What is a 'Commodity Swap'

A commodity swap is a contract where two sides of the deal agree to exchange cash flows, which are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity, and they have been trading in the over-the-counter markets since the middle of the 1970s.

BREAKING DOWN 'Commodity Swap'

A commodity swap consists of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or agreed-upon commodity index, while the fixed-leg component is specified in the contract. Most commodity swaps are based on oil, though any type of commodity may be the underlying, such as precious metals, industrial metals, natural gas, livestock and grains. Considering the nature and sizes of the contracts, typically large financial institutions engage in commodity swaps, not individual investors.

Structure and Example

Generally, the floating-leg component of the swap is held by the consumer of the commodity in question, or the institution willing to pay a fixed price for the commodity. The fixed-leg component is generally held by the producer of the commodity who agrees to pay a floating rate, which is determined by the spot market price of the underlying commodity. The end result is that the consumer of the commodity gets a guaranteed price over a specified period of time, and the producer is in a hedged position, protecting them from a decline in the commodity's price over the same period of time. Typically, commodity swaps are cash-settled, though physical delivery can be stipulated in the contract.

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two scenarios can happen: paying the entire cost upfront, or paying each year upon delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil per year for two years. However, there is counterparts risk, and the oil may not be delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels are being delivered. Here, the following equation must be solved to equate the total cost to the above example:

Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56.

Given this, it can be calculated that the consumer must pay $50.49 per barrel each year.

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