Commodity derivative markets

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Commodity derivative markets

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1. Commodity markets today

2. The behavior of commodity prices : main

characteristics

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1. Commodity markets today

• Huge rise in prices

UBC – PIMS - 2008 5 11 31 51 71 91 111 04/ 01/ 1989 04/ 01/ 1990 04/ 01/ 1991 04/ 01/ 1992 04/ 01/ 1993 04/ 01/ 1994 04/ 01/ 1995 04/ 01/ 1996 04/ 01/ 1997 04/ 01/ 1998 04/ 01/ 1999 04/ 01/ 2000 04/ 01/ 2001 04/ 01/ 2002 04/ 01/ 2003 04/ 01/ 2004 04/ 01/ 2005 04/ 01/ 2006 04/ 01/ 2007 04/ 01/ 2008 $/ b

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Growth rate of transaction volume on exchanges,

by category, 2006-2007

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• For oil, the volume of exchange traded derivatives is around 15 times larger than the volume of

production

• For gold, copper and aluminum, it is around 40 times larger

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The most important commodity markets today

Ranked by number of contracts traded :

• Crude oil, Natural gas, petroleum products • Soy Meal, Soybean & Corn

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> 232,000,000

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The relative importance of commodity markets

• Exchange traded contracts • OTC markets

UBC – PIMS - 2008 14 Interest rates 25% Commodities 9% Equity 37% Individual Equity 27% Foreign Currency 2%

Exchange traded contracts

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Source : BIS, November 2007 Unit : USD billion

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2. The characteristics of commodity prices

• Importance of quality differentials

- A lot of cross hedging in commodity markets

- Derivative products (swaps) on price differentials • Seasonality in the prices and basis

Basis : F(t,T) – S(t)

where: - F(t,T) is the futures prices at t for delivery at T - S(t) is the spot price

Seasonality is important for agricultural products (supply side) and for energy (demand side).

Seasonality of the basis of petroleum products:

During the winter, fuel oil inventory are rare and the basis is negative; during the summer, stocks are abundant and the basis is positive.

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• High level of prices’ volatility

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V

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• High level of prices’ volatility

• Volatility rises when commodity prices rise

• Mean reverting behavior

- for storable commodities

- still relevant ?

20 10,00 15,00 20,00 25,00 30,00 35,00 40,00 03/01/ 8 9 03 /01/ 90 03 /0 1 /9 1 03/ 0 1 /9 2 03 /01/ 93 03/ 01/ 94 03 /01/ 95 03 /01/ 96 03/ 01 /9 7 03/ 01/ 98 03/ 01 /9 9 03/ 01/ 00 03 /01/ 01 03 /0 1 /0 2 ($/ b )

1 month 3 months 6 months 12 months 18 months 24 months 28 months

UBC – PIMS - 2008 21 11 31 51 71 91 111 04/ 01/ 1989 04/ 01/ 1990 04/ 01/ 1991 04/ 01/ 1992 04/ 01/ 1993 04/ 01/ 1994 04/ 01/ 1995 04/ 01/ 1996 04/ 01/ 1997 04/ 01/ 1998 04/ 01/ 1999 04/ 01/ 2000 04/ 01/ 2001 04/ 01/ 2002 04/ 01/ 2003 04/ 01/ 2004 04/ 01/ 2005 04/ 01/ 2006 04/ 01/ 2007 04/ 01/ 2008 $/ b

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• Commodity futures contracts’ maturity : - Up to 7 years for crude oil

- Up to 3-4 years for agricultural products and metals • Samuelson effect

- Decreasing pattern of volatilities along the prices curve - Propagation of shocks. It depends on:

- the stocks’ level (the effect sometimes disappears when stocks are abundant)

- production, transportation and storage costs

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Fluctuation of prices curves at different dates, WTI

14,00 16,00 18,00 20,00 22,00 24,00 26,00 28,00 1 m ont h 3 m ont hs 5 m ont hs 7 m ont hs 9 mo nth s 11 mont hs 13 mont hs 15 mont hs 17 mont hs 19 mont hs 21 mont hs 23 mont hs 25 mont hs ($/ b ) 3/10/1999 3/19/1999 3/30/1999 4/21/1999 4/28/1999 6/1/1999 8/31/1999 9/20/1999 1/21/2000

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- Principal component analysis - Three kind of movements :

- parallel shift in the curve (level factor)

- relative shift of the curve (steepness factor) - curvature factor (only for long-term contracts)

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3. New trends in research on commodities

• Subjects inspired by other financial markets - Market efficiency (technical analysis)

- IFRS (International Financial Reporting Standards) : - Valuation of inventories

- Valuation of mineral reserves

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• Subjects that are more specific to commodities: - Real options

- Mineral reserves

- Extensively used in the petroleum industry: auctions on undeveloped fields

- Market integration and price convergence - In the energy field

- Between energy and agricultural products - The influence of speculation on prices

- CFTC data

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• Development of commodity indexes / futures on c.i.

- CRB (Commodity Research Bureau)

- S&P GSCI : (S& P Goldman Sachs Commodity

Index)

- S&P GSCI Excess Return Index

• Commodity are used for diversification purposes

- Massive investments in commodities because of

their counter-cyclic nature

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• Most active players:

- Commodity Trading Advisors - Hedge funds

- Pension funds

- Insurance companies

• Invest in commodity indexes (S&P GSCI) • Intend to invest more in the future

Barclays Capital Survey (2007) :

- Two years ago, 15% of institutional investors intended to invest more than 10% of their portfolios in commodities