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