What is Commodity Paper?

Commodity paper is a loan or advance for which raw materials owned by the borrower serve as collateral. The term paper refers to the contract, which is mostly a promissory note. For some commodities the collateral may be comprised of grading certificates, warehouse receipts or bills of lading.

Key Takeaways

  • Commodity paper is a loan or advance for which raw materials owned by the borrower serve as collateral.
  • Commodity paper is similar to a mortgage agreement or a car loan, but the loan deals with commodities.
  • It is generally not necessary for the goods to be present, as long verification of their situation can be accessed should the need arise.

Understanding Commodity Paper

​​​​​​​Commodity paper is similar to a mortgage agreement or a car loan. With a secured debt, the collateral pledged gives the lender assurances they have some recourse should the borrower default or fail to live up to the terms of the contract. Whereas a home or other real estate secures a mortgage, in the case of a loan involving commodity paper, the collateral is in the form of commodities.

Commodities are raw materials or production goods, such as oil, grain, gold, copper, coffee, cocoa, lumber, cotton, wheat, corn, sugar, and natural gas. By the nature of the products and materials involved, commodities may not be readily available at a specific location, and therefore it may sometimes be difficult, if not impossible, to produce them to provide as collateral. 

Providing Proof for Commodity Paper

It is generally not necessary for the goods which serve as collateral to be present, so as long as verification of their situation can be accessed should the need arise. The lender will not take possession of the commodities unless the borrower defaults.

Often, the lender will want to confirm that the assets securing the loan exist in the quality and quantity required. Depending on the commodity backing the note, proof may exist in several different formats. Products such as grains and oil may use a grading certificate. A grading certificate is a document issued by inspectors or an approved grading panel that formally signifies the quality of a commodity. Commodities such as live cattle or hogs may require proof of a delivery order or a bill of lading. Gold or other precious metals stored in a vault may need a vault or warehouse receipt.

An Example of Lender Risks

The inability to physically take possession of collateral or at least visually inspect and confirm its existence can present some element of risk to the lender, especially if the borrower is unethical or intends to deceive the lender.

Commodity paper was at the center of a notable incident known as the Salad Oil Scandal. In 1963, the owner of Allied Crude Vegetable Oil used doctored documents to inflate inventory levels and then borrowed against the fraudulent receipts. At the time the fraud was discovered, the company had just 134 million pounds of oil in its storage tanks, compared with 937 million pounds that appeared on its receipts. The fraud cost banks an estimated $200 million (in 1960s dollars).

Trading in Commodities

The most common methods of trading commodities include:

  • Futures are financial contracts obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. 
  • Options offer the buyer the right, though not the obligation, to call or put the underlying asset at an agreed-upon price during a specific period.
  • Exchange-traded funds are liquid marketable securities that track a commodity or a commodity basket and trade like stocks on an exchange.