Flat price Seasonality Commodities Spark spread Contango Exchange futures for physical are Dark spread Peak v Off-peak Backwardation different Dead spread Paper trading Front to back Demurrage
Commodities are different Why and How? Does it matter?
Why and how are commodities different? Oil Gas and power Precious and base metals Bulk (coal, iron ore) Agricultural (‘softs’) Size Mass Location Specifications
Does it matter – for a risk manager? Risk management = ‘What could happen to value over time’
Value of commodities Value of money Value of physical money Value of money substitutes
Value = f ( Specification, Location, Time) And none of those are invariant!
Specification Standards and regulations Change over time – aging Change due to conditions Changed deliberately
Spreads and Arbitrages ∆ value ( attributes) identical different ∆ attributes
Arbitrage examples Natural gas US: $3 Europe: $12 Japan: $15 LNG! Carriers are $100k+ per day… Unleaded gasoline US winter and summer specifications European specs
Transformation e.g., blending Regular unleaded gasoline + Blending components + Blending facilities + Time = Premium unleaded gasoline Real option or Optionality
Value revisited Inherent value = f ( spec, location, time) + Optionality = value of a real option Optionality is contingent: can it be realised? What impact does optionality have on risk?
Practical consequences for a risk manager Commodity trading = spread trading Analyse and model spreads Long term price evolution = Short term price + arbitrages
Market risk Daily vol 1 mo Brent 2.18% Daily vol 3 mo Brent 2.03% Correlation of daily returns 0.97 VaR @ 2 sigma 1.07% Daily vol of 1 - 3 mo spread 0.30% VaR @ 2 sigma 0.60% 1st/99th percentile of spreads 0.9%
Credit risk Long term, so…arbitrage matters for spreads ‘Mean reverting spreads’ Arbitrages hold…usually ‘the market can stay irrational longer than you can stay solvent’
Credit risk part 2 Legal Operational Credit Scope to modify and move risk
Summary Yes, commodities are different Differences result from inextricable link with the physical product Value = inherent value + optionality Inherent value f (spec, location, time)
Flat price Seasonality Commodities Spark spread Contango Exchange futures for physical are Dark spread Peak v Off-peak Backwardation More fun! Dead spread Paper trading Front to back Demurrage