This article explores how the EFP process works, focusing specifically on the ICE Gulf UCO  futures contract that settles based on the spot price of Fastmarkets/The Jacobsen Gulf used cooking oil and how a company can leverage this mechanism to lock in a price and settle a physical transaction. 

Understanding EFP in the futures market 

EFPs enable the exchange of a futures contract for a physical commodity at a pre-agreed price. This scenario can occur when a participant holds a futures contract and wants to terminate that position while simultaneously buying or selling the actual physical commodity. The EFP process allows for efficiency and transparency in price discovery, while maintaining the integrity of the futures market. 

The EFP process 

Creating an EFP occurs when one party wants to exchange a futures contract and buy a physical commodity. Conversely, the other party is interested in exchanging a futures position while agreeing to sell the physical commodity. 

Both parties agree on the terms of the EFP, including the quantity of the commodity, the delivery point, and the pricing. These are privately negotiated contracts. In the case of the ICE Gulf Futures contract, the physical agreement would match the futures settlement agreement. 

The EFP is executed on an exchange, and the corresponding futures contract position is offset against the physical transaction. This situation results in one party transferring the futures contract to the other and vice versa for the physical commodity. 

When the EFP is executed, the futures position will be closed out by the futures exchange, leading to a cash settlement based on the futures contract’s terms. The physical commodity is simultaneously exchanged outside the exchange system. 

The transaction is settled through the delivery of the physical commodity, depending on the agreement made during the initiation phase. 

The role of the ICE used cooking oil cash-settled futures contract 

ICE has developed a cash-settled futures contract for used cooking oil, designed to provide a tool for commodity hedging and risk management in the biofuels and renewable energy markets. This contract allows companies to lock in future prices and effectively secure their budgets and cash flows.  

How a company can use EFPs with the ICE gulf used cooking oil futures contract 

Managing commodity price risk is crucial for companies collecting, processing, or producing renewable diesel from used cooking oil. Here’s how a company can employ the EFP process using the ICE-used cooking oil cash-settled futures contract. 

Executing an EFP 

With futures contracts in place, the company can look for an opportunity to execute an EFP. Here, it must identify a counterparty – often another market participant interested in settling a physical transaction.  

Counterparts agree on terms such as quantity, pricing (linked to the futures price), and delivery locations.  

Through the ICE EFP exchange mechanisms, both parties offset their future positions. The company effectively transfers its futures contracts to the counterparty in exchange for the used cooking oil, completing the transaction. 

Settling the transaction 

Once the EFP is executed, the next space is settlement. The company can deliver the used cooking oil depending on the initial agreement. This transaction provides a stable price for the used cooking oil and mitigates risk, allowing the company to manage its cash flow and budgeting needs effectively. 

Benefits of using EFPs in the used cooking oil market 

Using the EFP process with the ICE-used cooking oil cash-settled futures contract offers a range of benefits. 

EFPs enable companies to lock in prices for the physical commodity, thus reducing the uncertainty associated with price fluctuations. 

By utilizing EFPs, companies maintain flexibility in their transactions. They can choose between cash settlement or negotiate an EFP based on operational needs and market conditions. 

EFPs can potentially lower transaction costs associated with physical trading, including logistics and transportation expenses. Companies can optimize their supply chain processes by aligning futures contracts with physical transactions. 

The EFP process can enhance market liquidity. As participants exchange futures for physical commodities, it can contribute to more stable pricing and better price discovery in the market. 

Hedging opportunities 

Companies can use EFPs as a strategic tool for hedging against price volatility. This capability is particularly vital in the used cooking oil market, where prices can be highly variable due to seasonal changes, regulatory impacts, and fluctuations in demand for renewable diesel and sustainable aviation fuel and other products. 

The bottom line 

The Exchange for Physical (EFP) process offers a valuable mechanism for companies operating within the futures market to manage price risk effectively. By leveraging the ICE Gulf UCO Futures contract settled using Fastmarkets/The Jacobsen used cooking oil spot price a, businesses can secure prices, ensure stable operational costs, and navigate the challenges posed by commodity market fluctuations. 

For companies producing and selling biofuels derived from used cooking oil, the EFP process not only adds a layer of price certainty but also enhances operational flexibility and efficiency. Understanding and utilizing the EFP mechanism can contribute to a more proactive and strategic approach to risk management in an increasingly dynamic market environment. 

By implementing these practices, firms can remain competitive while effectively managing their exposure to the used cooking oil market’s inherent volatility and contribute to the renewable energy sector’s sustainability and resource efficiency goals. 

Do you have a question about commodity futures contracts? Get in touch with our expert, David Becker, director of risk solutions.

The post Understanding how to use Exchange for Physical (EFP) using the ICE UCO futures contract appeared first on Fastmarkets.

The importance of renewable diesel

Renewable diesel is a type of biofuel that serves as a direct replacement for conventional petroleum diesel. Unlike biodiesel, renewable diesel is chemically identical to regular diesel and can be used in any diesel engine without modifications. It is produced through hydroprocessing technology, where waste oils and fats are refined to create a cleaner-burning diesel with lower greenhouse gas (GHG) emissions.

Used cooking oil: A prime feedstock

UCO is waste oil collected from the food service industry, including restaurants, commercial kitchens, and food processing plants. Traditionally, UCO is treated as waste, often disposed of through methods that can harm the environment. However, it is increasingly recognized as a valuable resource for renewable diesel production due to its lower carbon intensity than conventional feedstocks.

Environmental benefits

Utilizing UCO for renewable diesel production offers several environmental advantages.

Reusing UCO helps reduce the amount of waste that would otherwise end up in landfills or sewage systems. UCO-based renewable diesel results in lower GHG emissions than those produced from virgin vegetable oils or animal fats.

Renewable Identification Numbers (RINS)

The Renewable Fuel Standard (RFS) established by the United States Environmental Protection Agency (EPA) uses RINS to promote the integration of renewable fuels like renewable diesel into the national fuel supply. RINS are credits that track renewable fuel production and usage within the marketplace. Each RIN is generated when renewable fuel is produced and can be traded to help refiners and importers meet their renewable volume obligations.

How RINS work

When renewable fuel is produced, RINS are generated. Each gallon of renewable diesel, ethanol, or biodiesel is assigned a unique RINS number.

Upon blending renewable fuel with petroleum-based fuel or at the point of sale, the RINS can be ‘separated’ from the physical fuel. The separated RINS can then be traded independently on the RIN market.

Refiners and importers of petroleum fuels, or obligated parties, must acquire a set amount of RINS to meet their renewable volume obligations (RVO) each year. They must purchase RINS to make up the difference if they produce or import insufficient renewable fuels.

The value of RINS is determined by market supply and demand. If renewable fuel production increases, more RINS will be available, potentially lowering their price on the market.

Low carbon intensity feedstock and RINS

Using low carbon intensity feedstocks like UCO enhances the value of RINS due to the lower lifecycle greenhouse gas emissions associated with these materials. UCO-based renewable diesel generates lower-carbon RINS, recognized within the EPA’s RFS program as a more beneficial renewable fuel due to its reduced environmental footprint.

California Low Carbon Fuel Standard (LCFS)

In addition to the federal RFS program, California has implemented its own Low Carbon Fuel Standard (LCFS) to reduce further the carbon intensity (CI) of transportation fuels used within the state. The LCFS sets annual CI targets that decrease over time, incentivizing the use of low-carbon fuels.

Additional credits from the LCFS

Under the LCFS, fuel producers generate credits when they produce and sell fuels with a carbon intensity lower than the state’s benchmark. Each credit represents one metric ton of CO2 equivalent reduced.

Similar to RINS, LCFS credits can be traded on the open market. Producers of low-carbon fuels can sell their excess credits to other fuel providers who need them to comply with LCFS requirements.

Value of UCO

Using UCO further enhances the value of LCFS credits due to its low carbon intensity score. The lifecycle assessment of UCO accounts for the waste diversion from landfills and the energy used in its collection and processing, resulting in a lower overall CI.

Synergies between RFS and LCFS

Producers utilizing UCO can benefit from the RFS and LCFS programs by receiving RINS and LCFS credits. This synergistic effect maximizes the financial and environmental benefits.

As previously noted, low-carbon-intensity feedstocks like UCO produce more valuable RINS, positively influencing the profitability of renewable diesel operations.

LCFS credits augmentation

By generating LCFS credits, renewable diesel producers in California can gain additional revenue streams, further incentivizing the use of low-carbon feedstocks such as UCO. Together, these programs provide a robust framework that promotes the production and usage of renewable diesel with significant environmental benefits.

Economic advantages for producers

The dual benefits of RINS and LCFS credits enhance the economic viability of renewable diesel, especially when using low-carbon-intensity feedstocks like UCO. Here’s how these mechanisms bolster industry profitability.

Producers can realize higher returns due to the increased value of low-carbon RINS. The elevated market price for these RINS provides a substantial economic incentive to incorporate UCO in production.

LCFS credits offer an additional revenue stream, making it more attractive for producers to exceed the required carbon intensity reductions. These credits can be sold to other entities needing to meet their obligations under the LCFS program, creating a lucrative secondary market.

UCO is often cheaper than virgin oils and fats since it is a waste product. This cost differential can significantly lower the operating costs for renewable diesel producers, enhancing their overall profitability.

Challenges and opportunities for UCO

While there are numerous benefits to using UCO in renewable diesel production, the industry faces challenges, such as supply chain logistics, quality control, and competing uses.

Collecting, transporting, and processing UCO requires efficient logistics to ensure quality and minimize contamination. Developing robust supply chain networks can be capital-intensive but essential for scalability.

UCO can vary significantly based on its collection source and prior use. Ensuring consistent feedstock quality is critical for maintaining the high performance of renewable diesel.

UCO is also used in other industries, including animal feed and oleochemical production, which can create competition for this feedstock and impact availability and price.

Despite these challenges, the opportunities presented by leveraging UCO in renewable diesel production are significant. Technology and supply chain management advances can mitigate these issues and foster greater adoption of this practice.

Future outlook

The intersection of environmental policy and technological advancements positions UCO and other waste oils as pivotal in the future landscape of renewable diesel production.

Continued support and tightening of regulations under the RFS and LCFS will likely enhance the market dynamics favoring low-carbon-intensity fuels.

Advances in hydroprocessing and pretreatment technologies could improve the efficiency and scalability of converting UCO into renewable diesel. Innovations in catalyst and reactor designs may reduce processing costs and improve fuel yields, making the process more economically viable.

As other regions and countries adopt similar frameworks to the RFS and LCFS, the demand for low-carbon-intensity feedstocks like UCO is expected to rise, driving global markets towards more sustainable fuel solutions.

The use of UCO in renewable diesel embodies the principles of a circular economy. Businesses increasingly recognize the value of waste-to-fuel initiatives, which can transform environmental liabilities into economic assets.

Waste management and sustainable fuel production

Using UCO in the renewable diesel industry exemplifies an innovative approach to waste management and sustainable fuel production. This synergy between waste reduction and renewable energy production offers environmental benefits and significant economic opportunities for businesses and communities.

As we advance, the combined efforts of policy frameworks like the RFS and LCFS, along with technological innovations and public engagement, will be crucial in harnessing the full potential of UCO in renewable diesel production. By optimizing processes, enhancing collaboration, and promoting sustainability, the renewable diesel sector can effectively contribute to the global energy transition and a more sustainable future.

Ultimately, the dynamic interplay between waste reduction and renewable energy presents a model for future industrial practices, demonstrating how sustainable solutions can be economically viable and environmentally beneficial. Like other refining businesses, the cyclical nature of opportunity is market-based and consistently changes.

The renewable diesel industry can lead the charge toward a lower-carbon economy through strategic actions and continued innovation, setting a standard for other sectors.

View our used cooking oil prices

The post The growing role of used cooking oil in renewable diesel production appeared first on Fastmarkets.

Corporate debt investors, who provide funding to companies through bonds or other forms of credit, typically prioritize the stability and predictability of their investments. One crucial element that impacts the risk profile of corporate debt, especially in industries heavily dependent on commodities, is exposure to changes in commodity prices.

Consequently, the connection between corporate debt investors and commodity producers is significantly influenced by the necessity of safeguarding against these price risks.

How volatile commodity prices influence debt repayment

Commodity prices can experience substantial fluctuations due to several factors, such as alterations in supply and demand dynamics, geopolitical conflicts and broader economic trends.

Price variations can significantly influence revenue, profitability and overall financial stability for companies producing metals, forestry or agricultural goods. This volatility poses risks for the producers themselves and extends to investors who hold their corporate debt.

In times of declining commodity prices, businesses may encounter reduced cash flows, leading to challenges in meeting debt obligations, paying interests, or refinancing existing loans. This scenario is particularly problematic for debt investors since a company’s ability to repay its debts is often directly tied to its revenue, which commodity prices can significantly impact.

The demand for hedging mechanisms

Debt investors typically avoid risks and seek returns with lower volatility. Hence, they frequently encourage these companies to hedge their exposure to commodity price fluctuations when investing in commodity producers. Commodity hedging involves taking positions in derivatives or other financial instruments to minimize potential losses from adverse price movements.

By hedging, commodity producers can secure prices for their products well in advance, stabilizing cash flows and creating a more predictable revenue stream. This, in turn, enhances their ability to meet debt obligations. For debt investors, the knowledge that the companies they invest in actively manage their commodity price risks instills greater confidence in the issuer’s ability to maintain financial stability.

Creditworthiness

Credit rating agencies commonly evaluate companies’ risk profiles based on their operational and market risks, including exposure to commodity prices. Companies that hedge their positions may exhibit higher credit ratings due to improved risk management practices, resulting in potentially lower borrowing costs and increased interest from corporate debt investors.

Earnings stability

Hedging strategies like futures contracts, options, and swaps allow producers to mitigate the adverse impacts of price declines while enabling them to benefit from price increases to a certain extent. This situation leads to more consistent earnings, which is advantageous for investors seeking predictable returns.

How commodity producers hedge price risk

Commodity producers use various hedging strategies to manage their exposure effectively.

One method involves entering into futures contracts that enable producers to sell a specified amount of a commodity at a predetermined price, ensuring a guaranteed minimum revenue regardless of market fluctuations.

Options grant producers the right, but not the obligation, to buy or sell a commodity at a specific price within a particular timeframe. This strategy allows producers to capitalize on favorable price increases while safeguarding against downside risks.

Commodity swaps allow producers to exchange variable commodity cash flows for fixed ones, smoothing income and reducing exposure to price variations. By combining these instruments, producers can create a comprehensive risk management strategy tailored to their business needs and prevailing market conditions.

The investor’s perspective

The implications of producers’ hedging decisions are significant for corporate debt investors. Investors may carefully evaluate companies’ hedging strategies before making investment choices. A company with a robust hedging policy may be perceived as a stable, lower-risk investment rather than a speculative one.

Investors must continuously monitor the credit risk associated with their investments. Companies with well-structured hedging programs are often seen as having a lower risk profile, potentially affecting yield spreads. Tighter spreads may indicate lower perceived risk, allowing companies to reduce borrowing costs.

Debt investors typically prefer companies with predictable performance metrics. Industries highly exposed to commodity price fluctuations carry inherent risks, but companies committed to hedging can reduce the unpredictability linked to earnings reports.

The impact on debt markets

Hedging benefits individual corporations and has broader implications for the debt markets. Emphasis on hedging promotes the development of credit risk models to evaluate corporate debt investments’ viability. Effective hedging practices across industries can enhance overall market stability, boosting investor confidence in the credit markets.

The bottom line

Corporate debt investors are vested in ensuring that commodity producers hedge their exposure to commodity price fluctuations. The unpredictable nature of commodity prices poses significant risks for producers and the investors funding their operations through debt. Corporate debt investors can mitigate the risks associated with their investments by encouraging commodity hedging and aiding producers in implementing effective hedging strategies. When a company relies heavily on debt, price fluctuations that generate volatility can elevate borrowing rates.

The post Why commodity price risk managment matters to debt investors appeared first on Fastmarkets.

• Protect against potential adverse price fluctuations when a derivative market does not exist.
• Customize your risk management strategy using self-insurance.
• Create a commodity hedging process that prioritizes stable cash flows.

Procurement managers and commodity producers are often exposed to price fluctuations, which can significantly impact their profitability and financial stability.

To hedge against adverse commodity price movements, market participants often turn to financial instruments such as futures, swaps, and options.

In some instances, a derivative market might not be available yet.

However, a potential solution exists.

Commodity market participants can opt for self-insurance strategies by setting aside self-insurance premiums equal to the value of a cap or floor. While caps and floors are often embedded in physical contracts, they are frequently a source of complexity in negotiations on how to price an underlying physical contract.

What is a cap and floor?

A cap in commodity trading refers to a price limit placed on a transaction or contract. It represents the maximum price at which the commodity can be bought or sold. Conversely, a floor represents the minimum price at which a commodity can be bought or sold. It acts as a price floor to protect against price declines and ensure a minimum return on investment.

Together, caps and floors provide traders with a range of possible prices for a commodity transaction, creating a level of certainty and protection against extreme price movements.

What is commodity price self-insurance?

Self-insurance is an alternative to physical market caps and floors or using derivatives to mitigate exposure to higher or lower prices. Self-insurance in the commodities market involves the establishment of a fund to cover potential losses resulting from price fluctuations. Companies exposed to commodity price fluctuations can calculate the premium cost for purchasing call or put options and allocate an equivalent amount to their self-insurance fund. This fund serves as a buffer to offset losses that may arise if prices fall below or rise above a certain level.

How self-insurance works

By setting aside self-insurance premiums, companies’ exposure to commodity prices can create a financial cushion that can help mitigate the impact of adverse price movements on their bottom line. Instead of relying solely on financial instruments that might not exist, companies exposed to commodity prices can take control of their commodity price risk management strategy and build internal reserves to protect against unforeseen events. The accounting method to buffer losses can be customized based on company practices.

The benefits of self-insurance

One key advantage of using self-insurance premiums to create a fund for price risk mitigation is the flexibility it offers. Unlike traditional insurance or hedging arrangements, self-insurance allows market participants to tailor their risk management approach to specific market conditions and operational requirements. This customized approach can create a competitive advantage and financial resilience in volatile commodity markets, especially if a derivative market is unavailable.

Another benefit of self-insurance is the potential cost savings that companies can achieve in the long run. Companies exposed to commodity prices can reduce their overall risk management expenses by avoiding premium payments to external insurance providers or financial institutions and retaining more control over their financial resources. Additionally, self-insurance premiums can generate investment income for producers if not immediately used to cover losses, further enhancing their financial position.

Managing commodity price self-insurance

However, it is essential for commodity producers to prudently manage their self-insurance fund and regularly assess its adequacy in light of evolving market conditions. Producers and procurement managers should conduct thorough risk assessments, monitor price trends, and adjust their self-insurance premiums to ensure they have sufficient resources to withstand adverse price movements.

What are the risks?

A self-insurance premium strategy is not without risks. The strategy incorporates forecasted volatility to estimate the appropriate reserve needed for commodity hedging. While it is an alternative to financial instruments and

The bottom line

In conclusion, self-insurance premiums offer commodity-exposed businesses a flexible and cost-effective way to create a fund to offset losses due to adverse price movements instead of a derivatives market. By leveraging self-insurance strategies when no derivative market currently exists, commodity procurement and producers can enhance their risk management capabilities and strengthen their financial resilience during volatile market periods. Embracing self-insurance as part of a comprehensive risk management strategy can help market participants navigate price fluctuations and safeguard their profitability.

Have questions? Contact our Fastmarkets risk solutions team today.

The post Mitigating risks without financial instruments appeared first on Fastmarkets.

On April 22, 2024, the Intercontinental Exchange will list a refined, bleached and deodorized (RBD) soybean oil basis futures contract. Significant volatility in the basis over the last five years has led to some extensive swings in costs and revenues for those who purchase and sell RBD soybean oil. The benefits of having an exchange-traded derivative that matches the movements of a product widely consumed in the United States will help stabilize cash flows, improve budgeting and reduce the volatility of profits for those exposed to the movements of RBD soybean oil.

What is RBD soybean oil?

Refined, bleached and deodorized (RBD) soybean oil is a type of vegetable oil that undergoes a series of processing steps to enhance its quality, flavor and stability. The RBD process involves refining, bleaching and deodorizing crude soybean oil to create a clear, odorless, neutral-flavored cooking oil suitable for various culinary applications. Refined soybean oil is also utilized in non-food applications, such as renewable diesel, biodiesel, lubricants, cosmetics and personal care products. Its versatility and stability make it a valuable ingredient in various industries.

How is RBD soybean oil created?

Refining soybean oil involves removing impurities from crude soybean oil, such as free fatty acids, pigments and undesirable flavors. This step typically includes degumming, neutralization and filtration to produce a clean and clear oil with improved quality.

Bleaching is the next step in the RBD process, where the oil is treated with natural or chemical agents, such as activated carbon or clay, to remove any remaining impurities and color pigments. This process helps to improve the appearance and shelf stability of the oil.

Deodorization is the final step in the RBD process, where the oil is heated under a vacuum to remove any residual odors and volatile compounds. This process eliminates unwanted flavors and ensures that the soybean oil has a neutral taste suitable for various cooking applications.

Typical uses of RBD soybean oil

RBD soybean oil is a versatile cooking oil widely used for frying, baking, sautéing and general cooking. According to Fastmarkets, slightly more than 40% of the soybeans consumed in the United States are RBD for food use. RBD soybean oil is commonly used in food processing to produce snacks, baked goods, dressings, marinades and sauces. Refined soybean oil is also utilized in non-food applications, such as renewable and biodiesel.

What is the RBD soybean oil basis?

The basis between different types of refined soybean oil refers to the price difference between various grades or qualities of soybean oil products. This price differential can be influenced by factors such as quality specifications, processing methods, market demand and supply, supply chain logistics and specific uses or applications of the different types of soybean oil. Understanding the basis between various types of refined soybean oil is essential for market participants to assess price differentials and make informed trading decisions.

The RBD soybean oil basis reflects the difference between the price of crude soybean oil in Chicago* and RBD Soybean oil in central Illinois, as reported by Fastmarkets.

How do RBD soybean oil basis futures contracts work?

The Intercontinental Exchange RBD Soybean Oil basis futures contract trades as a differential to the Chicago price in cents per pound. The final settlement is a cash settlement, in cents per pound, based on the monthly average daily prices in the determination period (calendar month). The futures contract is cash-settled.

A cash-settled commodity futures contract is a type of financial derivative agreement where parties agree to buy or sell a specified quantity of a commodity at a predetermined price in the future. Unlike physically settled futures contracts, where the actual delivery of the underlying commodity occurs at expiration, cash-settled futures contracts are settled in cash based on the difference between the transaction price and the actual final contract settlement at expiration. Participants can trade in and out of contracts just like physically settled contracts.

For example, if you purchased one RBD Soybean basis futures contract at 10 cents per pound and the final settlement of the Fastmarkets RBD price for the calendar month was 15 cents per pound, you would gain five cents per pound multiplied by 60,000, which equals $3,000.

How volatile is the RBD basis?

The RBD basis can be volatile. The chart shows the RBD basis overlayed with a rolling 12-week historical volatility. Historical volatility has been as high as 130% and as low as 17% during the past five years. Price volatility increases risks for businesses and investors, affecting profitability, cash flow, and financial stability. Mitigating volatility through risk management strategies such as commodity hedging, diversification, and insurance helps protect against adverse price movements and minimize potential losses.

Why does the industry need an RBD soybean oil basis futures contract?

The volatility of the RBD basis can be significant. Since most soybean oil is refined, what is clear is that physical players that are exposed to RBD soybean oil can experience a substantial hit to their bottom line if they decide to hedge using a proxy or forego hedging completely.

Using 60,000 pounds of RBD soybean oil basis, the profit and loss chart shows that exposure to one contract over a quarter (12 weeks) can lead to profit and loss changes as high as +14,000 or -11,000. Mitigating price volatility is crucial for various stakeholders across industries to manage risks, ensure financial stability, and make informed decisions. High price volatility can lead to uncertainty, market fluctuations, and potential financial losses, impacting businesses, investors, consumers, and the overall industry.

The listing of a refined, bleached, and deodorized (RBD) soybean oil basis futures contract on April 22, 2024, by the Intercontinental Exchange aims to address significant volatility in the basis experienced over the past five years, resulting in substantial cost and revenue fluctuations for buyers and sellers of RBD soybean oil. Introducing an exchange-traded derivative that mirrors the movements of a product extensively consumed in the United States is expected to bring several benefits to market participants. By providing a mechanism to hedge against price fluctuations, the futures contract will help stabilize cash flows, enhance budgeting accuracy, and reduce profit volatility for those exposed to price movements in RBD soybean oil. This initiative offers risk management tools that promote financial stability, predictability and improved decision-making for industry stakeholders in the soybean oil market.

*The soybean oil price in Chicago is the settlement price of the prompt month CME soybean oil futures contract.

Get in touch to find out more about futures contracts and all our risk management products

The post RBD soybean oil basis futures contracts: The benefits appeared first on Fastmarkets.

Companies that practice risk management techniques in the volatile battery raw material (BRM) space will likely benefit from consistent investment flows. Volatile profits driven by fluctuating commodity prices can yield hefty rewards as well as unattractive losses. While there may be varying perspectives, it’s crucial for companies to effectively communicate their hedging rationale and strategies to align with investor expectations.

BRM volatility

The price of lithium, a key component in energy storage technologies like batteries, can be highly volatile due to various factors such as supply-demand imbalances, changes in production capacity and geopolitical events. Financial derivatives, such as futures or options contracts, can provide a mechanism to mitigate price risk and stabilize costs.

To put the price volatility in perspective, the historical annualized monthly average volatility of the Fastmarkets lithium hydroxide (LiOH) index was 41% in January 2024 and monthly historical volatility has been above 40% for the prior nine months.

These statistics equate to a monthly average change of approximately 12% per month, which might go directly to a firm’s bottom line. Persistent and large double-digit profit swings can raise concerns about a company’s ability to withstand economic downturns.

Managing financial expectations

Energy storage players often require a consistent and predictable cost structure to manage their budgets and plan for future projects effectively. By hedging lithium prices with financial derivatives, energy storage system (ESS) companies can lock in a predetermined price for future purchases, ensuring stability and reducing uncertainty.

Energy storage projects, particularly those that require funding, may involve providing a hedging program to insulate a lender from changing prices. Hedging with derivatives can protect against potential price increases during the contract period, giving assurance and reducing the risk of unexpected cost escalations.

By hedging lithium prices, energy storage players can gain a competitive advantage by securing a stable cost structure. This situation allows ESS companies to offer more competitive pricing to customers or improve profit margins in a market where lithium prices exhibit significant volatility.

Want more information on how to manage BRM price risks? Take a look at our 35-page report that breaks down the complex topic of price risk management and offers insights into the historical and projected volatility of BRM prices. Access our report here.

How can ESS players manage risk? 

The key to managing commodity price risk is understanding your exposure and having a physical benchmark for procurement and an index for derivatives trading.

For example, an ESS company might purchase batteries that are based on the prior month’s average of a physical benchmark such as the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg.

A significant benefit of using a physical benchmark is that it is also a financial benchmark used to settle several exchange-traded and over-the-counter (OTC) derivatives.

Exchanges that use the Fastmarkets lithium hydroxide index include the Chicago Mercantile Exchange (CME), the London Metals Exchange (LME), and the Singapore Commodities Exchange (SGX). Additionally, several swap dealers in financial institutions use the Fastmarkets lithium hydroxide index to settle OTC swaps and options.

The transformation of a physical benchmark

Physical commodity benchmarks are vital in bringing transparency to opaque commodity markets by providing standardized price references for the underlying commodities. Physical benchmarks are the linchpin in generating a robust commodity futures market, which can provide the liquidity needed to change an opaque market into a transparent market.

The transparency journey relies on the market participants to broaden benchmark acceptance. Derivative markets are critical in enhancing physical commodity benchmarks.

As markets develop, moving from bilateral agreements to those transacted based on a price index, futures contracts, and OTC agreements generate a globally acceptable benchmark that can be used to set physical contracts for commodity producers and consumers.

What is a price benchmark?

Benchmarks serve as a reference point for price discovery. As a benchmark becomes more acceptable, it attracts market participants and fosters liquidity, providing a common basis for trade execution. Increased liquidity enhances market depth, reduces bid-ask spreads and improves price stability.

What is a futures contract?

A futures contract is a financial agreement or contract between two parties to buy or sell an asset at a predetermined price and date in the future. This type of contract is commonly used for commodity hedging or speculation on the underlying asset’s future price movement.

A futures market is a marketplace where standardized contracts for future delivery of a commodity are bought and sold. These contracts typically have specific terms, including settlement dates, quantities, and quality specifications. Participants in the futures market use these contracts to hedge price risk.

What is an OTC commodity derivative?

An OTC commodity derivative is a financial contract that derives its value from an underlying commodity. Unlike exchange-traded derivatives that are standardized and transacted on organized exchanges, OTC derivatives are privately negotiated contracts between two parties.

In the context of commodities, an OTC derivative allows participants to hedge against price fluctuations or speculate on the future price movements of various commodities. These derivatives can take multiple forms, including swaps, options and forwards.

The main characteristic of OTC commodity derivatives is that they are customized to meet the specific needs and requirements of the parties involved. For example, market makers often quote average quarterly or average annual swaps. 

What is a cash-settled derivative?

The futures and swaps that are traded outside of China are cash-settled. The benefit of cash-scheduled futures and OTC derivatives is that the buyer and seller do not have to handle the issues and costs related to physical delivery. Participants are only responsible for the difference between where they buy and sell an index, or the entry price of a transaction on an index, and the settlement price of the index.

A cash-settled futures contract is where the settlement is performed in cash rather than through physical delivery of the underlying asset, with a settlement based on the average of an index over a specific period.

A physical benchmark index is a reference point representing a particular commodity’s price in the physical market. It is often used as a benchmark for pricing other transactions or settling contracts in the industry. Robust futures markets can contribute significantly to the establishment of these benchmarks.

The appeal of financial derivatives

As a benchmark gains acceptance, a broadening of trade begins within the financial markets. Financial derivatives are appealing to trade for several reasons.

Derivatives allow traders to control a more extensive exposure to the underlying asset with a smaller upfront investment. This leverage amplifies potential gains or losses by mitigating the capital required to control a specific commodity volume. This scenario can offer higher returns than physical commodity trading.

A mature derivatives market tends to be more liquid than physical commodity markets, meaning a higher notional value of trading activity exists. This liquidity makes entering and exiting positions easier, facilitating efficient price discovery and providing a broader range of trading opportunities.

The derivatives market offers greater flexibility for speculation and hedging purposes. Traders can speculate on price movements without owning the physical asset, allowing them to take positions regardless of the availability or storage of the underlying commodity. Additionally, derivatives enable market participants to hedge against price risks by establishing offsetting positions to protect against adverse price movements.

Trading derivatives often involves lower transaction costs than physical commodity trading. Derivatives are typically traded on electronic platforms. Additionally, the standardized nature of many derivatives contracts streamlines trading processes and lowers transactional expenses.

The acceptance of a physical benchmark initially relies on physical players. Still, as the market grows and financial players agree to broaden liquidity, the derivatives market begins to drive volumes.

The bottom line

The upshot is that ESS concerns will likely need to incorporate risk management into their budgeting framework to successfully negate the volatility experienced when using lithium batteries to store power.

Current historical volatility levels equate to a monthly average change of approximately 12%. In any instances, this type of movement would filter into the bottom line, creating potential problems for those lending to ESS concerns. By hedging their exposure, an ESS company can reduce this impact on their EBITA and provide stable cash flow that reduces their bottom line volatility.

The best way to coordinate your commodity hedging is to use a futures contract that mimics the commodity index that you use for your physical procurement. For example, the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg, is used by futures exchanges, OTC derivative transaction and physical procurement. You can learn more about ESS risk management using BRM derivatives by contacting our risk solutions team.

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Mitigating price volatility

Input costs for electric vehicles (EVs) differ from combustion engine vehicles, due to battery technology, maintenance and repair, residual value and charging infrastructure. While EVs tend to have lower fuel costs and reduced maintenance needs, the upfront cost of purchasing an EV may be higher, mainly attributed to battery technology. These input cost differences may change as the EV market evolves and technological advancements accelerate.

Material costs in the automotive industry, such as steel, aluminum, lithium, cobalt and nickel, are subject to price volatility influenced by global economic factors, market demand, geopolitical issues and other unpredictable forces. By hedging their price risk, automotive companies can protect themselves against sudden price spikes or prolonged periods of elevated costs. This mechanism helps stabilize profit margins and allows for better planning and budgeting.

Ensuring cost predictability

Commodity hedging allows automotive companies to predict their budget more efficiently, which is crucial for long-term strategic planning and decision-making. By locking in prices for essential inputs, auto manufacturers can accurately forecast production costs, set competitive prices for their vehicles, and avoid sudden financial shocks. This plan helps improve business performance and offers a competitive advantage in a dynamic marketplace.

Learn more about price risk management: Special report

Get your copy of this special 35-page report that breaks down the complex topic of price risk management, offering insights into the historical and projected volatility of the materials used in the production of automotives, and illuminating their price interplay.

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Safeguarding against supply chain disruptions

Global supply chains in the automotive industry are vulnerable to disruptions caused by natural disasters, political conflicts, labor strikes, or unexpected events like the Covid-19 pandemic. By hedging input costs, automotive companies can mitigate the price risk of a supply chain disruption on manufacturing costs. This risk mitigation process can help create a competitive advantage, maintain customer satisfaction and protect revenue streams.

Enhancing profitability and competitiveness

A risk management strategy can give automotive companies a competitive edge by improving their profitability. Effective hedging mechanisms help manage expenses, optimize procurement strategies and stabilize pricing. With controlled input costs, manufacturers can offer competitive prices to consumers, invest in research and development and allocate resources for innovation and product improvement.

Assuring investor confidence

Financial stability is a significant factor for investors when assessing the viability of automotive companies. A robust risk management strategy can demonstrate that a company has taken proactive measures to manage risks and protect its financial position. When management uses a risk management strategy, their efforts can instill confidence in investors, establish credibility and enhance the perception of the company’s ability to navigate uncertainties in the market.

Complying with stakeholder expectations

Automotive companies often face pressure from stakeholders, including investors, customers, suppliers and regulatory bodies, to ensure sustainability and responsible business practices. Hedging input costs can contribute to a more sustainable and accountable approach, as it helps mitigate financial risks, ensures the stability of operations and supports long-term business viability.

How to create a risk management process

There are a few steps to design a risk mitigation plan.

Step one: Risk measurement

Price risk measurement refers to assessing and quantifying the potential volatility or variability in the prices of commodity input costs. It involves analyzing the potential fluctuations in prices and understanding the associated risks.

Various methods and tools are used for price risk measurement, including statistical analysis, historical data analysis and mathematical models. The objective is to estimate the potential losses or gains that may arise from price movements and assess the risk exposure level.

Download our risk measurement analysis to learn more.

Step two: Preparing for action

Once you have measured your input costs risks, you can set up your operations to accommodate your risk management program. You likely need to consider:

• Legal and regulatory Compliance
• Capital requirements
• Technology infrastructure
• Market access
• Accounting
• Operations for settlement, payment, invoicing and confirmations
• Trading accounts and documentation

Step three: Risk management

Once your risk mitigation operation is set up, you can start considering the appropriate financial products that you should use to hedge your risk exposure. An appropriate strategy would be to match your future physical procurement with financial derivatives that will mitigate the variability of these physical prices. Automakers can use financial derivatives such as exchange-traded futures and options contracts and over-the-counter swaps and options to hedge price risks.

The bottom line

In an industry as complex and competitive as the automotive sector, hedging input costs is a prudent risk management strategy for automobile companies. By mitigating price volatility, ensuring cost predictability, safeguarding against supply chain disruptions and enhancing profitability, input cost hedging provides essential benefits that strengthen automotive manufacturers’ financial stability and resilience. Embracing effective hedging practices helps companies adapt to market changes, improve planning and secure their position in the global automotive industry.

Learn more about price risk management. Get your copy of this special 35-page report that breaks down the complex topic of price risk management for automotive buyers. The report offers insights into the historical and projected volatility of the materials used in the production of automotives and illuminates their price interplay. Get your copy here.

Glossary of price risk management terms used in the report

• Autoregressive: A statistical model where future values are predicted based on past values.
• Correlation matrices: A table showing the correlation coefficients between sets of variables, in this case, different commodity prices.
• Forecast volatility: Historical volatility helps in determining forecast volatility. The method used to forecast is GARCH. The generalized autoregressive conditional heteroskedasticity (GARCH) describes an approach to estimate volatility. GARCH is a statistical model that can be used to analyze and forecast volatility.
• Futures: Contracts that obligate the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.
• Hedge: A strategy used to reduce the risk of adverse price movements in an asset by taking an offsetting position, often through a derivative such as an option or a futures contract.
• Historic volatility: Historical volatility is calculated using logarithmic returns. Historical volatility = the standard deviations of the logarithmic returns multiplied by the square root of time.
• Monte Carlo Simulation: A computerized mathematical technique that allows people to account for risk in quantitative analysis and decision-making.
• Notional value: The total value of a leveraged position’s assets. This term is commonly used in the options, futures, and foreign exchange markets.
• Options: Financial contracts that provide the right, but not the obligation, to buy or sell an asset at a specified price within a specific time period.
• Price volatility: The degree to which a commodity’s price varies over time, indicating the level of risk or uncertainty.
• Probability bands: Forecasted potential price levels based on current volatility.
• Risk reversal: An options strategy that involves the simultaneous buying of a call option and selling of a put option, or vice versa.
• Strike price: The set price at which an options contract can be bought or sold when it is exercised.
• Swaps: Financial agreements that involve the exchange of cash flows or liabilities under predetermined conditions.
• Value at Risk (VaR): An estimate of the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval.

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As a producer or consumer of physical commodities, you likely engage in procurement or sales with physical contracts tied to a physical benchmark.

In many instances, each party might request specific criteria written into a physical contract that will allow them to mitigate price risk and avoid an unforeseen situation. These criteria act as an insurance policy.

How a commodity index is embedded in a physical contract

An insurance policy is similar in many ways to an option. You pay a premium for a specific payout. Before describing how these embedded physical contract options can be monetized, discussing how commodity indexes are used in physical contracts might be helpful.

A commodity index is typically embedded in physical contracts through a pricing mechanism. In physical contracts, commodities, such as lithium hydroxide or lithium carbonate, are traded based on their underlying index, which serves as a benchmark for pricing and settlement. The index represents the average value of trades that occurred in the market over a specific period.

When a commodity index is embedded in a physical contract, the contract’s pricing or settlement is tied to the index’s average price. This linkage allows parties involved in the contract to have exposure to the overall movement of the commodities represented by the index.

For example, if you have a physical contract for purchasing lithium hydroxide, instead of fixing the price solely based on the spot price of lithium, you could use a commodity index like the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg as a reference. The contract’s terms might stipulate that the price will be a certain percentage above or below the index’s value at the time of settlement to incorporate transportation duties or taxes.

By using a commodity index in physical contracts, participants access a standardized pricing mechanism that reflects the overall market conditions for a particular commodity.

How does a commodity index work in a physical contract?

Discussing a theoretical case study helps describe the potential monetization of embedded physical contract options.

Cathode Corporation ABC agreed to purchase lithium hydroxide from New Energy Production Company XYZ. The deal stated that the price Cathode Corporation ABC would pay New Energy Production Company XYZ each month would be based on the previous month’s average price of Fastmarkets lithium hydroxide index. Cathode Corporation ABC would purchase the same volume each month during the contract’s life, but the average monthly price could not exceed 105% of the prior month’s price.

The clause in the contract that capped the price that Cathode Corporation ABC will pay per month is an option. No matter how high lithium hydroxide prices move during the current month, Cathode Corporation ABC can purchase lithium hydroxide at the prior month’s rate plus 5%.

Cathode Corporation ABC performed some analysis using historical Fastmarkets lithium hydroxide prices. They saw that during the past five years, there was a lot of volatility in the monthly average price of lithium hydroxide. Still, only 23% of the months had month-over-month changes that were more than 5%, and 10% of the months had moves that were greater than 10%. The cap in the price acts like an insurance policy that is embedded in the physical contract.

The monetary value of embedded options

One of the benefits of having caps or floors embedded in a physical contract is that they can be monetized by selling them to another counterparty. If you sell the cap or a floor, you will no longer be insured but receive a premium.

The option premiums are based on several factors. The most fundamental variables include the current price of the underlying asset and the specified price (the strike price) at which the option holder has the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.

The remaining time until the option contract expires and volatility, which is a measure of how much the price of the underlying asset fluctuates.

Higher volatility generally leads to higher option prices because the option is more likely to be profitable.

Additionally, the rate of return without any price risk is typically derived from government bonds or similar instruments. It affects the cost of holding the underlying asset and is used in some option pricing models.

Cathode Corporation ABC has to determine if the cap is worth holding or if receiving cash would be more beneficial. For example, if you can pass the price on to your customers, you might not need the cap and be willing to sell it. The cap Cathode company owns as part of their physical contract is a form of commodity hedging.

Additional strategies and embedded options

An alternative strategy might be to hold only part of the insurance. Cathode Corp might decide to sell a cap that is 10% out of the money to receive some options premium but still be protected if the price of lithium hydroxide rises by more than 5% and up to 10% month over month. This options strategy is called a call spread, a partial insurance policy. The same concept can be used for floors.

In this theoretical payout profile, where the current price of lithium hydroxide is $18/KG, Cathode Corporation ABC might receive $0.30 of premium by selling a 10% out-of-the-money call options and have protection from $19/KG (5% out of the money, which is embedded in their physical contract) to $20/KG (which is 10% out of the money). Above $20/KG, they would not have any protection if the price rose more than 10% during a month.

In this theoretical payout profile, where the current price of lithium hydroxide is $18/KG, New Energy Mining Corporation XYZ might receive $0.30 of premium by selling a 10% out-of-the-money put options and have protection from $17/KG (5% out of the money) to $16/KG (10% out of the money). Below $16/KG, they would not have any protection if the price declines by more than 10% during a month.

While caps and floors might be popular in physical contracts, other options have names such as look-back pricing, extendables, escalators or de-escalators. You might find wording describing the right to extend your purchase at a specific price. The value of these embedded options can be monetized if you have an idea of their value and have a willing counterpart who will purchase these options.

The bottom line

The upshot is that an embedded option within your physical contract has a monetary value. It’s essential to understand options to monetize this value and have someone to pay for the option. While each option is unique, you might find a counterpart willing to purchase your embedded option and provide you with a premium that will allow you to unlock some of its value.

If you are interested in determining the value of your embedded options or learning more about hedging, feel free to contact our risk solutions team.

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These option settlements are cash-settled and differ from many of the CME commodity options on futures that provide the right but not the obligation to purchase a futures contract.

Several strategies can be employed by producers and end-users who engage in commodity hedging, which take advantage of the flexibility offered by option contracts. Before we dive into some of the hedging strategies that can be used, we will touch on some option contract basics.

What is an option on futures contract?

There are a few different types of options offered by the CME. An option on a futures contract is a financial derivative that combines options and futures trading. It allows traders to have the right, but not the obligation, to buy or sell a futures contract at a specific price (known as the strike price) on or before a predetermined date (known as the expiration or exercise date). To purchase an option, the buyer pays the seller a premium.

Unlike futures contracts, options on futures provide flexibility and can have limited risk for traders and procurement managers. A call option gives the holder the right, but not the obligation, to buy the underlying futures contract at a specific price. In contrast, a put option gives the holder the right to sell the underlying futures contract at a predefined price.

Traders and procurement managers can use these options to hedge against potential losses, limit their exposure to market volatility, or speculate on lithium price movements. The most money the option buyer can lose is the premium that is paid to purchase the call or put option. Unlike the buyer, the seller can have unlimited risk.

What is an average-priced option contract on lithium hydroxide and cobalt metal?

The new lithium and cobalt option contracts that are listed are average-priced. An averaged-priced option is a type of financial security that derives its value based on the average price of an underlying asset over a specific period. The CME contracts use the average price calculated by Fastmarkets for a calendar month. These lithium and cobalt option contracts are cash-settled.

Instead of the option buyer having the right to buy or sell lithium futures or cobalt futures contracts, the buyer receives a cash payment for the difference between the strike and settlement price. An option strike price refers to the predetermined price at which an option can be exercised. No cash payment is made if the option settles out-of-the-money.

“Out of the money” for a call option means the option’s strike price is higher than the current market price of the underlying asset. Similarly, for a put option, it means the strike price is lower than the current market price. When an average-priced option settles out-of-the-money, the option seller keeps the premium, and the buyer does not receive a payout.

With an averaged-priced option, the payoff is determined by the average price of the underlying asset over the specified period. This averaging mechanism helps reduce the impact of short-term price fluctuations and can be helpful in situations where the underlying asset’s price is volatile.

The averaging can be suitable for hedging regular cash flows. The average-priced lithium options contracts settle like the lithium futures contracts. The difference is the option contract buyer’s loss is limited to the premium paid for the option.

Since the payoff of the options equals the under-average price, the effective historical volatility is lower. Daily spikes or drops in a commodity price generally occur more often than spikes or drops in a monthly calendar average. Therefore, average-priced options usually cost less than European or American-style options that expire simultaneously and have similar lengths of time remaining before a financial contract expires.

What option strategies can be used to hedge lithium or cobalt?

Asian option contracts on lithium hydroxide and cobalt offer traders and corporate hedgers several ways to mitigate their exposure to changing lithium prices and cobalt prices.

For example, a producer might consider purchasing a put option. The producer attains the right to sell lithium hydroxide at a specific strike price. The most the producer can lose on the hedge is the premium of the options.

The payout profile of a $20 strike put option shows that the producer will receive a payout for any price below $20 minus the premium paid for the put option. The producer will lose the premium paid for the options at expiration if the price of lithium hydroxide remains above $20.

Another example could be that an electric vehicle OEM exposed to lithium hydroxide might consider buying a call option. In this scenario, the OEM will pay an option’s premium, and the most they could lose is the premium paid for the option. The payout profile of a $30 strike call option shows that the OEM will receive a payout for any price above $30 plus the premium paid for the call option. A loss will occur at expiration, which is limited to the premium, if the price of LIOH remains below $30.

What if you don’t want to pay a premium?

If volatility rises, the premiums on lithium options could also increase, making call options and put option contracts more expensive. An alternative to purchasing a call or put option might be to combine one with another, where the producer or consumer sells one type of option and simultaneously buys another.

A costless collar is a hedging strategy that can be used to hedge lithium exposure where the producer or consumer does not have to pay a premium. For example, an OEM might purchase a $28 call option and sell a $20 put option where the premium from the sold put option offsets the premium from the call option purchase.

The payout profile of a purchase of a $28 strike call option combined with the sale of a $20 put option shows that a loss will occur at expiration if the price of LIOH remains below $30. The OEM will receive a payout for any price above $30. If the average price of lithium hydroxide is below $28 and above $20, there will be no exchange of cash. If the average price is below $20, the OEM will pay the difference between the average settlement price and $20. 

For example, if the average price of lithium for a calendar month settles at $30, the OEM will receive $2 = $30 – $28. No cash will be exchanged if the average price settles at $25. If the average price settles at $18, the OEM must pay $2 = $20 – $18.

The bottom line

The upshot is that there are several different option strategy combinations that a producer or consumer can use to hedge their lithium hydroxide or cobalt metal exposure. The benefit of using options is that they provide more flexibility than a futures contract. What is essential to understand is several components are used to generate the premium of an averaged-price option.

In addition to the price of lithium hydroxide and cobalt metal, the implied volatility, the strike price, current interest rates, and the time to maturity play a critical role in determining the premium of an option contract.

Additionally, when financial option contracts initially launch, success can sometimes be attributed to finding options sellers. 

For example, a producer might want to sell a call option since they already own the physical underlying commodity. An OEM might want to sell embedded options, which are listed in their physical offtake contracts. These are sometimes called ceilings or caps, look-back pricing, or escalators. These types of options can be monetized by potentially selling them to a financial institution.

Don’t hesitate to contact our risk solutions team if you would like some insight into how to hedge your lithium hydroxide/carbonate or cobalt metal risk using option contracts.

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Broader use of futures contracts drives liquidity

As more traders accept a futures contract as a benchmark for the industry, open interest begins to grow. Open interest is the number of outstanding futures and options on futures transactions that have not been settled or closed.

For example, if you open a new position by purchasing a cobalt futures contract and do not sell it, your futures contract is counted as part of open interest. When there are more than 25 sizeable open interest holders, the Commodity Futures Trading Commission begins to report volume and open interest information.

The Commodities Futures Trading Commission (CFTC), a US government independent agency, reports the Commitment of Traders (COT) report weekly.

Why would you want to know who is trading what?

The COT report allows you to derive some sentiment information and evaluate whether producers are hedging or managed funds are active. The report can also tell you whether swap dealers or financial institutions are involved in providing liquidity.

What information is in the Commitment of Traders report?

The report is usually released by the CFTC every Friday and generally reports information as of the prior Tuesday. The data from the CFTC comes in a report format with few bells and whistles.

Before we dig into the report, let’s review a few basics.

The COT sorts the transaction that occurred during the week and adds or subtracts weekly volume from open interest by trader category.

When a trader opens a position by purchasing a futures contract, their position is “long.” When a trader opens a position by selling a cobalt futures contract, their position is “short.” If a trader opens a position with a futures contract purchase and simultaneously opens a position by selling another futures contract with a different maturity date, their position is referred to as “spreading.”

What can the COT report tell you?

There are several pieces of information that you can derive from the COT report.

For example, the COT report released for the reportable position date November 29, 2022, shows that producers/merchants are short. That likely means that producers are hedging their inventory.

The report also shows that swap dealers, generally financial institutions, are long cobalt futures contracts trading on the CME. Banks typically do not take an outright directional risk, which likely means they are short over-the-counter swaps and have used the futures market to hedge their short swap position exposure.

Another piece of valuable information is that managed money, generally viewed as hedge funds or commodity trading advisors, are long cobalt futures. Hedge funds typically take directional views, meaning they might speculate that cobalt futures will rise.

One last piece of open-interest information is positions held by “other reportables.” This category is left ambiguous, as it does not fall into commercials, managed money, or swaps dealers.

For example, a parent organization might not set up separately reportable trading entities to handle their different businesses or locations. In such cases, there will not be a separate Form 40 to allow the CFTC to determine that entity’s proper disaggregated commitment of traders classification.

What do changes in volume mean?

The COT report focuses on open interest, but futures contract volume information is also available. For example, on the November 29, 2022 report, you can see that nearly all of the long “swaps dealers” purchases of cobalt futures were offset by sales of cobalt futures contracts by “other reportables.”

Significant changes in volume, especially by swap dealers, indicate that liquidity is likely rising or falling.

How can open interest help you hedge?

While the information that is provided is objective, the analysis of what the data means is subjective.

Here are some tips.

The COT report can be used as a contrarian sentiment indicator.

The positions initiated by “managed money” are generally speculative. They will eventually exit their futures positions if the change in the futures contract prices generates a significant unrealized loss.

If the open interest is skewed (meaning the long position held by “managed money” is much greater than the short position), there is a chance of a rush to the door to exit quickly. The market might be poised for a short squeeze if the “managed money” short position is much larger than the long position.

Producers/merchant processors are more likely to hold on to their positions as they are usually a hedge to their underlying production.

Swap dealers are usually liquidity providers and generally exit futures contract positions when Over Counter (OTC) swaps roll off their books.

The bottom line

It’s not easy to find valuable commodity risk management information. Taking the market’s pulse is an essential piece of the puzzle in attempting to gauge future price movements. Certain information from the Commitment of Traders report (COT) can help you gauge sentiment.

The Commitment of Traders report is released weekly. The information categorizes volume and open interest on futures contracts by trader type. While the information is objective, the analysis can be used as a sentiment index to help traders make commodity hedging and trading decisions. If you want more information about cobalt futures contracts or hedging your battery raw material risk, contact our risk solutions team.

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