Financial Markets for Commodities

Agricultural, energy or mineral commodities are traded internationally in two market categories: physical markets and financial markets. More specifically, on the financial markets, contracts are negotiated, the price of which depends on the price of a commodity. These contracts are called derivatives (futures, options contracts, swaps).

This book presents, on the one hand, the characteristics of these derivatives and the markets on which they are traded and, on the other hand, those transactions that typically combine an action on the physical market and a transaction on the corresponding financial market.

The understanding of commodity financial markets mainly relies on the resources of economic analysis, especially the financial economy, because the use of this discipline is essential to understanding the major operations that are conducted daily by the operators of these markets: traders, producers, processors, financiers.

• Language: English
• Publisher: Wiley
• Release date: Dec 31, 2018
• ISBN: 9781119579250

Book preview

Preface

This book was born out of two sets of courses that we were lucky to be able to conduct for quite a long time for very enthusiastic students. The first set of courses were meant for – and are still intended for – engineering students, most of whom do not work in the field of commodities but who still wish to understand the fundamental principles underlying the working of these markets. The second set of courses is meant for students of economics and engineering students who are specializing further, following their initial training, with a masters in economics of the environment, energy and transport.

The book that has resulted from these two sets of courses is, in fact, a summary that has been hugely augmented by the additional course material that we gradually developed. It consists of a very descriptive set of materials that aim to present the basic mechanisms of the financial commodity markets: forward markets, call options and swaps markets. These fundamental mechanisms are not very difficult to understand, however they still require a certain amount of effort in order for the reader to become familiar with them. Although we resort to a few simplifications, we present all the elements that are essential for a rigorous comprehension of the subject; in this sense, the book presents no impasse, and thus, the reader who has assimilated all the information we present can understand how the financial commodity markets function.

This book is also, partly, a work on economic theory. Our aim was to show how economists use conceptual frameworks that they find familiar to represent and analyze these markets. On first reading, a reader who is unfamiliar with the theory may find it a little difficult to understand the analytical scope of these conceptual approaches. We are, nonetheless, convinced that the analytical frameworks used by economists are essential for shedding light on the subject. Similarly, some developments in financial mathematics are also presented as certain aspects of the functioning of the financial markets cannot be approached with any rigor without using the mathematical instruments on which they were founded, both theoretically and empirically.

We have chosen to give as simple an explanation of the subject as possible, but have also retained all that is essential to an authentic comprehension of the financial commodity markets. Consequently, certain passages in this book may at first seem difficult, but these few arduous explanations are not gratuitously inserted for denseness. They represent certain inevitable examples. If the reader who takes up this book feels the need for specific motivation, it would be good to remind them that – essentially – knowledge of the financial commodity markets in fact represents an advanced step toward a comprehension of all financial markets.

Joël PRIOLON

October 2018

Introduction

Physical commodity markets are markets where products that have material reality are bought, sold and delivered. Financial commodity markets are markets where financial contracts are negotiated. The value of these contracts is derived from the value of the commodities. Prices form on each market; the central objective of this book is to describe and analyze the dynamics of physical prices and financial prices, with the trickiest point being understanding the joint dynamics of these two groups of prices.

Commodities – agricultural, sources of energy or minerals – are mainly used in the initial phases of a production cycle. For example, corn serves as fodder for animals but is also used to produce fuel; oil makes it possible to provide fuel and other by-products in chemistry; and iron is a basic product in the steel industry. The concept of what a commodity is can vary from one activity to another. To take just one example: corn is undoubtedly considered as a commodity. However, for certain industries, the commodity is the starch – which makes up about of 72–73% of corn. It appears difficult in practice, and quite futile, to try and define commodities based exclusively on their physical characteristics. And thus, we offer the following definition: […] in practice, the first form through which the product obtained from a natural resource can travel through the next phase of its transformation is called a commodity [GIR 15]. Commodity trading is a highly technical activity, reserved either for specialized companies or for specialized departments of more general organizations. This trading is highly globalized and there is fierce competition through prices.

In this book, we will study those commodities where at least a part of the trading is via organized financial markets. As a result, we will exclude certain commodities for which there exists no financial market. For example, to the best of our knowledge, there is no market where forward contracts or call options are traded around cement. Another example: in France, there is no futures market for potatoes, which poses some problems for actors in this sector. It is not possible to draw up a list – not even an approximate list – of the commodities for which there is no financial market; it is, however, important to note that the absence of a financial market is not necessarily definitive as all that is required for a market to be created eventually is for a sufficient number of actors to express an interest in developing this market. If we go back to the origins of the financial markets for agricultural commodities – the mid-19th Century in the American Northwest – it can be seen that it was because traders, farmers and industrials simultaneously took an interest in this that the Chicago Board of Trade was established [MOR 79]. On the contrary, certain markets that performed well for a time disappeared when there was no longer a sufficient number of participants to keep it alive. The world of financial markets evolves constantly: certain contracts appear, and others disappear. All of the markets that endure do, however, have one point in common: they interest a diverse and sufficiently large group of operators for contracts to be negotiated using these markets as the intermediary.

Chapter 1 presents an overview of physical commodity trading and provides the key principles required in order to understand the basics of this field. It also makes it possible to understand why the prices on the physical market are so volatile and how this volatility can pose a problem to various operators. The main aim of Chapter 2 is to explain the large operations that are carried out in financial markets in association with operations on the physical markets: arbitrage speculation and hedging. Chapter 3, which essentially focuses on futures contracts, occupies a central position here insofar as it presents and analyzes the financial tool that has been used the longest by actors in the commodities market. Continuing with this theme, Chapter 4 – by Christophe Gouel – is dedicated to the joint formation of prices on the futures markets and the physical markets by integrating the impact of storage and removal. Chapter 5, dedicated to options, presents not only a financial tool that is very commonly used, but also an evaluation method that can be extrapolated to any financial contract. In Chapter 6, we will study some landmark texts in economic analyses. This selective review makes it possible to introduce the broad themes that have, historically, been studied in academic literature, and allows us to recognize the invaluable contributions made by this literature in promoting an understanding of these particular markets. Chapter 7 continues in the same manner, but reviews more recent texts. Given the proliferation of literature, we have chosen texts that offer diverse perspectives on questions of regulations. At the end of this technical, often arduous study, we offer a lengthy conclusion with an overview of some of the questions that arise for the regulators. We have also tried to offer our answers to these questions.

Introduction written by Joël PRIOLON.

1

General Observations on the Physical Trading of Commodities

The physical trading of large commodities clearly differs from the trade of transformed products on several important points. Competition through prices plays a decisive role as these commodities are standardized and there cannot really be competition through differentiation in the product itself, only in the logistical services and financial conditions attached to the transaction. There may be large fluctuations in price, both in the short term as well as in the long term, which could be problematic for producers as well as intermediaries and transformers. Finally, given their strategic importance, states intervene in the trading of commodities either directly (as vendors, buyers or stockers) or indirectly through regulations that are put in place.

1.1. The standardization of commodities and commercial contracts

In the context of a commercial transaction related to transformed products, vendors and buyers negotiate both the technical characteristics and prices. In the case of commodities, the standardized physical characteristics are agreed upon by all operators and, thus, negotiations revolve chiefly around the prices. In practice, these negotiations are very brief: if, at a given point of time, a certain price is acceptable to both a buyer and a seller, an agreement is very quickly established between the two parties and the transaction is carried out. If the quality of the products delivered is better than standard quality, the vendor asks for a higher payment, if it is inferior to the standard quality, the buyer asks for a discount. Let us note that the conditions of physical delivery and the modes of the financial transaction may also be negotiated; nonetheless, the price remains the primary criterion.

For greater precision, the negotiation itself is standardized. This standardization is perfect when operators use an organized market (stock exchange) as the platform of negotiation. It is still of a high standard when the negotiation is carried out through direct telephonic contact between buyers and vendors. In this case, the language used by the negotiators is very highly codified and if an agreement is concluded, there are not many conditions (chiefly price, site and date of delivery, and the mode of payment). The various modalities of negotiations that we find either in organized markets or over-the-counter markets will be studied in greater detail in section 1.2. To illustrate the principle of the standardization of commodity trading, we use the case of the quality of milling wheat, traded on the futures market Euronext Paris1: Wheat of good quality, conforming to a quality standard, and saleable, whose specifications are: specific weight 76 kg/hl, moisture content 15%, percentage of broken seeds at 4%, germ seeds 2%, and a maximum impurity content of 2%. The bonuses or deductions are applied as per Incograin formula no. 23 and technical addendum no. 22.

The standardization also relates to commercial contracts, for example:

The Paris Syndicate [for Commerce and Seed Industries] establishes and diffuses the models for buying and selling contracts adapted to European commerce around primary agricultural products. These agreements are characterized by a balance between the interests of the buyer and those of the seller. These documents, known as the ‘Incograin formulae’ (for example: the Paris formulae) are periodically revised to take into account the evolution of commerce and uses, as well as of arbitrage decisions3.

At the risk of oversimplification, we can thus consider that the price is the heart of the commercial negotiation on the physical markets for commodities. Further on we will examine, in detail, how prices are formed. This question is crucial to the study of the problem of price fluctuations, for which we use the term volatility.

1.2. Price volatility of commodities

Most commodities see large fluctuations in price, as can be seen, for instance, in the World Bank price index for commodities.

Figure 1.1. Price index of commodities in agriculture, metal and fuels [WOR 17]. For a color version of this figure, see www.iste.co.uk/priolon/markets.zip

The concept of volatility encompasses two aspects:

– the prices of commodities sometimes see large variations over the medium and long term, as can be observed from the graph shown in Figure 1.2, which represents changes in the price of corn between 2012 and 2017;

– the prices of commodities also see multiple fluctuations in the short term, as can be seen in the evolution of the price of corn over 24 h, knowing that evolutions similar to those represented here are perfectly normal.

Figure 1.2. Corn prices in USD/BU: 2012–20174

Figure 1.3. Corn prices in USD/BU: December 20–21, 20175

In a general sense, the concept of volatility designates these fluctuations in price. In a narrower sense, volatility is a measure of these fluctuations. This measure almost exclusively takes the form of a variance, calculated either through the price itself, or the variations in price. We will point out right away that the formula for calculating volatility, as well as the parameters for this formula (periodicity of measurements, duration of observations, etc.) cannot be canonically defined. We will return to this point in Chapter 5. Knowing that volatility is often compared to an assessment of the risks taken by operators, we see that this lack of clarity on the optimal measurement results in problems in evaluating the risks operators take on the markets.

More importantly, perhaps, using variance is a questionable strategy. This is because this measure of distribution of a series flattens out extreme phenomena, which represent large risks. More generally, the Gaussian models, widely used in economics and financial mathematics, risk underestimating the magnitude of extreme phenomena. Among the many authors who support this idea is, notably, the mathematician Benot Mandelbrot [MAN 97], as well as his direct or indirect successors, sometimes grouped together under the term econophysicists [JOV 16].

Price volatility is a problem for the majority of actors operating on physical markets: producers, traders, stocking organizations and transformers. Finally, the consumers of those transformed products that incorporate the commodities whose prices are volatile are impacted by these fluctuations. In order to combat the problems brought in by price volatility, public authorities can schematically offer two strategies:

– putting in place measures that aim to stabilize prices;

– making available to operators the tools that are needed for private risk management as concerns prices.

We will review these public policies in detail in Chapter 8. We continue here with the study of causes for, and the consequences of, price volatility. The concept of elasticity is an essential prerequisite to understand this.

1.2.1. Elasticity

Generally speaking, elasticity is the ratio between two relative variations. If ∆P/P designates a relative variation in price and ∆Q/Q designates a relative variation in the quantities traded on a market, then the elasticity of price with respect to quantity is measured by the ratio . This dimensionless number measures the impact of a variation in quantity on the price. For example, if the quantity on offer increases, it usually translates into a decrease in prices. In this case, the price/quantity