Commodity Derivatives: Futures, Options, and Swaps Explained
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
The Building Blocks of Commodity Investing
Chapter 5, by Neil Schofield, walks through the derivative instruments used in commodity investing: futures, swaps, and options. If you have ever wondered how investors get exposure to oil or gold without actually owning barrels or bars, this chapter explains the mechanics.
In late 2016, commodity investment assets under management totaled about $245 billion. That broke down to precious metals ($129 billion), energy ($63 billion), agriculture ($37 billion), and base metals ($17 billion). Most of this money does not touch physical commodities. It flows through derivatives.
Commodity Indices: The Foundation
Before getting into specific products, the chapter starts with commodity indices. These are the benchmarks that most commodity investment products reference.
The most commonly referenced index is the S&P GSCI, formerly the Goldman Sachs Commodity Index. It tracks 24 exchange-traded futures across five sectors: energy, industrial metals, precious metals, agriculture, and livestock. The weighting is based on world production, which means energy dominates. In 2016, Brent crude and WTI crude oil alone made up over 42 percent of the index.
The S&P GSCI is what is called an “investable index.” You can actually replicate it by trading the underlying futures according to the index rules.
The index is published in three forms:
- Spot return: Just the price movement of the futures.
- Excess return: Spot return plus or minus the roll yield (profit or loss from rolling expiring contracts into new ones).
- Total return: Excess return plus interest earned on the cash deposit backing the position.
These three numbers give you different views of the same strategy. Total return is what an actual investor would earn.
As the market evolved, banks started creating “enhanced beta” indices to address perceived weaknesses in the standard ones. These might use different roll periods, reference longer-dated futures, or use customized weightings. Some even allow going both long and short.
Futures: Fixing a Price for the Future
A futures contract locks in a price today for delivery of a commodity at a future date. The chapter uses Brent crude oil as the main example.
A Brent crude futures contract on ICE (Intercontinental Exchange) covers 1,000 barrels, is quoted in U.S. dollars per barrel, and can extend up to 96 consecutive months. The October contract expires on the last business day of August.
When futures prices increase with maturity (longer-dated contracts cost more), that is contango. When they decrease, that is backwardation. Contango is usually driven by carry costs: storage, insurance, and financing. Backwardation tends to happen during supply bottlenecks or demand spikes.
Here is an important difference between commodities and financial futures: the “no arbitrage” pricing that works for stock index futures does not apply cleanly to commodities. You cannot just buy the commodity, store it, and sell a future to lock in risk-free profit, because storage and delivery logistics make it complicated.
The Three Sources of Futures Returns
When you hold a commodity futures position, your return comes from three places:
- Price movement of the futures contract. If oil goes up, you make money. If it goes down, you lose.
- Roll yield. Since short-dated futures expire, you have to sell the expiring contract and buy a longer-dated one. If you are rolling from a higher price to a lower price (backwardation), you profit. If you are rolling from a lower price to a higher one (contango), you lose.
- Interest on collateral. Since you are not using leverage, the cash backing your position earns interest, usually at the Treasury bill rate.
Clearinghouses and Margin
Every exchange-traded future goes through a clearinghouse. The clearinghouse becomes the buyer to every seller and the seller to every buyer. This removes counterparty risk, but it also means both parties need to post margin.
Initial margin is a small percentage of the contract value, set to cover the expected cost of closing out a defaulting position. For ICE contracts, it is calibrated to a 99 percent confidence level.
Variation margin is collected daily. If your position loses money today, you pay. If it gains, you receive. This daily settlement is the mark-to-market process.
Total Return Swaps: Synthetic Commodity Exposure
A total return swap lets an investor get commodity exposure without owning futures directly. The investor pays a fixed fee plus interest, and the bank pays the return on a commodity index.
Here is how it works with a simplified example. Say an investor enters a one-year swap referencing the S&P GSCI total return index with a $100 million notional amount. Monthly, the bank pays the investor the percentage change in the index multiplied by $100 million. If the index goes up, the bank pays the investor. If the index goes down, the investor pays the bank.
The investor also pays a fee (say 0.25 percent annually) and a floating interest amount based on the Treasury bill rate. On the other side, the bank hedges by actually trading the futures.
Total return swaps are flexible. They can reference different indices or sub-indices, be structured with fixed or variable notional amounts, and settle monthly or as a single payment at maturity.
Options: The Right Without the Obligation
Options add another layer. A futures contract obligates you to buy or sell. An option gives you the right but not the obligation.
A call option gives you the right to buy at a fixed price (the strike price). A put option gives you the right to sell. You pay a premium for this right, and that premium is the most you can lose.
The chapter walks through the basic payoff profiles:
- Long call: You profit if the price goes above the strike plus the premium. Your downside is limited to the premium paid.
- Short call: You collect the premium but face potentially unlimited losses if the price rises.
- Long put: You profit if the price falls below the strike minus the premium.
- Short put: You collect the premium but face large losses if the price drops.
One thing unique to commodities: negative prices can happen. Natural gas, power, and agricultural commodities have all traded at negative prices when overproduction occurs. This means put option profits are not necessarily limited the way they are for equities (where prices cannot go below zero).
Asian-Style Options
Many commodity options use an average price rather than a single price at settlement. These are called average rate options or “Asian-style” options. Instead of looking at the spot price on one specific day, the settlement is based on the average price over some period.
Asian-style options are cheaper than vanilla options because the averaging process smooths out price spikes. They are popular in commodities because physical market participants often care more about the average price they pay or receive over time than the price on a single day.
Structured Products
The chapter covers three popular structures built from these derivatives:
Capital Protected Notes
These guarantee you get your initial investment back, plus potential upside if the commodity price goes up. The note works by putting most of your money in a deposit that grows to repay the principal, and using the rest to buy a call option on the commodity. The challenge for the structurer is making the participation rate attractive. Features unique to commodities, like backwardation and the inverted volatility term structure, can help lower the option cost and improve the deal for investors.
Reverse Convertibles
These pay an enhanced coupon (higher than market interest rates) in exchange for the investor selling a “down and in” barrier put option. If the commodity price stays above the barrier, you get your money back plus the enhanced coupon. If the price drops through the barrier, you take a loss. The barrier provides some protection since the option only activates if prices fall significantly.
Basket and Outperformance Options
Basket options let you bet on a portfolio of commodities rather than a single one. Because different commodities are not perfectly correlated, the basket option is cheaper than buying individual options on each commodity. Lower correlation means lower portfolio volatility, which means a cheaper option.
Outperformance options let you bet on one commodity doing better than another. You do not need a directional view on either one. If you think aluminum will outperform gold, you can express that view directly. These options actually become more valuable when correlation between the two assets is lower, because that means more divergence and bigger potential payoffs.
My Take
This chapter is technical but practical. The key insight is that commodity derivatives are not just for hedging or speculation. They are the building blocks of investment products that let ordinary investors access commodity markets.
The most interesting part is how the unique features of commodities, like the shape of the forward curve and the inverted volatility term structure, create structuring opportunities that do not exist in other asset classes. This is why commodity structured products can sometimes offer participation rates and terms that would be impossible in equities.
But complexity cuts both ways. The more layers of derivatives involved, the more important it is to understand exactly what you are buying and what risks you are taking.