What is Commodity Swap?

A commodity swap occurs when two parties agree to exchange their cash flows in a derivative contract, depending on the price of any underlying commodity. This allows hedging against any volatility in prices in the commodity market. There are several aspects to swaps that can be vital for managing risks better as far as investors are concerned. Let’s learn more about it below. 

Introduction 

A commodity swap is a derivative contract where two parties agree to exchange cash flows based on an underlying commodity’s prices. This enables better hedging against potential volatility in prices. In some cases, corporations also make use of swaps as a means of cost-control.

Why is it important? 

• Businesses/investors can safeguard themselves from price fluctuations/swings in the commodities that they sell or purchase, thereby enabling better risk management 
• They enable investors/businesses to discover and agree on commodity prices in the future 
• Investors can use them to diversify portfolios while gaining more exposure to the commodity market 
• They are more efficient and lower transaction costs considerably

A few examples of commodities traded in this manner include hard (gold, oil, natural resources, etc.) and soft (agricultural products such as wheat, coffee, corn, sugar, etc.) commodities. 

Understanding Commodity Swaps

Here is the basic structure of commodity swaps to help you understand better -

• One party or the fixed rate payer will agree to pay the other party or floating rate payer, the fixed price for a particular quantity of any commodity. 
• In return, the floating rate payer will also agree to pay a price to the fixed rate payer that is linked to the commodity’s market price. 

Please note these swaps are different from futures and options. While they are all derivatives, the purpose and nature are quite different. Swaps involve cash flow exchanges based on commodity prices, whereas, futures are standardized contracts for the future delivery of any commodity. Options, on the other hand, give the right to the holder, minus the obligation, to buy/sell the commodity at a particular date and price. 

Types of Commodity Swaps

Here are some of the types of commodity swaps that you should know more about. 

• Fixed-For-Floating Swaps - In this case, one party pays a fixed price, while the other party pays a floating price (tied to the market price of a particular commodity).
  This helps hedge against volatility in prices, speculate on the price movements of any particular commodity or in securing stable revenue irrespective of the market fluctuations. 
• Floating-For-Floating Swaps - Here, both parties exchange floating prices which are based on different benchmarks for the same or different commodities.

The receipts are exchanged on a notional principal that is based on a floating interest rate referenced to two different benchmarks. 

• Fixed-For-Fixed Swaps - This is relatively rare although it comes into play for specific contracts at times. Here, both parties agreed to pay a predetermined fixed price which will remain the same throughout the duration of the contract.
• Commodity-For-Interest Swaps - It is another type, where one party will pay the rate based on the price of a commodity, while the other pays either a fixed/floating interest rate. This could help with hedging against interest rate-related risks or those linked to commodity prices. 

How Do Commodity Swaps Work 

Here are some more insights on how commodity swaps work: 

• Commodity swaps are executed over-the-counter between the two parties, typically facilitated by a financial institution.
• Most times, the companies do not actually swap the underlying commodity, but exchange the cash flows based on the price difference.
• The Settlement can be in two different forms - physical and cash settlement.
• Physical settlement - Involves the actual delivery of the underlying commodity. While it is useful for companies who expect to physically use/hold onto the commodity, it is costlier and more complex in terms of logistics, quality control, storage, transportation, etc.
• Cash settlement - Involves a net cash payment based on the difference between the that reflects the price difference here. The latter will involve the actual delivery of the underlying commodity. 

Pricing Considerations: 

• With respect to pricing swaps, some major considerations include the underlying commodity’s forward curve, hedging costs, and interest rates. 
• The fixed price in the swap derives from the anticipated future price of the underlying commodity as seen in the forward curve. The swap length also impacts the fixed price (long-term swaps need higher fixed prices to cover fluctuation risks over a higher duration). The payment timing also affects the pricing. 
• Interest rates play a role when discounting the anticipated future cash flows to their current value. It is a crucial factor when determining the fixed price. Furthermore, the risk-free rate is considered a benchmark when the swap is priced. 
• The cost of hedging could also impact the fixed price, which depends on the liquidity of the underlying commodity market.
• Other considerations include seasonality, commodity market structure, and credit risks among others.  

Market Benchmarks: 

Benchmarks help determine commodity values based on aspects like transport logistics, storage, production, and more. Here are a few examples: 

• Henry Hub 

The Henry Hub is the benchmark pricing hub for the North American natural gas market and also a large chunk of the global LNG (liquified natural gas) sector. It is a pricing benchmark for commodity swaps, enabling market participants to speculate on future natural gas prices and manage risks. 

• WTI and Brent Crude Oil

West Texas Intermediate (WTI) is a well-known crude oil benchmark for derivative contracts/swaps. The WTI price thus helps in exchanging cash flows and hedging against fluctuations in the future. The more widely used global benchmark for pricing is Brent crude oil. It is one of the major global benchmarks for oil worldwide, including in Europe, Africa, and the Middle East. 

Benefits of Commodity Swaps 

Commodity swaps come with multiple benefits of their own. Here’s looking at some of them: 

• Hedge against future volatility - Either parties in the contract can hedge against the risks of commodity market price fluctuations.
  By locking in a fixed price for the commodity, companies may safeguard themselves against the rising price.
  At the same time, by agreeing to pay the price linked to the market price of the commodity, any entity can benefit from falling prices as well.
  This hedging ability could prove to be beneficial in a volatile and fluctuating market with higher unpredictability, allowing companies to stabilize operating costs, cash flows, and safeguard profit margins. 
• Predictable cash flows - Commodity swaps help gain predictable cash flows. They can stabilize the same by agreeing to fixed prices for commodities with higher certainty. This enables better financial planning and budgeting, while helping the organization maintain steady cash flows.
  Also, by agreeing to pay the price linked to the commodity market price, companies can enhance cash flows when the prices drop. 
• Risk management - Consumers and producers can manage risks better with swaps. They enable the exchange of variable cash flows for fixed flows, thereby lowering exposure to price fluctuations and streamlining income. Hedging against price swings for crucial commodities by locking in a set price helps participants create better risk management strategies tailored to their specific needs and market conditions. 

Risks and Challenges of Commodity Swaps

Here are a few risks to keep in mind in case of commodity swaps -

• Counterparty risk & credit exposure - 

Counterparty risk refers to the scenario where one of the parties fails to meet the obligations in the contract. For example, in case a company agrees on a fixed price and the other party does not deliver the commodity, then the first party may not have access to the commodity which is necessary for their operations. 

Similarly, if one company agrees to pay the price linked to the commodity’s market price and the other party does not make the necessary payments, it could lead to losses. This risk can be tackled by using collateral to secure the swap. 

• Market risks due to price fluctuations - 

One of the main risks involved in swaps is the market risk linked to price fluctuations. There is always a chance that the commodity price can move in a direction that does not benefit at least one of the parties in the contract.

For instance, if one party agrees to a fixed price and the market price comes down, the company will have to pay more than the latter. In the same way, if the company agrees to pay a price linked to the market price of the commodity, it will have to pay more than it anticipated in case this increases considerably.  

Commodity Swap Example

Let’s take a more specific example to give you a better idea - 

Suppose an airline enters into a contract for paying a fixed rate that is ₹1,000 per gallon for its fuel requirements of 100 gallons. If the price of the fuel is ₹1,200 per gallon at the payment period, then the airline will save ₹200 per gallon, i.e. 200*100 = ₹20,000. The other party will pay this difference to the airline, helping it offset the increase in fuel prices.  So, the airline will naturally be able to maintain its margins better and ensure stable cash flows. 

Conclusion

A commodity swap is a good way to hedge against future price fluctuations, stabilize cash flows, and streamline operations for companies and commodity traders. You can diversify your portfolio with strategic swaps while gaining more exposure to the commodity market in turn.

Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.

To read the RA disclaimer, please click here