Commodities & Commodity Derivatives

Commodities & Commodity Derivatives Commodities: definitions and characteristics Commodities are typically broken down into number of categories: Energy products: crude oil, gas oil, natural gas Precious metals: gold, silver, platinum Industrial metals: aluminum, copper, zinc, lead Agricultural commodities: wheat, corn, cotton, sugar Live-stocks: live cattle, feeder cattle Key players in commodities are: producers, end-users, brokers, banks, hedge funds and institutional investors Investors are attracted to high returns, suitability as hedges for inflation, and low correlation with other assets despite high volatility and modest Sharpe ratio. Available alternatives: Investing in commodity itself or on its derivatives including futures, swaps and options Via mutual funds, ETFs, commodity indices or structured notes linked to commodity prices Commodity trading in spot and futures market uses strategies similar to other asset classes, plus some strategies specific to commodities Drivers of commodity prices Price drivers include: supply & demand, new discoveries, geopolitics, technological advances, production disruption (especially for energy products), economic factors, and technical analysis These typically cause more immediate and sizeable price movements than with other assets classes Fundamental differences from other asset classes Commodities come in variety of different grades and specifications that must be defined carefully to ensure appropriateness of product delivered under contract Delivery location: distances & cost of shipping different prices in different locations Significant basis risk may arise for end-users seeking to hedge exposure using derivatives where underlying has different specifications (e.g. hedging Nigerian crude with Brent futures) Pricing models for commodities often assume mean reversion: there is long-term equilibrium level towards which prices revert over time Price movements driven by external events fade out as time passes Producers alter production to fit new level of prices: prices marginal high-cost producers initiate production; prices marginal high-cost producers reduce output Mean reversion for commodities is substantially faster than for interest rates Mean reversion means long-term volatility < short-term volatility Spot/forward arbitrage relationship does not apply rigidly for commodities: ownership today has different value than ownership on future date 1

Forward pricing for commodities Two important considerations: 1. Party holding commodity and awaiting delivery date under forward must store it and insure it increases cost of carry 2. End-user that needs commodity in its industrial process must include in cost of carry under forward costs of having to shut down factory (foregone profits) if commodity is not available for immediate use If define (in %) S = cost of storage, I = cost of insurance, and Y = foregone profit: 1-year Forward = Spot * (1 + S + I + RFR)/(1 + Y) Continuous time version: 1-year Forward = Spot * EXP(S + I + RFR Y) Y denotes convenience yield : designates benefits of having commodity available immediately vs. in the future Y varies significantly from user to user, since it depends on production process, cost structure, financial leverage and other factors that vary from one consumer to another Y causes severe distortions in ordinary spot/forward relationship Limited ability to borrow/short commodities is another factor causing distortions Forward curve shapes for commodities Forward curve for commodities is often inverted as a consequence of convenience yield, difficulty to short and willingness of producers to pay premium to assure immediate availability Crude in particular often evidences inverted pattern, known as backwardation, in contrast to upward sloping forward curve, said to be in contango Research suggests backwardation is more logical pattern for many commodities because producers are under greater pressure to hedge revenues than consumers to hedge costs Use of commodity derivatives Derivatives on commodities, typically settled in cash on a net basis, are used for same reasons and in same ways as derivatives on FX, interest rates and equities Institutional investors use commodity swaps to rebalance portfolio allocation towards heavier commodities exposure, given favorable risk-return-diversification benefits Retail investors purchase principal-protected structured notes that give them synthetic exposure to commodity, basket of commodities, or commodity index Corporates use commodity derivatives to eliminate price risk of commodity purchases (consumers) and sales (producers), and to improve ability to budget costs or revenues Directional traders use derivatives in OTC or exchange-listed form to go long or short commodities through forwards and futures Long-short speculators and hedge funds take opposite positions in two different commodities, or two grades of same commodity, or involving same grade of same commodity but for delivery on different dates in future, to exploit short-term imbalances Commodity derivatives may involve spreads between prices of different commodities: refiners usually hedge crack spread = price of basket of refined products minus price of crude 2

Refiners use classical hedging strategies for either locking in or setting floor under spread, by either selling spread forward or by purchasing puts on spread Roll strategy: exploiting forward curve shape Roll strategy exploits curve in backwardation, often crude oil, and involves: Purchase of crude under forward/futures contract Invest spot equivalent amount in T-bills and pledge as collateral under forward On forward settlement date, sell crude in spot market and roll over position Total return under roll strategy = t-bill return + degree of curve backwardation +/- change in spot Fiascoes involving commodity derivatives Metallgesellschaft Developed solid business involving sale of oil and natural gas to end-users under multiple- year fixed-price supply contracts Hedged contracts by going long futures on same commodities; but due to low liquidity of long-dated futures, adopted stack-and-roll strategy: Purchase short-term futures on total deliveries required under supply contract Liquidate in each period fraction of underlying contracts = fraction of overall deliveries to end-user in that period Roll remaining number (= outstanding future deliveries) into new contracts t prices declined abruptly in early Ni company under futures, not offset by margin calls under uncollateralized supply Spo neties, generating huge margin calls against contracts Problem exacerbated by curve reversal from backwardation to contango MTM loss on long futures position > MTM gain on supply contract Management panicked at worst possible moment, forcing traders to unwind position when losses had reached maximum company needed bailout from parent and exited business Sold gold forwards on several years of production, realizing sizeable gains from price declines in 90s Ashanti Gold Market rallied in 1999 after Washington Agreement limiting sales by central banks massive MTM losses under forwards with huge margin calls in excess of company s available liquidity Forced restructuring that involved granting equity warrants to forward counterparties in lieu of unavailable margin Slovnaft Refiner had crude-linked loan agreement with Merrill Lynch paying interest < market rate, but requiring additional interest if prices for Brent crude fell < $15. View was: 3

Further falls in Brent below current $22 were unlikely In any event these would widen refining margin and enable company to afford more easily additional interest payments Brent prices fell to $10 payments under loan dramatically; but prices for refined products fell even more jeopardized company s ability to service increased interest payments Company sued Merrill for poor advice in structuring original loan and encouraging company s belief that crude prices would rise rather than fall China Aviation Oil Sold calls on crude struck around $34, to generate premium for use in other aspects of operations, including hedging activities Start of oil bull market around 2004 1 st wave of losses on short call positions company requested restructuring to reset strike of calls upward, in exchange for in notional amount Prices continued steady, turning losses of a few dozen million into around $550 million Company sued counterparties arguing lack of suitability of strategies proposed, including strategies recommended in restructuring exercise Corporate use of commodity derivatives in fundraising Use of options in fundraising Commodity producers sell calls on commodities to headline coupon of fundraising Pay additional interest if commodity prices exceed specified level in exchange for lower interest payments when prices Logic: commodity prices revenues additional coupon payments more affordable, in exchange for coupons when prices (and revenues) Premium earned from selling calls is calculated upfront and spread over bond s life in form of reduced coupon mple: Exxon can borrow for 5yrs @ barrels of oil each expiring on coupon dates & struck @ $100, Exxon offers following Exa 5% (s.a.). Through sale of 10 call options on 10,000 term sheet: Frequency Exxon $100,000,000 1.32% + [Max (0, S F 100)]/500, where S F is the spot price of crude oil on the coupon payment date 4

Exxon pays minimum coupon of 1.32% plus additional 1% for each $5 increase in crude above $100 Structure can be tailored for other specific levels of minimum paid coupon or participation formula Inventory monetization Alternative to non -recourse loan with inventory as collateral: lenders usually rel uctant to lend > 60% of inventory s current market value Structure: Exxon has 1MM bbl of crude in inventory and wishes to borrow against them for 1yr. Current spot = $100, forward = $105 and interest rates < 5%: Company sets up SPV that purchases inventory at spot price for $100MM SPV sells crude under 1-year forward to highly-rated bank, for $105 per barrel SPV borrows $100MM In 1yr, SPV delivers crude, receives $105MM, and uses it to repay loan and interest Risks under loan: limited to risk of counterparty default under forward (acceptable if counterparty is highly-rated bank) and risk of damage or theft to inventory (addressed with normal property insurance) benefits for company: Transaction usually structured to attain off-balance sheet treatment Company s leverage unchanged but it obtained $100MM of funding: accounting treatment is debit cash/credit inventory, each by $100MM Company may borrow crude from SPV through borrowing facility for periods not exceeding settlement date under forward Prepaid forward sale Example: Exxon seeks 5-year funding that amortizes in equal annual payments. Current forward curve for crude is flat @ $105: Exxon agrees to deliver 1MM bbl/annum for next 5 yrs, in exchange for upfront payment by SPV = PV of hedged proceeds from sale of crude under forward contracts SPV enters 5 forward sale contracts on 1MM barrels each, with settlement dates on each anniversary of transaction closing date SPV discounts future stream of $105MM/annum to raise funds = aggregate PV Bank discounting SPV s future revenues under forwards assumes risk than under inventory monetization = Exxon fails to produce and deliver 1MM barrels on any delivery date Accounting treatment: cash debited on day 1 against deferred income/revenue as liability (not debt strictly speaking), with reduction in size each time crude is delivered Total debt is normally not affected no impact on covenant related to total debt, as opposed to total liabilities Structured notes Instruments used by investors to express bullish or bearish views on commodities, with note s coupon linked to performance of commodities through purchase/sale of calls or puts 5

Average rate notes linked to commodities Options are Asian type where payoff depends on average price: underlying volatility option premium compared to European-style options Ability to exposure to/participation in rising prices coupon impact of last minute drop in price Averaging may be on daily, weekly or even monthly observations. frequency vol Example: Bearish crude-linked average rate note Frequency Double-A bank $100,000,000 1.32% + [Max (0, S * 100)] /333 Where S * is the arithmetical average of the daily spot price of crude oil during the 6-month period from the preceding coupon payment date to the current coupon payment date Note linked to baskets of commodities Link coupon t o performance of basket of commodities instead of individual commodities ations of items in basket is very important in pricing, with correlati cheapening option < than correlations, and << than (-) correlations Future correl ons d hedge funds may use baskets to take views on future correlatio instrument like this if they expect correlations to, and short if they expect them to Traders an n, going long Commodity range-accrual note Example : investor who feels crude is likely to remain between 80 and 120 is a ttracted by: Frequency Double-A bank $100, 000,000 10% on each coupon payment date on which $80 < S F < $120, otherwise 0, where S F is the spot price of crude oil on the coupon payment date 6

Payoff generated by embedding long digital call @ 80 and short digital call @ 120 ctured so that price on each day affects payoff: investor accrue annualized 10% on each day price of crude falls within range, and 0 on each day it falls outside range Typically stru s coupon @ Quanto notes revious structures, except denominated in currency other than fact that that commodity prices are quoted exclusively in US dollars in most cases Identical to p US dollar, despite Example: Bullish crude-linked note quantoed into Euro Frequency Double-A bank 100,000,000 1.32% + [Max (0, S F 100)]/500, where S F is the spot price of crude oil in US dollars on the coupon payment date 7