What Are Commodity Swaps?
Swaps bring to mind an exchange of sorts, which is why we talk about commodity swaps from the producer’s and the consumer’s sides. A commodity swap is an agreement whereby a floating price based on an underlying commodity is traded for a fixed price over a specified period. Although a commodity swap is similar to a fixed floating interest rate swap, the difference is that in an Interest rate swap the floating leg is based on standard interest rates, but in a commodity swap the floating leg is based on the price of underlying commodity. It is important to note that no commodities are exchanged during the trade.
In a commodities swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved. On the other hand, a producer who prefers to fix his income might agree to pay the market price to a financial institution, in return for receiving payments on the commodity as a fixed maximum price.
Commodity swaps were first traded in the mid-1970’s, and enable producers and consumers to hedge commodity prices. The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index). Although swaps involving oil prices are probably the most common, swaps involving weather derivatives are increasingly popular. For example, a commodity swap may be used in the circumstance of a political situation developing in an oil producing nation, negatively affecting the supply of oil. Similarly, an adverse weather condition or unexpected drought could markedly affect the harvest of a commodity crop.
It is common for a commodity swap to be settled in cash, although physical delivery is becoming increasingly common. In most cases, swap rates are fixed either by commodity futures, or by estimating the commodity forward price. Commodity swaps are usually traded in the Over-the-Counter (OTC) market and are risky to trade. The basis of trading commodity swaps is to look for price correlations, for example a correlation between the price of heating oil to crude oil in the wintertime, but such correlations do not always work and therefore the prices of commodity swaps are highly unpredictable.