-2010 24-Jan-2011 28-Feb-2011 28-Mar-2011 25-Apr-2011 24-May-2011 27-Jun-2011 25-Jul-2011 24-Aug-2011 26-Sep-2011 24-Oct-2011 22-Nov-2011

Discount Factor 0.99 0.985 0.98 0.975 0.97 0.965 0.96 0.955 0.95 0.945 0.94 0.935

MTM ($) 0.00 (492.50) (980.00) (1,462.50) (970.00) (482.50) 0.00 477.50 950.00 1,417.50 1,880.00 2,337.50

PnL Explained Attributes
# 1 2 3 4 5 Attribute Impact of New Trades Impact of Amendments Impact of Cancelations Impact of Time Impact of Commodity Prices For the sensitivities approach: Effect Name First Order Delta Second Order Gamma Cross Effects Cross Gamma Impact of Interest Rates Applicable Yes Yes Yes Yes Yes

Applicable Yes No No Yes

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Note: Interest rate exposure for a commodity swap tends to be very small relative to the commodity price exposure, but it will be non-zero For the sensitivities approach: Effect Name First Order Delta Second Order Gamma

Applicable Yes Yes

7

8 9

Cross Effects Cross Gamma Impact of Volatility For the sensitivities approach: Effect Name First Order Delta Second Order Gamma Cross Effects Cross Gamma Impact of Cross Price/Volatility Impact of Correlations

Yes No Applicable No No No No No