Commodity Swaps for Producers and Consumers
Commodity Swaps for Producers and Consumers
Commodity swaps allow producers and consumers to exchange floating commodity prices for fixed prices, locking in revenue or costs without taking physical delivery. These OTC derivatives are essential tools for energy companies, airlines, mining firms, and agricultural producers managing price volatility.
Definition and Key Concepts
Core Structure
A commodity swap involves:
- Fixed-price payer: Pays a predetermined price per unit
- Floating-price payer: Pays the market index price on settlement dates
Producer hedge: Producer receives fixed price, pays floating → locks in revenue
Consumer hedge: Consumer pays fixed price, receives floating → locks in cost
Swap Types
| Type | Structure | Common Use |
|---|---|---|
| Fixed-for-floating | Fixed price ↔ Index price | Primary hedging tool |
| Basis swap | Index 1 ↔ Index 2 | Location or quality basis |
| Calendar spread | Month 1 ↔ Month 2 | Time spread hedging |
| Differential | Product A ↔ Product B | Crack/crush spread |
Key Terms
| Term | Definition |
|---|---|
| Notional quantity | Volume hedged (barrels, MMBtu, tonnes) |
| Floating index | Reference price (Brent, WTI, Henry Hub) |
| Calculation period | Time over which floating price is averaged |
| Settlement | Cash difference between fixed and floating |
| Business days | Days used for averaging (typically all trading days) |
How It Works in Practice
Index Selection
Crude oil:
| Index | Description | Typical Use |
|---|---|---|
| WTI (NYMEX) | Light sweet crude, Cushing delivery | US producers |
| Brent (ICE) | North Sea crude | International pricing |
| Dubai/Oman | Middle East sour crude | Asian refiners |
Natural gas:
| Index | Description | Typical Use |
|---|---|---|
| Henry Hub (NYMEX) | Louisiana delivery point | US gas producers |
| TTF | Dutch hub | European gas |
| JKM | Japan-Korea Marker | Asian LNG |
Metals:
| Index | Description | Typical Use |
|---|---|---|
| LME Copper | London Metal Exchange | Global copper |
| COMEX Gold | CME Group | Precious metals |
| LME Aluminum | London Metal Exchange | Global aluminum |
Averaging Conventions
Asian-style averaging: Floating price = arithmetic average of daily index prices over the calculation period
Example (monthly average): If WTI closes at $75, $76, $74, $77, $75 over five trading days: Average = (75 + 76 + 74 + 77 + 75) / 5 = $75.40/bbl
Averaging reduces manipulation risk and smooths volatility.
Settlement Mechanics
Monthly settlement process:
- Calculation period ends (e.g., month-end)
- Floating price calculated (average of daily fixings)
- Settlement amount = (Fixed - Floating) × Quantity
- Payment made 2-5 business days after calculation
Worked Example
Trade details:
- Commodity: WTI Crude Oil
- Notional: 50,000 barrels per month
- Term: 12 months
- Fixed price: $75.00/barrel
- Floating index: NYMEX WTI first nearby settlement
- Producer receives fixed, pays floating
Month 1:
- Average WTI price: $72.50/barrel
Settlement = (Fixed - Floating) × Quantity Settlement = ($75.00 - $72.50) × 50,000 Settlement = $2.50 × 50,000 Settlement = +$125,000 to producer
Producer receives $125,000 (market price below hedge level).
Month 6:
- Average WTI price: $82.00/barrel
Settlement = ($75.00 - $82.00) × 50,000 Settlement = -$7.00 × 50,000 Settlement = -$350,000 to producer
Producer pays $350,000 (market price above hedge level).
Annual Hedge Analysis
| Month | WTI Avg | Settlement | Physical Revenue | Total Revenue |
|---|---|---|---|---|
| 1 | $72.50 | +$125,000 | $3,625,000 | $3,750,000 |
| 2 | $71.00 | +$200,000 | $3,550,000 | $3,750,000 |
| 3 | $74.00 | +$50,000 | $3,700,000 | $3,750,000 |
| 4 | $78.00 | -$150,000 | $3,900,000 | $3,750,000 |
| 5 | $80.00 | -$250,000 | $4,000,000 | $3,750,000 |
| 6 | $82.00 | -$350,000 | $4,100,000 | $3,750,000 |
Total monthly revenue stabilized at $3,750,000 ($75 × 50,000 barrels).
Basis Swap Example
Situation: Producer sells physical oil at Midland, Texas pricing but wants to hedge using WTI Cushing.
Basis swap:
- Receive: WTI Midland index
- Pay: WTI Cushing index
- Notional: 50,000 barrels/month
- Fixed differential: -$2.00/barrel (Midland discount)
This locks in the basis between production location and hedge index.
Combined hedge economics:
| Component | Price/Differential |
|---|---|
| Physical sale at Midland | Midland floating |
| WTI swap (receive fixed) | +$75.00 |
| Basis swap (pay Midland, receive Cushing) | +Cushing - Midland |
| Net realized price | $75.00 - $2.00 basis = $73.00 |
Risks, Limitations, and Tradeoffs
Basis Risk
If hedge index differs from actual sale/purchase price:
| Scenario | Hedge Index | Actual Price | Basis Impact |
|---|---|---|---|
| Widening discount | WTI Cushing | Midland -$5 | Loss of $3/bbl vs. expected |
| Narrowing discount | WTI Cushing | Midland +$1 | Gain of $1/bbl vs. expected |
Basis swaps reduce but may not eliminate this risk.
Volumetric Risk
If production or consumption differs from hedged quantity:
| Scenario | Hedged | Actual | Risk |
|---|---|---|---|
| Underproduction | 50,000 bbl | 40,000 bbl | 10,000 bbl unhedged exposure |
| Overproduction | 50,000 bbl | 60,000 bbl | 10,000 bbl at market prices |
Roll Risk
Multi-year hedges often use calendar strips that must be rolled:
| Factor | Impact |
|---|---|
| Contango steepening | Deferred months become more expensive |
| Backwardation | Front months expensive vs. back |
| Liquidity thinning | Wider bid-ask in far-dated months |
Counterparty Credit Risk
| Hedge Direction | Exposure When |
|---|---|
| Producer (receive fixed) | Oil prices fall below fixed |
| Consumer (pay fixed) | Oil prices rise above fixed |
Large price moves create significant counterparty exposure.
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Index mismatch | Hedge index differs from actual pricing | Use basis swaps or match indices |
| Averaging period error | Different averaging windows create mismatch | Align calculation periods |
| Calendar roll gaps | Missing days between settlement periods | Specify continuous coverage |
| Quality adjustment | Hedge grade differs from physical grade | Include quality differentials |
Checklist and Next Steps
Pre-trade checklist:
- Confirm commodity and grade specification
- Verify notional quantity and units
- Check floating index source and publication
- Confirm calculation period (averaging dates)
- Review settlement timing and currency
- Verify fixed price per unit
- Establish margin requirements
- Ensure ISDA documentation includes commodity annex
Basis risk checklist:
- Compare hedge index to physical pricing index
- Quantify historical basis volatility
- Assess need for basis swap
- Document basis risk tolerance
Related articles:
- For credit default swaps, see Credit Default Swaps Contracts
- For equity swap applications, see Equity Swap Use Cases for Hedge Funds