Commodity swaps and their applications
What are commodity swaps?
With commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy and agriculture. For example: In a commodity swap, a party may agree to exchange cash flows linked to the prices of oil for a fixed cash flow.
Commodity swaps are used for hedging against fluctuations in commodity prices or changes in spreads between final product and raw material prices.
A company that uses commodities as inputs to the manufacture of its goods may find its profits becoming very volatile if the commodity prices become volatile. This is particularly worrying if output prices cannot change as frequently as the commodity prices do. In such instances, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange.
How do Commodity Swaps work?
For example, consider a commodity swap involving a notional principal of 100,000 barrels of crude oil. One party agrees to make fixed semi-annual payments at a fixed price of $120/barrel (bl), and receive floating payments.
On the first settlement date, if the spot price of crude oil is $110/bl, the pay-fixed party must pay ($120/bl)*(100,000 bl) = $12,000,000.
The pay-fixed party also receives ($110/bl)*(100,000 bl) = $11,000,000.
The net payment made (cash out flow for the pay-fixed party) is then $1,000,000.
In a different scenario, if the price per barrel will have increased to $125/bl than the pay-fixed party would have received a net inflow of $500,000.