Commodity Pricing and Benchmarking Practices

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Questions and Answers

What role do Price Reporting Agencies (PRAs) play in the metal markets?

PRAs bring transparency to the metal markets by publishing price assessments based on market fundamentals.

How do hedging strategies benefit traders in metal markets?

Hedging strategies protect traders from price fluctuations by using financial instruments to secure prices in advance.

What is spot trading in the iron ore market?

Spot trading in the iron ore market refers to the immediate purchase and sale of iron ore for delivery and payment right away.

What are benchmarking practices in commodities?

Benchmarking practices involve establishing standard prices or indices against which other prices are measured. Signup and view all the answers

How do price assessments for agricultural commodities differ from those for metals?

Price assessments for agricultural commodities take into account seasonal factors and harvest yields, while metals assessments focus on supply-demand dynamics and market conditions. Signup and view all the answers

What are the characteristics of a good benchmark in commodity pricing?

A good benchmark should adhere to international norms of trading, reflect market fundamentals, and promote transparency and market acceptance. Signup and view all the answers

How does the American Metal Market contribute to price reporting in the metal industry?

The American Metal Market provides intelligence and reports on over 2000 prices for various metals and minerals, capturing real-time market activity. Signup and view all the answers

What are some key components of the LBMA standards in gold trading?

The key components include the Good Delivery system for quality assurance, the Global Precious Metals Code for ethical trading, and the Responsible Sourcing Program for ethically sourced materials. Signup and view all the answers

What transition regarding LIBOR was indicated by the Financial Conduct Authority in 2017?

The FCA indicated that it would no longer require banks to participate in the LIBOR rate setting process after 2021. Signup and view all the answers

What role do price reporting agencies (PRAs) play in the commodity markets?

PRAs report price information and market intelligence, which aids in price discovery and enhances market transparency. Signup and view all the answers

What is the purpose of the Responsible Sourcing Program within the LBMA framework?

The Responsible Sourcing Program ensures that metals are sourced ethically, providing confidence in the market that materials are responsibly acquired. Signup and view all the answers

What challenges are associated with price reporting in evolving commodity markets?

Challenges include maintaining transparency and adapting to market evolution from both a market and policy perspective. Signup and view all the answers

How does chain formation and circulation impact benchmarking practices in commodities?

Chain formation and high circulation enhance the quality of benchmarks by ensuring that they reflect actual market conditions and facilitate the development of a forward market. Signup and view all the answers

What is a primary advantage of using Derivative Based PRAs in market assessments?

They enable assessment in illiquid markets. Signup and view all the answers

How do Fixed Panels benefit the process of pricing in commodities?

They lock in commitment from key market players. Signup and view all the answers

Identify a key disadvantage of using Survey methodologies for market assessments.

Surveys often lack context, and timing can skew the assessment. Signup and view all the answers

What was the significance of the US Gulf Crude Oil Price Assessment established in 1928?

It became an independent reference point for oil sales contracts in the US. Signup and view all the answers

Why might Volume-weighted Averages be limited in their effectiveness?

They have limited underlying liquidity and participation. Signup and view all the answers

What role did the Arab Oil Embargo of 1973 play in the evolution of the PRA industry?

It led to increased volatility in oil prices and the emergence of several competitors. Signup and view all the answers

How does a Hybrid Panel methodology improve market assessment processes?

It reflects both 'trade' and 'panelist' views, providing comprehensive insights. Signup and view all the answers

What is one primary use of PRA benchmarks in market practice?

They serve as reference prices for both term deals and spot trades. Signup and view all the answers

What does the term 'Best Offer' indicate in the context of commodity markets?

It shows where sellers are operating within the marketplace. Signup and view all the answers

Explain one disadvantage of the Non-adjusted Panel methodology.

It may lead to the exclusion of key information due to bad judgment. Signup and view all the answers

Study Notes

Commodity Derivatives - Exotic Products - Relevance for India

Commodity derivative contracts involve weather-related risks
Weather affects almost all business activities, beyond agriculture
Companies in agriculture, energy, aviation, construction, mining, and event management are affected by weather risk
Weather risk leads to uncertainty in revenue, profit, and cash flow
Weather conditions include temperature, rainfall, humidity, snowfall, and windspeed

Weather Derivatives - Basics

Weather derivatives allow companies to manage weather-related risks
They are similar to financial derivatives, used to hedge risk
The value depends on the underlying asset (commodity, index, or index)
Weather derivatives help protect from abnormal weather outcomes

Weather Derivatives - Salient Features

Weather derivatives help hedge volumetric risk, the decline in sales volume due to unfavorable weather, mitigating this risk
Other types of commodity derivatives help mitigate price risk
Weather derivatives are used to hedge weather risks that are not catastrophic
Weather risks emanate from ordinary climatic variations including temperature, rainfall, humidity, snowfall, etc.

Advent of Weather Derivatives

Weather derivatives are a relatively young industry, emerging in 1997 due to severe weather events like El Niño
Growth was initially limited by credit risk associated with the over-the-counter market
CME introduced the first exchange-traded temperature-related weather futures and options (Heating Degree Day (HDD) and Cooling Degree Day (CDD) futures contracts) in 1999
CME offers futures and options for monthly and seasonal temperature-related events, particularly HDD during fall and winter (October through April) and CDD during spring and summer (April through October)
These contracts use indexes of HDDs and CDDs from various cities in the US, Europe, and Asia-Pacific
The benchmark temperature for differentiating heating and cooling seasons is 65 degrees Fahrenheit, based on the daily average temperature minus 65 degrees Fahrenheit

Exchange Traded Weather Derivatives Contracts at CME

Derivatives are based on temperature
CDD/HDD Futures contracts with a contract size of USD 20 times the respective CME Degree Days (HDD/CDD) Index
CDD/HDD Seasonal and Seasonal Strip Futures and Monthly Options
Hurricane Index Futures and Options
Futures Contracts on Frost and Snowfall Index
Rainfall Index Futures and Options

Weather Risks

Average Temperature (HDDs/CDDs)
Abnormal Temperature
Rainfall
Precipitation or snowfall
Snowfall
Humidity
Wind speed
River flow
Combinations of the above

Weather Derivative Customers

Utilities and energy companies
Agricultural companies/producers
Municipalities
Seasonal clothing manufacturers
Airlines
Ski/beach resort operators
Golf course management companies
Beverage companies and distributors

Prospects of Weather Derivatives in India

Pros: Variability in Indian monsoon, increased water-intensive cultivation, rapid commercialization of agriculture, necessary amendments (SCRA) post-merger of FMC with SEBI
Cons: Farmers covered by crop insurance schemes (mostly government-sponsored), regional variations in weather, and small & marginal farmers
Weather Derivative Developments: MCX and Rainfall Index, NCDEX tied up with Skymet for Weather indices

Emission Trading

Emissions trading (ET) is a mechanism enabling countries with legally binding emissions targets to buy and sell allowances amongst themselves
EUA - European Union Allowances
CER - Certified Emission Reductions

Risk Elements in CDM

Delivery risk, particularly regulatory risk (certification risk, cap in European National Allocation Plan, implementation of ITL, and risk of contract fulfillment)
Market price risk (fuel prices, weather, economic growth, EUAs, etc.)

Price Influencing Factors

EUA price influencing factors include policy issues, CO2 emissions, weather/fuel prices, and foreign exchange fluctuations
Pricing of CERs is based on fixed contracts or index-linked contracts to get high prices of the EU market
Correlation between Brent Crude Oil and EUAs (78.05% in 2007) and between Electricity and EUAs (49% in 2007) influences market price

Emission Markets Participants/Platforms

Participants include hedgers, producers, intermediaries (spot markets), ultimate consumers (Annexure I), investors (arbitragers and speculators), portfolio managers, diverse participants, commodity financiers (OTC traders), funding agencies, and corporate risk exposure in energy products/clean technology developers
Trading platforms include Nord Pool Exchange (Electricity & CERS), European Energy Exchange (EEX), European Climate Exchange (ECX), Chicago Climate Exchange (CCX), and VERS

Physical Markets for Freight

Freight involves bulk transportation of goods (trucks, ships, and railways)
Charterers use ships to transport cargo

Dry Bulk Carriers and Tankers

Main vessel types include handysize, handymax, supramax/ultramax, panamax/kamsarmax, post panamax/mini cape, capesize, valemax, chinamax for bulk carriers
Handysize, MR, MR2, panamax, aframax, suezmax, and VLCC are different tanker types

Causes of Volatility in Freight Rates

Supply and demand for ships
General economic conditions and global trade state
Seasonal trading patterns/industrial cycles
Strikes and port delays
Vessel speed (slow steaming)
Vessel orderbooks (lots of new ships)
Vessel recycling (decreases supply)
Floating storage (decreases vessel supply)

Baltic Freight Indexes

Started in 1985 with 13 voyage routes (14k-120k tons)
Tracks dry and wet cargo (coal, grain, iron ores, crude oil, chemicals, LNG, etc.)
Geographical balance: avoids concentrating routes in one area
Standard terms used in routes
Indices include Baltic Handysize Index (BHI), Baltic Panamax Index (BPI), Baltic Supramax Index (BSI), Baltic Capesize Index (BCI), Baltic Dirty Tanker Index (BDTI), Baltic Clean Tanker Index (BCTI), and Baltic Dry Index (BDI)

The Baltic Code 2020

Guidance for shipbrokers and principals on ethical conduct in physical freight and freight derivative markets
Principles concerning integrity of markets, fairness and competition, ethical business, market conduct, and robust and credible benchmarks

Forward Freight Agreements (FFAs)

Exist since 1985, based on the Baltic Freight Index (BFI)
Individual shipping routes can be traded OTC
Freight rates are expressed in $/day (time charter) or $/tonne (voyage charter)

Water Derivatives

Water is a crucial resource, and scarcity impacts quality of life and farming practices
Australia is a leader in water markets, and their 1994 reforms aimed to make water tradeable
Water Corp Victoria manages trading issues and controls almost 90% of Australia's pear production, and about a third of its apples, tomatoes, potatoes, and carrots
Water availability and its costs are significant concerns
Physical water markets and associated spot prices emerge

The Water Market Structure

Water markets are structured geographically within the State of Victoria with six trading zones
Each business is allocated a defined water volume tied to a water consumption history pattern
Closed auctions allow successful bidders to purchase water rights, triggering a need for defined timing windows to purchase
Rainfall conditions influence water availability and associated costs, leading to potential hedging needs

Water Futures

CME Group designed the first-ever water futures contract based on the Nasdaq Veles California Water Index, which is tied to water entitlement and transactional data recorded since 2018 in California
Pricing is tied to the prevailing market price or water transactions for the market
Data gathering is from WestWater Research, providing pricing, valuation, and advisory services

The Commodity Impact (based on Covid-19)

Lower demand and inflexible supplies lead to lower prices globally (in energy, commodities)
High Volatility and global economic data
Non-functional markets and lower liquidity, impacting risk management and physical commodity efforts

COVID Impact - Energy

Significant demand reduction, tepid supply response, limited storage, and landlocked WTI futures influenced by COVID contributed towards an oil price drop
Volatility surged, and unplanned, unprepared intermediates contributed to widening spot-futures divergence

Key Lessons from Negative Crude Oil Prices

Market functioning failures potentially due to manipulation attempts and unforeseen behavior patterns
International exchanges were prepared, but intermediaries did not address negative price scenarios and risk management
Disputes arose across geographies concerning roles, responsibilities, and market integrity amongst stakeholders
The fall in crude oil prices had significant implications, especially on equities indices like the DJIA

Negative Crude Oil Prices - The India Story

CME Clearing enabled negative oil prices in 2020
Timing mismatches and contract sanctity were questioned amidst unprecedented events
Legal battles ensued as several firms moved court cases for price and risk management issues due to negative price trading.

The Nickel Short Squeeze on LME - April 2022

Nickel prices soared from USD 39,000 to 100,000 per tonne
Sudden price jumps due to significant economic factors and margin calls impacted significant market participants
Russia significantly influenced the market and its stability
Market manipulation/speculation was a key factor potentially driving price spikes
Extreme volatility led to temporary shutdowns and deal cancellations at the LME
This price volatility and short squeezing caused unforeseen issues and challenges and influenced subsequent trading

The Global Spillover Effect

Trade cancellations were a critical market rule breach and caused significant problems in the LME
Retroactive trade cancellations had negative impacts and heightened conflicts
LME and regulators worked to reverse the impacts and restore confidence

Emergence of Price Reporting Agencies

Warren C. Platt started the National Petroleum News in 1909
Platts established itself as a prominent price reporting agency, primarily for petroleum products
The emergence of PRAs from McGraw-Hill, initially for petroleum products, grew to include several sectors (fossil fuels, power markets, agriculture, forestry, metal markets, and environmental markets)
Price reporting agencies acted as critical sources of data

Price Reporting Agency?

Providing transparency in physical commodity markets through price assessments
Publishing data, analysis, and market news, often with subscription fees
Independent from the markets they cover to avoid vested interest
Competition drives accuracy and relevance of price assessments
Frequency varies: daily, weekly, or monthly

Benchmark Pricing

Expectations for convergence between market values and published values, reflecting market fundamentals responsibly and transparently
Adherence to international norms with chain formations, circulations, and the development of forward markets
Necessary for transparency and a reliable market mechanism, ensuring benchmarks are correctly determined

Process of Commodity Price Determination

Price signals from futures exchanges or auctions affect spot transactions
Spot transaction price signals are further relayed to price benchmarks
Price reporting agencies (PRAs) provide detailed information, data, and assessments of the market and prices

American Metal Market

Data collection occurs across markets, with high-quality PRAs and AMM's code of conduct improving data quality
The analysis of data includes normalizing and removing outliers
Assessments are completed and peer-reviewed before publication
The information is published
Based on market transaction data that are collected with bid/offer prices and data points

LIBOR - Awaiting Transition

LIBOR was a critical benchmark, a global reference rate used for numerous financial transactions (>$400 trillion)
LIBOR's reliance on expert judgment instead of actual market transactions led to opaqueness and potential manipulation
Scandals revealed LIBOR's fundamental flaws
The FCA announced the end of LIBOR-related participation by Panel banks, in preparation for new alternatives that focus more on actual market transactions

LBMA Standards in Gold

The LBMA standard in gold involves good practices for delivery systems
Good Delivery List: gold that complies with the standard, used globally
Responsible sourcing program that ensures materials meet ethical criteria

Challenges with Price Reporting Agencies and Market Transparency

Evolving markets (from a market and policy perspective) affect reporting methodologies
Transparency concerns: Are reports accurately representing supply, demand, and commercial aspects

IOSCO Principles for Price Reporting Agencies - 2012

Robust governance, quality methodologies, adherence to a strong conduct code, and stakeholder transparency with methodologies communicated and subject to review
All changes to price specifications are subject to market feedback and implemented with considerable due diligence

Platts' Market on Close (MOC)

Process to reflect current market values at close of trading day.
A structured system to gather and verify market data
General guidelines for MOC: all bids/offers are publicly available, sufficient time to react, no affiliate transactions used, open to all credible participants, participants understand guidelines, and firm bids/offers

PRA Methodologies - A Review

Evaluating various PRAs used to measure, determine, and provide assessment of price and market trends.

PRA Benchmarks and their usage

Identifying the usage of PRA benchmarks in various scenarios, including derivative settlement prices, reference prices, and market data.

Energy PRAs

Key historical contributors, ranging from Warren Cumming Platt and his early emphasis on oil pricing and assessments and advancements in oil products assessment from information providers to the industry, to the emergence of competitors, the independent assessments and services of the industry, eventually to the emergence of LIBOR-related products.

Metal PRAs

Emphasizing prominent PRAs, ranging from historical entities to significant modern counterparts, along with assessments' specifics and data points
Highlighting the inclusion of a wider range of coverage (precious metals, ferrous metals, rare earth materials)
Highlighting the prominence of contract terms, and providing specifics on timing (e.g. 3pm fix) and important aspects for the trade.

Agricultural PRAs

Historical context, including public ledger companies and their products like Cotton Outlook and the Cotlook A Index, the emergence of commodity transactions for related products like Coffee and Wood Pellets, providing details on how they developed specific indices/reports and their geographical areas of influence

Are you a user of PRA benchmark?

Important considerations for PRA usage, emphasizing that benchmarks are crucial for establishing and defining reliable reporting and pricing mechanisms for relevant markets
Critical aspects, including the relevance of the benchmark's market, transparent methodology, public consultation, and the role of employees and internal reviews

Commodity Price Risk Management

Identifying, measuring, managing, governing, and accounting for commodity price risk
Methodologies and procedures involving understanding, categorizing, and tracking market exposures are essential.

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Description

Explore the intricate roles of Price Reporting Agencies (PRAs) in metal and agricultural markets, including the benefits of hedging strategies and spot trading. This quiz also delves into benchmarking practices, the standards set by the LBMA, and the challenges faced in current commodity markets.