CHAPTER 5 Agricultural, Energy and Metallurgical Futures Contracts

1
CHAPTER 5 Agricultural, Energy and Metallurgical
Futures Contracts

• This chapter explores futures contracts on
  physical commodities, those written on
  agricultural, energy and metallurgical
  commodities. This chapter is organized into the
  following sections
• Commodity characteristics that interfere with
  the Cost- of-Carry Model.
• Commodity Supply and Storability
• Commodity Seasonal Production
• Commodity Seasonal Consumption
• Commodity Poor Storability
• Spread
• Intra-commodity Spreads
• Inter-commodities Spreads
• Hedging

2
Commodity Characteristics

• Recall the Cost-of-Carry Model implies a range
  of permissible prices. These prices are defined
  by the cash-and-carry and reverse cash-and-carry
  arbitrage strategies.
• Applying the cash-and-carry arbitrage strategy
  assumes that the physical good or commodity can
  be stored from one day to the next.
• Applying the reserve cash-and-carry arbitrage
  depends upon short selling.
• Some goods have a convenience yield, which stems
  from the usefulness of having them in inventory.

3
Commodity Characteristics

• Recall the relationships between cash and
  futures prices depend upon
• Storage characteristics of the commodity
• Supplies of the commodity
• Production and consumption cycle for the
  commodity
• Ease of short selling the commodity
• Transaction costs
• In the following section, we begin by discussing
  how the supply and storability move the market to
  or away from full carry. Then, we provide
  examples of commodities that are at full carry
  and commodities that are not at full carry.

4
Commodity CharacteristicsSupply and Storability

• Insert Figure 5.1 here

5
Commodity Characteristics Supply and Storability

• Table 5.1 presents the various features of the
  commodities and the expected price behavior.

6
Commodity Characteristics

• SUMMARY
• If a good has excellent storage characteristics
  and a large supply relative to consumption, we
  expect markets for the good to approximate full
  carry (e.g., gold).
• Commodities with good storability may at some
  point, depart from full carry, due to fluctuation
  in production (grains during harvesting time) or
  fluctuations in consumption (gasoline during
  summer time).
• Commodities with poor storability can depart
  substantially from full carry (e.g., livestock).

7
Full Carry Markets Precious Metals

• Figure 5.2 shows gold prices for the JUN and DEC
  futures contracts.
• Highly storable commodities with a large supply
  relative to annual consumption should behave
  according to the Cost-of-Carry Model.
• For precious metals, both the cash-and-carry and
  reverse cash-and-carry arbitrage strategies are
  potentially effective because short selling is
  fairly accessible for precious metals like gold.
• Recall the carrying costs consist of storage,
  insurance, transportation, and financing charges.

• Insert Figure 5.2 here

8
Full Carry Markets Precious Metals

• If gold is a full carry market, the following
  relationship should hold

where d gt n
Applying this equation to our present example
implies DEC gold futures JUN gold futures (1
C)
Dividing both sides of the above equation by the
right-hand side and subtracting 1, we have
Any time this equation equals something other
than zero, an arbitrage opportunity is possible.
9
A Full Carry Example Gold

• Assume that the prices in Table 5.2 are present
  in the market and assume that the financing cost
  is the T-bill rate for the June-December period.
  All other transaction costs are ignored. We would
  like to know if the market is at full carry.

10
A Full Carry Example Gold
While this value is close to zero indicating that
the market is near full carry, the trader with a
total carrying cost equal to the T-bill rate
could make a profit from a cash-and-carry
strategy.
442.60 - 426.00 (1.038132) .36/ ounce
11
A Full Carry Example Gold

• If the T-bill rate is 7.7719. What is the repo
  rate?

The futures contract is for ½ year, so to compare
this rate to the T-bill rate, we must annualize
it as follows
The difference between the T-bill rate and the
repo rate is 7.9453-7.7719 0.1734 Thus, if a
traders financing cost is below 7.9453, She/he
could engage in a cash-and-carry strategy. This
analysis demonstrates that gold market was very
close to full carry on that day.
12
Departure from Full Carry Gold

• Figure 5.2 shows how gold and other precious
  metals behave in similar fashion.

• INSERT FIGURE 5.3 HERE

13
Departure From Full CarrySilver

• If prices decline, the results of the full carry
  market equation may be above zero. This is said
  to be above full carry.
• If the market is above full carry,
  cash-and-carry arbitrage strategies become
  attractive.
• Assuming short selling is possible and that no
  convenience value exists
• Borrow money.
• Sell a futures contract.
• Buy the commodity.
• Deliver the commodity against the futures
  contract.
• Recover the money and payoff loan.

14
Departure from Full CarrySilver

• If prices rise, the results of the full carry
  market equation may fall below zero. This is said
  to be below full carry.
• If the market is below full carry, reverse
  cash-and-carry arbitrage strategies become
  attractive.
• Assuming short selling is possible and that no
  convenience value exists
• Sell short the commodity.
• Lend money received from short sale.
• Buy a futures contract.
• Accept delivery of futures contract.
• Use commodity received to cover short sale.

15
Product Profile The NYMEX Silver Futures
16
Departure from Full CarryThe Hunts Silver
Manipulation Case

• In January 1980, the Hunt Manipulation was at its
  peak and silver hit its all-time record price of
  50/ounce.
• Traders with no convenience value, delivered
  silver to benefit from the quasi-arbitrage
  opportunities.
• On Thursday, March 27,1980, the silver
  manipulation ended, the market crashed, and the
  silver market quickly returned to almost full
  carry again.
• Figure 5.4 shows the silver market from October
  1, 1979 through June 30, 1980.

17
Departure from Full CarrySilver

• Insert figure 5.4 here

18
Commodities with Seasonal Production

• In this section, we examine commodities that are
  produced seasonally. To facilitate the discussion
  assume
• Consumption of the commodity is steady.
• Long-term inventory is constant.
• Production will equal consumption.
• Commodity stores well (e.g., wheat, corn, oats,
  barley, soy products).
• Prices exhibit seasonal trends due to harvesting
  patterns.
• Wheat is used to illustrate the seasonal
  characteristics of commodities.

19
Inventories and Price Patterns

• Insert Figure 5.5a Here

• Insert Figure 5.5b here

• Insert Figure 5.5c here

20
Inventories and Price Patterns Basis

• A fluctuating basis is often interpreted as a
  sign of high risk and unstable prices.
• However in this example, due to our assumptions,
  there is no risk.
• This shows that the basis may fluctuate radically
  even under conditions of certainty.
• It is important to separate fluctuations in the
  basis into the expected and unexpected
  components.

• Insert Figure 5.6

21
CBOTs Wheat Futures Profile
22
Wheat and Wheat Futures
Although, wheat does not fit our model perfectly.
The seasonal factor and the availability of wheat
in the US is very strong. Figures 5.7 shows that
wheat prices tend to be high during winter and
low during summer.
23
Seasonal Character of Cash Wheat Prices

• Insert figure 5.7 here

24
Wheat and Wheat Futures

• Table 5.3 shows the average stock of wheat in the
  US by month from 1969 to 1982. Notice the low
  inventory for June, and the high level for August
  and September.

25
Wheat and Wheat Futures

• Based on Table 5.3, high supply should cause a
  drop in price (other factors held constant).
• Table 5.4 shows the seasonal character of cash
  wheat prices.
• Results confirm the view that cash prices should
  be high when inventories are low and low when
  inventories are high.

26
Wheat and Wheat Futures

• The large number of highs and lows in these
  months reflects the large forecasting errors in
  futures prices when the expiration is distant.
• There is no tendency for high prices to occur in
  one month and low prices to cluster in some other
  time period. Thus, cash prices can be seasonal,
  while futures prices for the same commodity are
  not.

27
Wheat and Wheat Futures

• Table 5.6 presents a portion of Telsers classic
  study of wheat and cotton futures. Telser
  concluded futures data offer no evidence to
  contradict the simple hypothesis that the futures
  price is an unbiased estimate of the expected
  spot price.

28
Wheat and the Cost-of-Carry Model

• Given the characteristics of wheat, we expect
  wheat price relationships to differ substantially
  from the full carry behavior of gold.
• First, wheat production is seasonal. Even if the
  harvest were known well in advance, wheat would
  still be abundant after harvest and scarce later.
  
• Second, the harvest is not known in advance, so
  shortages or surpluses of wheat can develop.
• In general, we would not expect wheat to behave
  as a full carry market in all circumstances.

29
Wheat Versus Gold The Cost-of-Carry Model

• Insert Figure 5.2
• JUL and DEC Gold Futures Prices

• Insert Figure 5.8 Here
• JUL and DEC Wheat Futures Prices

30
Wheat Versus. Gold The Cost-of-Carry Model

• Insert Figure 5.9 here
• Deviations from Full Carry for Wheat

31
Wheat Versus Gold The Cost-of-Carry Model

32
Wheat Versus Gold The Cost-of-Carry Model

• Summary
• Wheat cash prices are seasonal, due to
  fluctuating supply and surprises about the
  harvest.
• The spread between two futures maturities can
  vary in a systematic way, due to seasonal
  factors.
• Storage, insurance, and transportation costs, as
  well as the financing cost should be evaluated to
  determined if a market is at full carry.

33
Commodities with Seasonal Consumption

• In this section, we examine commodities that show
  seasonal consumption. Particular attention will
  be given to crude oil.
• Seasonal consumption patterns can produce
  fluctuating stocks of some commodities. This can
  create shortages and give a convenience value to
  these commodities.
• Oil and related products provide an example of a
  good with fairly steady production, but highly
  seasonal demand (e.g., gasoline during summer,
  heating oil during winter).
• Crude oil futures sometimes are at full carry,
  while at other times, crude oil can have a
  substantial convenience yield or the market can
  even be in backwardation.
• Table 5.7 shows crude oil prices with virtually
  every possible price pattern.

34
Crude Oil Futures Prices
35
Commodities with Poor Storability

• In this section, we examine commodities that show
  poor storability. Particular attention will be
  given to livestock.
• Livestock is an example of a commodity with poor
  storability.
• Example
• Live cattle must have an average weight between
  1,050 and 1,200 pounds at delivery. If cattle are
  held too long, they cannot be delivered in
  fulfillment of the contract.
• Difficult storage conditions loosen the
  no-arbitrage connection between futures contracts
  with different expirations.

36
Feeder Cattle and Live Cattle
The CME trades contracts on feeder cattle and
live cattle. The decision to slaughter feeder
cattle, or to carry forward for delivery as live
cattle, depends on the spread between to feeder
cattle and live cattle futures contracts and the
cost of feeding.
37
Live Cattle Futures Prices

• Figures 5.10 and 5.11 show that there is little
  chance live cattle adhere to the cash-and carry
  structure.

• Insert figure 5.10 here

38
Commodities with Poor StorabilityLive Stock

• Insert figure 5.11 here

• We conclude that the Cost-of-Carry Model does not
  apply very well to cattle. Prices fluctuate from
  above to below full carry.

39
Spreads

• In this section, we examine spreads
• Intra-commodity spreads.
• Every intra-commodity spread must have at least
  two contracts (one short/one long).
• Bull Spread
• A bull spread is an intra-commodity spread
  designed to profit if the price of the
  underlying commodity rises.
• B. Bear Spread
• A bear spread is an intra-commodity spread
  designed to profit if the price of the
  underlying commodity falls.
• Inter-commodity spreads.
• Every inter-commodity spread must have at least
  two contracts in two different, but related
  commodities
• Soybeans complex
• Energy complex
• Livestock

40
Intra-Commodity Spreads

• Recall the Cost-of-Carry Model for a full carry
  market with perfect markets.

d gt n
Recall further changes in spreads and changes in
prices for full and non-full carry markets
behaves as follows In full carry markets, if
the commodity price rises, the distant futures
price rises more than the nearby futures
price. In non-full carry markets, if the
commodity price rises, the nearby futures price
rises more than the distant futures price. Table
5.9 lists commodities that follow each type of
relationship.
41
Bull and Bear Intra-commodity Spreads
42
Inter-Commodity Spread Relationships

• In this section, the spread relationships between
  the following related commodities will be
  explored
• Soy complex
• The energy market (oil)
• The livestock market (feeder cattle and live
  cattle)

43
Soybeans Futures Market
44
Soybeans and The Crush

• Soybeans must be crushed to yield edible soymeal
  and soyoil. A 60-pound bushel of soybeans
  produces approximately
• 48 lbs. of soymeal 11 lbs. of soyoil 1 lbs.
  of waste
• Crush Margin
• The crush margin is the difference in value
  between a bushel of soybeans and the resulting
  meal and oil.
• One soybeans contract ( 5000 bushels) produces
  approximately 120 tons of soymeal or 1.2
  soymeal contracts 55,000 pounds of oil or 92
  of a soyoil contract
• 10 contracts ? 5,000 bushels 2,400,000 lbs. of
  meal 550,000 lbs. of oil
• 12 contracts of meal 9 contracts of oil

45
Soybeans and Crush Spreads

• In normal conditions, the value of the meal plus
  the oil must exceed the value of the soybeans. If
  this were not the case, there would be no
  incentive to process the soybeans. Thus, we
  expect the crush margin to be positive.
• The following crush and reverse crush information
  along with Table 5.11 will be used to illustrate
  soybean crush spreads.

46
Soybeans and Crush Spreads

• Assume that today, August 4, a speculator
  believes that the crush margin is too small. That
  is, the speculator believes that by buying beans
  and selling the combined meal and oil positions,
  he/she will make a profit.

Table 5.12 details the transactions the
speculator enters to take advantage of his/her
beliefs.
47
Soybeans and Crush Spreads
Bean prices actually fell resulting in a net loss
of 27,733.
48
Soybeans and Crush Spreads
Now the speculator believes that the prices will
continue to fall, so the speculator enter the
market again with the transactions as shown in
Table 5.13.
Bean prices rise causing the speculator another
net loss of 13,013.
49
Oil and the Crack
50
Oil and the Crack

• Crude oil must be refined into other products
  (e.g., gasoline, heating oil, or propane).
• Cracking
• Cracking is the process of refining crude oil.
  The same crude oil can produce a variety of
  products depending on the techniques used to
  crack it.
• A barrel of oil can only produce a certain amount
  of total product. The mix is variable, but the
  total output is a zero-sum game.
• Cracking patterns are largely governed by the
  season of the year (more gasoline will be produce
  during summer, and more heating oil during
  winter).
• Crack Spread
• The price relationship between crude oil and its
  refined products.

51
Oil and the Crack

• There are several kinds of crack spreads,
  including
• Crude oil/heating oil crack spread
• 1 barrel crude oil 1 barrel gasoline
• Crude oil/gasoline crack spread
• 1 barrel crude oil 1 barrel heating oil
• Other Combination based on multiple units of
  crude oil
• 2 barrels crude oil 1 barrel gasoline 1
  barrel heating oil
• Buy a Crack Spread
• The trader buys the refined product and sells the
  crude.
• Sell a Crack Spread (Reverse Crack Spread)
• The trader sells the refined product and buys the
  corresponding crude.
• The most popular crack spreads are the 11
  spreads between crude and heating oil or crude
  and gasoline.

52
Oil and Crack Spreads

• Table 5.14 shows the contract specifications for
  crude oil, heating oil and gasoline.

1 barrel 42 gallons
Figures 5.12 shows the prices of July crude oil
and heating oil futures in dollars per gallon and
5.13 illustrates the spread.
53
Oil and Crack Spreads

• Insert Figure 5.12 here
• JUL Crude and Heating Oil Futures

• Insert Figure 5.13 Here
• Spread between JUL Heating and Crude Oil Futures

54
Oil and Crack Spreads

• Assume that today, March 16 a trade has gathered
  the information from Table 5.15. The trader
  believes that the .0616 crude oil/ heating oil
  crack is not sustainable (.4569-.5185 .0616).
  The trader thinks that the justifiable refining
  spread is only .04 per gallon. Therefore, the
  trader expects the spread to narrow and thus
  decides to enter into a reverse crack spread
  (sell heating oil and buy crude oil).

Table 5.16 shows the transactions the trader
enters into in order to take advantage of her/his
beliefs.
55
Oil and Crack Spreads
The traders assessment was correct and thus
he/she made a profit.
56
Oil and Crack Spreads
The trader now believes that the spread will
widen, and that heating oil will now rise in
price relative to crude. Therefore, she decides
to place a crack spread (crack spread consists of
buying the refined product and selling crude).
Table 5.17 shows the traders transactions.
Notice that the traders overall profit depends
only on the crack spread, not on the direction of
oil prices in general.
57
Feeder Cattle and Live Cattle

• Insert Figure 5.14 here
• A Time Line for Cattle Production

58
The Cattle Crush

• The cattle crush depends upon the price of cattle
  today, the expected price of cattle in the
  future, and the price of grain necessary to feed
  the cattle to a larger future size.
• A popular cross-exchange spread occurs between
  corn contracts on the CBOT and cattle contracts
  on the CME.
• The cattle crush spread can be established by
  holding a long position in corn futures while
  simultaneously establishing a short position in
  live cattle.
• A reverse cattle crush involves buying two live
  cattle contracts for each corn contract the
  trader is short.

59
Feeder Cattle and Live Cattle

• Example
• The owner of the newborn calf sells two futures
  contracts for the calf
• One contract for delivery as a feeder in 12
  months.
• One contract for delivery against the live
  cattle contract in 18 months.
• The owner has the following options
• Deliver the calf against the feeder contract, and
  offset the live cattle contract.
• Offset the feeder contract, maintain the live
  cattle contract, and deliver the 18 month steer
  against the live cattle contract.
• The owners potential profitability is largely a
  function of the cost of corn.
• If feed prices rise, the profitability of feeding
  is reduced. Thus, spread between the cash price
  of feeder cattle and the futures price for live
  cattle will narrow as corn prices rise.

60
Corn and Live Cattle Future Prices
Assume that today, May 22, you, a cattle feeder,
have gathered the information from Table 5.18.
You have 65 steers and anticipate that the steers
will be on feedlot rations for sixth months in
order to produce slaughter weight cattle. You
know that one corn contract will feed the steers
underlying 2 live cattle contracts to slaughter
weight. You calculate your current spread to be
739.46 per steer. You fear that the cattle crush
spread may narrow, and wish to lock in the
current spread. The ratio of corn contracts to
live cattle contracts is 12.
61
Corn and Live Cattle Future Prices

• The current spread is calculated as follows
• Value of two cattle contracts
• 2(40,000)(.7680) 61,440 or 945.23 per steer
• Value of one corn contract
• 1(5,000)(2.675) 13,375 or 205.77 per steer
• The spread is the difference between the value of
  the cattle contracts and the cost of corn.

62
The Cattle Crush Spread Position
Table 5.19 shows the transactions you enter in
order to lock in your current spread.
Your cattle crush produce a 1,265 gain.
63
Reverse Cattle Crush Spread Position
Now assume that you believe that the corn/cattle
spread will widen. Therefore, to take advantage
of your belief, you establish a reverse cattle
crush spread. Table 5.20 shows the results of a
reverse cattle crush using the prices displayed
in Table 5.18.
You miscalculated. As the spread narrowed, your
reverse cattle crush position in the futures
market lost 1,265.
64
Hedging

• Chapter 4 explored hedging and basic hedging
  strategies. This section explores more
  complicated strategies particular to
• Energy markets
• Agricultural markets
• Metallurgical markets
• We consider hedging different grades of oil.
• Two highly publicized cases of improperly
  implemented hedges will also be explored.

65
Hedging Worldwide Crude Oil

• There are different kinds of crude oil
  originating around the world. The following table
  illustrates six types of oil.

66
Hedging Worldwide Crude Oil

• Recall that the easiest way to compute the
  risk-minimizing hedge ratio, number of futures
  contracts to hold for a given positions in a
  commodity, is by estimating the following
  regression

From the previous regression ß The
risk-minimizing hedge ratio ? A measure of
hedging effectiveness Where
The closer to 1, the better the chance that the
hedge will work.
67
Hedging Worldwide Crude Oil

• Table 5.21 reports the volatility of the weekly
  price changes for the different oils and the
  results from two hedging strategies.

Finding a futures contract that closely matches
the spot commodity is important and will
generally improve the hedge considerably. Second,
for cross-hedges, the naive 11 hedging approach
may be markedly inferior to using a
risk-minimizing hedge ratio.
68
Improperly Implemented Hedges

• Two highly publicized cases of improperly
  implemented hedges were
• The Hedge-To Arrive (HAT) Fiasco
• Agricultural commodities
• The Metallgesellschaft Hedging Fiasco
• Energy Products