Commodity Markets: Hedging Your Bets

Exciting times we live in. Never before in the history of humanity have we been able to boil down millions of tons of coal and acres upon acres of wheat to mere numbers in a Bloomberg terminal. However, such a mechanism exists in Wizard of Oz world of high finance. It is in the form of commodity markets and exchange traded commodities in those markets.

Trading commodities is not a new phenomenon; in fact it is the oldest one when it comes to business in its truest sense. People have traded wheat for corn and coal for clothes since the beginning of time. However, global commodity markets operate a little differently than they used to before; well, actually, it operates in a way that is worlds apart from the way it used to before alternating current turned into 0s and 1s. What has not changed since those times is the fact that commodities such as oil, natural gas, coal, wheat, corn and others play a pivotal role in industry and is the fuel that keeps globalization ticking. The process by which this mechanism works will be explained below; from the perspective of a layman, by a layman, for a layman.

The principle difference between a vanilla commodity trade (the way it has always been traded) and the status quo (the way global commodities are traded) is the concept of hedging. Suppose that a farmer grows potato every year and sells his harvest in his local market. Now, the supply of potatoes varies from year to year, the reason being that the climatic conditions may be favorable for potato harvest one year and unfavorable in the next; and the farmer has no way of forecasting this before the fact. So the farmer might have to absorb a huge loss in a bad year and undue gains in good ones. Take, on the other hand a fast food franchise such as KFC (Kalu Miyar Fried Chicken) that buys potatoes, makes French fries with them and sells them at obscene prices. Now, in a particular year when there has been a bumper harvest of potatoes, its bottom line improves because the spread between its obscene selling prices and the price of the potato has increased. The opposite happens during a bad year for potatoes. What has just been described is a situation where there are cyclical variation in the price of a particular commodity, in this case potatoes that affects the seller (farmer) and the buyer (KFC) in opposing ways; that is, when one goes bust, the other has a ball.
Now, suppose the farmer comes to KFC and makes a deal. He says that I will sell you 30 tons of potatoes (he’s apparently a potato baron) one year from now and you are going to pay me 20 taka per kg for it regardless of what the market price is at that time. What has just happened is that two parties have hedged (trimmed) their risk profiles and settled somewhere where they will neither go bust nor have a ball. I therefore welcome you to the world of derivatives by way of the forward contract. Where prices of commodities are set beforehand (sometimes years ahead of time) by the buyer and the seller. If the story ended here, then it would not have been worth an entire blog post. But being the geniuses that some of our particular brethren are, they figured out new ways of ‘hedging’ risk to the point where the actual physical commodities that were being traded were made to take the back seat to people such as Mr. Black, Scholes and countless others.
Another sort of derivative is called the futures contract. The principle difference here is that futures, unlike forwards are traded in exchanges. Hence, they are a form of standardized forward contracts that allow for increased liquidity in the market for these instruments and take away from the counterparty risk because the exchange guarantees settlement of all transactions. In addition, because futures are traded in exchanges and are inherently more flexible, gains and losses from these contracts are settled daily. This gives rise to a very interesting and sometimes confounding phenomenon. That is, even though futures contracts, in essence, function to reduce the price risk for a commodity, the person trading the futures contract doesn’t necessarily have to take delivery of the commodity. In other words, if person X buys 500 tons of crude oil futures, he doesn’t have to necessarily take delivery of the said commodity; (so he doesn’t have to worry about waking up one morning to see an oil tanker berthed in the nearest harbor). This creates scope for speculation in the futures market where investors who have absolutely nothing to do with crude oil or potatoes will nonetheless be trading them and making money off of them. This sort of speculative trading was argued to ‘hedge’ and distribute risk in an efficient way. But after the recent financial crisis, these voices have quietened down quite a bit.
 
This was meant to be an introduction to the world of commodity trading. In the upcoming write-ups, the various instruments of this trade and their implications are going to be covered in detail.