Light Sweet Crude Oil commodity swap

Light Sweet Crude Oil commodity swap – If you need some background on commodity swaps, read this….. Light Sweet Crude Oil commodity swap

The case

An entity annual purchase 500 barrels of Light Sweet Crude Oil. These purchases are made in a regular pattern over the year. To ensure the price risk the entity enters into a commodity swap-contract with a contract volume of 500 barrels and a duration of one year. The purchase price for 500 barrels Light Sweet Crude Oil is fixed at USD 88.37. Light Sweet Crude Oil commodity swap

Light Sweet Crude Oil commodity swap

Light Sweet Crude Oil commodity swapAt settlement date of the commodity swap-contract, the average exchange spot price of Light Sweet Crude Oil on the Chicago Mercantile Exchange was USD 91.21.

As a result, the entity receives USD 1,420 or 500 barrels x (91.21 – 88.37) or USD 2.84/barrel. Light Sweet Crude Oil commodity swap

Because the purchases are made in a regular pattern over the year the average purchase price over that period will be close to USD 91.21/barrel. As a result, the entity has paid (on average) USD 91.21 for its 500 barrels. Which is more than anticipated! However with the gain on the commodity swap, the average purchase price is 91.21 – 2.84 = 88.37, exactly the price swapped.

You can perform a calculation with different average prices, however, the end result will be that a loss on the actual average price of purchased barrels of Light Sweet Crude Oil is compensated by a gain on the swap and vice versa.

A commodity swap is similar to a fixed-floating interest rate swap. The difference is that in an interest rate swap, the floating leg is based on standard interest rates such as LIBOR and EURIBOR. However, in a commodity swap, the floating leg is based on the price of underlying commodity like oil, sugar, and precious metals.

Something else -   Contractually specified risk components

No commodities are exchanged during the trade. In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then, in return, the user would get payments based on the market price for the commodity involved.

On the other side, a producer wishes to fix the income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity.

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.

Commodity Swap Explained

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.

Something else -   Hedge of a net position

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 counterparty 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.

Light Sweet Crude Oil commodity swap

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Something else -   Credit risk on the hedged item

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