Exchanges, Markets, and Who Is Trading! (for those with a deep interest in Commodities and some time on their hands)

After the success of my New Year's post on 'So, What is a commodity', I was inundated with requests by my fellow LinkedIn folks on any other writing I may have done around the commodity markets. I wrote another (half) chapter on exchanges, markets and market participants, and some history on the development and utility of commodity markets. I hope this is as useful as the original post. And remember, I am not writing about how to trade: There are plenty of successful authors already out there who have tackled that question.

A. Introduction

One well-thumbed dictionary of mine defines a Market as the following:

A regular gathering of people for the purchase and sale of provisions, livestock, and other commodities.

This definition made me think simultaneously of the Open Outcry pits of the NYMEX in the 90s and shopping in Pudong's fake goods and fresh food markets in the 2010s. Both marketplaces had commodities and exhibited wild price swings, shouting, passion and winners and losers. Ultimately, they were similar experiences, and the former shows how the latter developed. China has several world-famous commodity exchanges, and I did business on them all.

When I think of who a Commodity Trader is, I keep going back to that famous scene in the 1983 movie Trading Places where Dan Ackroyd (Louis Winthrope III – great name, by the way) is explaining to Eddie Murphy's character (Billy Ray Valentine, an equally great name) about trading Futures just as they are about to start trading Frozen Orange Juice futures on the commodity exchange's floor (or the pits) with other market traders.

“Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That's the other guy's problem. Nothing you have ever experienced will prepare you for the unlimited carnage you are about to witness. Superbowl, World Series - they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits and you take no prisoners. One moment you're up half a mil in soybeans and the next, boom, your kids don't go to college and they've repossessed your Bentley. Are you with me?“

The type of trading where many (mainly) men in brightly coloured jackets shout at each other and use hand signs to communicate and transact is known as Open Outcry. The advent of technology has seen most commodity exchanges become electronic marketplaces. However, the London Metals Exchange does retain a trading floor (A ring) and continues to trade some contracts in Open Outcry.

Watch the movie! Then you can skip the rest of the chapter…

B. Commodity markets (Who and what makes a market?)

Commodity Exchanges and Market Participants

A Commodity Futures contract is an agreement to buy or sell a particular commodity at a future date. The commodity's price and amount (volume or weight) are fixed at the time of the agreement. The deliverable commodity must meet specifications, including intrinsic physical and chemical properties, quality and delivery location, as discussed below.

An option on a Commodity Future is a contract that gives the owner the right, but not the obligation, to buy or sell the underlying Futures contract it is written against. The option holder will call or put the underlying commodity future from or to the seller. Options are more complicated to price and have their tradeable markets. Nearly every commodity futures market (and OTC) has an associated options market. The expiry of these contracts is before the expiry of the underlying future, allowing the parties involved to sell out of any position they have incurred due to the exercise of an option.

These listed futures and options contracts are traded on a Commodity Exchange, a physical centre, such as the LME or the CME, where market participants meet to trade commodity futures in an environment with rules and regulations to safeguard market users.

The seller of a futures contract on a commodity exchange does not usually intend to deliver the actual commodity, nor does the buyer intend to accept the delivery; each will, at some time before the date of delivery specified in the contract, cancel out his obligation by making an offsetting purchase or sale. The parties involved in a futures transaction wish to assume or delegate the risks involved in a price change of the commodity future.

Commodity exchanges are thus ancillary to the markets in which commodities are bought and sold; in effect, they provide insurance against the risk of price changes by transferring that risk to entities with an opposing risk profile. These parties can include speculators and investors, participants who do not need the certainty of cash flow provided by hedging actual underlying exposures but who have an opinion and thus wish to speculate (express a view) on what the true price of the underlying future will be in the future.

Hydrocarbon producers and Refineries use commodity exchanges to sell futures on oil, gas and refined products. This guarantees them a price for their production, allowing them to operate profitably and continue drilling for oil and gas and refining crude oil profitably. Large global oil and gas companies are known as Majors; Independent companies are known as IOCs, and state (or National) oil companies are known as NOCs. Supermajors are the largest, including Aramco, NIOC, ExxonMobil, Gazprom, BP, Royal Dutch Shell, Chevron, ConocoPhillips, and Total.

Agricultural products (Ags) companies are active globally on most commodity exchanges. The earliest recognised exchanges were explicitly created for the farming sector. These included, amongst others, the Dojima Rice Exchange (1730) in Japan, the Chicago Board of Trade (CBOT) in 1848, and, in 1870, the New York Cotton Exchange.

Ag companies are involved in the farming, harvesting, storing, processing and distributing agricultural commodities and the associated finished food products. According to GlobalData, Cargill Inc, BASF SE, Archer Daniels Midland Co, Wilmar International Ltd, and Bunge Ltd were the world's top five agricultural products companies in 2021 by revenue.

Merchant commodity traders and trade houses buy and sell commodities for their accounts. Merchant traders have existed in various forms for thousands of years. Capital is critical in most aspects of trading (financing cargoes, bills of lading, margining at exchanges, etc.), and banks supply financing in asset, trade and commodity finance packages.

The major investment banks also moved into commodity trading and merchant activities around the early 1980s, when Goldman Sachs Inc. bought the FX, and commodity merchant J Aron and Morgan Stanley started their legendary commodity business. The two banks set the benchmark for commodity trading globally. They became known by the amusing soliloquy ‘The Wall Street Refiners’

After the repeal of the Glass Steagall Act in 1998, many other global banks copied this business model and, as well as trading derivatives, traded physical commodities, too. The aftermath of the Global Financial Crisis (GFC) saw a slew of new regulations to control the banks and avoid any situation that might lead to a bank failure. These new rules swept up commodity activities, forcing the banks to divest assets and leave nearly all physical commodity trading. They could provide risk management services in OTC derivatives (discussed later) and pure commodity financing.

The departure of the banking community, coupled with a world that had effectively zero per cent interest rates for borrowing for over a decade, allowed various merchant commodity traders to grow exponentially and become significant participants in the world's commodity markets. The principal merchant traders are Vitol, Trafigura, Mercuria, Gunvor, Koch Industries and Glencore. Many are headquartered in Switzerland (known for its secrecy and lack of belief in extradition). They are subject to little regulation and oversight apart from what is demanded of the commodity exchanges in which they participate. Ironically, their activities are funded by the banks they displaced in this business and are essentially more profitable because of it!

Consumers and producers are the primary users of the exchanges, but there is also a role for speculators to play. Historically, many trading floors had locals who would trade small volumes for their accounts. They would own a seat on the exchange (the right to trade on an exchange and make markets) and participate in the mismatched flows between buyers and sellers. In 1983, a NYMEX seat cost less than a New York City taxi medallion. Taxi drivers must pay to operate a yellow cab, and there is a market for taxi medallions (and hot dog stands, too). These are, by definition, commodities, and markets exist for buying and selling them.

Hedge Funds (lightly regulated private pools of capital) and other financial investors also had opinions on where prices should be and would buy and sell commodities accordingly. These extra market participants add liquidity to the market, allowing it to move up and down more freely and encouraging more users of all kinds to participate since they would see sufficient liquidity to trade in and out of positions, whether they are speculative or hedges.

In 1990, Goldman Sachs invented the GSCI (Goldman Sachs Commodity Index). A commodity index is an index that tracks the price and returns on a basket of commodities. These indices are primarily accessible for investing through OTC swaps, mutual funds or exchange-traded funds (ETFs). Many investors who want access to the commodities market without entering the futures market decide to invest in commodity index funds. Many investors have allocated to commodity markets as part of their diversified investment strategy. In a later chapter, we will discuss inflation and geopolitical risk and the role commodities can play in hedging them.

The early index products were long only. The Index creator would buy a weighted basket of different commodity futures on various exchanges to reflect the notional exposure of the Index swap with their clients. These days, Indices can be long and short, and these new and growing market products have allowed markets to flourish and grow.

Investing in commodities, particularly food, had also caused controversy, such as in 2008 when agricultural prices rallied sharply, and speculators were blamed for raising the prices of food staples for poorer countries and everyday people. Many academic papers have discussed whether the futures markets drove the physical markets. High prices encourage more production; the best cure for high prices is high prices! Higher prices lead to demand destruction through switching to a cheaper alternative. Moreover, new production becomes a reality and brings new supply to the market, ultimately lowering prices.

The Major Listed Exchanges: CME, ICE, LME, OSE (formerly TOCOM)

Commodity Exchanges are also known as Futures Markets or Futures Exchanges. They are organised markets for buying and selling enforceable contracts to deliver a specific grade of a fixed amount (volume, energy content, weight, etc.) of a commodity such as wheat, gold, or crude oil at a specific location during a specified time. These contracts are called Futures and trade through a competitive auction process on the commodity exchange. Participants show bids or offers for the commodity future they wish to buy and sell; a Market Maker will show both as they make a market in a commodity. Options and Indexes on commodities also trade on these exchanges.

There are dozens of commodity exchanges worldwide covering many more commodities than discussed here. A glance at Wikipedia (inside secret) will enlighten you further. The history and necessity of certain commodities led to the creation of exchanges in the first place. Below, we briefly review the most important of them.

The Chicago Mercantile Exchange (CME) (often called "the Merc") is a global derivatives marketplace based in Chicago. Its product offerings extend beyond commodities. They include FX, Interest rate products, equity derivatives, Cryptocurrency and even contracts on the weather.

The CME was founded in 1898 as the Chicago Butter and Egg Board, an agricultural commodities exchange. For most of its history, the exchange was in the then common form of a non-profit organisation owned by members of the exchange (this was a global trend). The Merc demutualised in November 2000, went public in December 2002, and merged with the Chicago Board of Trade in July 2007 to become a Designated Contract Market of the CME Group Inc., which operates both markets.

The Commodity Futures Trading Commission (CFTC) define Designated Contract Markets (DCMs) as exchanges that may list for trading futures or options contracts based on all types of commodities and may allow access to their facilities by all traders, including retail customers. The CFTC provides oversight of all US exchanges and derivatives markets; its mission is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.

The CME Group owns four major exchanges, each with a rich and varied history: CME (Chicago Mercantile Exchange), CBOT (Chicago Board of Trade), NYMEX (New York Mercantile Exchange), and COMEX (Commodity Exchange, Inc.).

The Chicago Board of Trade (CBOT) is a commodity exchange established in 1848. It started as a cash market for grains; however, Forward or "to-arrive" contracts began trading at the CBOT soon after. While it originally traded agricultural commodities such as wheat, corn, and soybeans at the time of the merger with the CME, The CBOT (through other acquisitions and developments) brought a suite of interest rates and agricultural and equity index products to the new group.

The NYMEX was founded in 1872 and is the world’s largest physical commodity futures exchange. It is home to the WTI (West Texas Intermediate) Oil contract and the Henry Hub Natural Gas future. The COMEX originally merged with the NYMEX in 1994, and both became a part of the CME Group in 2008. The NYMEX brought many energy products, and the COMEX brought essential metals products, including several global benchmarks in precious, base, and ferrous metals.

The CME is the world's largest futures and options market by daily volume of the notional value of traded futures.

The following Exchange, The Intercontinental Exchange or ‘TheICE’, was partly created in response to the rise of a former energy market behemoth, ENRON.

Enron was an energy trading and utility company based in Houston, Texas. It was created in 1986 following a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated. After the merger, Kenneth Lay, the chief executive officer (CEO) of Houston Natural Gas, became Enron's CEO and chair. Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices. And Enron began to trade extensively in energy derivative markets.

Enron was a trailblazer in many markets and businesses, and its crowning glory (in the author’s humble opinion) was EnronOnLine (EOL).

Enron Online (EOL) was a web-based trading system that could complete transactions in many commodities, including power and natural gas, with anyone who signed up for an account. It removed the need for phone calls, and Enron could set bids and offers, manage client position limits and be a market maker to anyone who signed up to use the web-based service. They effectively saw most of the energy market OTC flows, which gave them an incredible edge when trading for their account (knowledge is power when it comes to commodity trading). At one point, they were set to become ‘the market’ and compete with any Exchange. They were also handily stealing OTC transactions from the global banks that were slow to create automated solutions for their customer bases. Something had to be done to fight back, and although the ICE had its origins in 1997, in 2001, it had a huge opportunity to dominate electronic trading.

Despite the cleverness of EOL and its commodity traders (most of whom were blameless in Enron's demise), Enron’s executive management perpetrated one of the biggest accounting frauds in history. Enron's executives employed accounting practices that falsely inflated the company's revenues and, for a time, made it the seventh-largest corporation in the United States. Once the fraud came to light, the company quickly unravelled and filed for Chapter 11 bankruptcy in December 2001. Bethany Maclean and Peter Elkinds’ outstanding book ‘The Smartest Guys in the Room’ remains a remarkably informative and entertaining record of Enron's meteoric rise and staggering fall. Their book should be a must-read for anybody interested in commodity trading (after this one, if I ever finish it).

The Intercontinental Exchange (ICE) is an American company that owns and operates financial and commodity marketplaces and exchanges. It was founded in May 2000 in Atlanta, Georgia, by Jeffrey C. Sprecher, a power plant developer who wanted to create a more transparent and efficient platform for over-the-counter (OTC) energy commodity trading. The new platform provided greater price transparency, efficiency, liquidity, and lower costs than open outcry trading.

The company's primary focus was on energy products, specifically crude and refined oil, natural gas, power, and emissions when it was founded. Through various acquisitions, the company's activities broadened to include other commodities—such as sugar, cotton, and coffee—in addition to foreign cash exchanges and equity index futures.

In response to the 2007–08 Financial Crisis, Sprecher formed ICE Clear Credit, which would serve as a clearing house for credit default swaps and over-the-counter (OTC) derivatives and provide crucial risk management services for the market.

ICE operations include futures exchanges, cash exchanges, central clearing houses, and market services for off-exchange trading; ICE operates futures exchanges in the U.S., U.K., EU, Canada, Singapore and Abu Dhabi. According to the 2021 FIA report, ICE is the fourth-largest exchange group in the world, behind CME Group, Brazil's B3, and the National Stock Exchange of India, ranked at the top spot!

The U.S. Commodity Futures Trading Commission (CFTC) regulates the commodity futures, options, swaps and OTC markets and is an excellent source for market data and reports.

The roots of the London Metal Exchange (LME) can be traced back to the opening of the Royal Exchange in London in 1571 when traders in metals and other commodities began to meet. As Britain became a major exporter of metals, European merchants began to arrive to join in these activities.

According to the LME's website, the "ring" tradition originated in the early 18th century in the Jerusalem Coffee House. Here, a merchant with metal to sell would draw a circle in the sawdust on the floor and call out, "Change!" All those wishing to trade would assemble around the circle and make bids and offers.

The London Metal Exchange is the world centre for trading industrial metals. The LME provides the market three transparent and regulated platforms for trading industrial metal contracts: LMEselect (electronic), the Ring (open outcry) and the 24-hour telephone market. The LME is unusual in that it still has an open outcry floor where traders meet several times a day in a Ring, shout prices, and use hand signals to communicate the buying and selling of futures: “O trading!”

Lastly, they also trade some PGM or platinum group metals, which we discussed in my last post.

Despite this antiquated but popular method of futures commerce, the LME remains at the cutting edge of metals markets and has developed a platform for trading EV (electric vehicles) metals, including lithium, cobalt and Molybdenum. However, advances in AI may mean new materials being created that will eventually displace the anticipated need for such metals.

The LME is now a member of the HKEX Group. Market users value the LME as a vibrant futures exchange but also for its close industry links. The possibility of physical delivery via the worldwide network of LME-approved warehouses makes it the perfect hedging venue for the industry and provides a reference price they trust.

The LME has existed as a recognised futures exchange since 1877.

The origin of securities exchanges in Japan stems from the Edo Period when an exchange for rice & crops was established in Osaka, the centre of the Japanese economy of the day.

Each prefecture set up its warehouses in Osaka for shipping & preservation of their rice (to be taxed by the government) and sold them to merchants. One of the most famous merchants was "Yodoya", in the southern part of the Yodoyabashi area. Other merchants gradually gathered to create one market. This market was called "Yodoya-Komeichi", the first securities trading in the nation.

The market was moved to Dojima in 1697 and officially approved as the "Dojima Rice Exchange" by Japan's shogunate government in 1730. At that time, rice futures trading, with trades recorded and settled in books of accounts, was known to be the world‘s first institutional futures exchange.

Japan has a proud history of commodity exchanges; the famous TOCOM (Tokyo Commodity Exchange) was established in 1984 with the merger of the Tokyo Textile Exchange, founded in 1951, the Tokyo Rubber Exchange, founded in 1952, and the Tokyo Gold Exchange, founded in 1982. Many energy-related commodities traded on the Tocom, including electricity (in 2019)

On Oct 1st, 2019, TOCOM Became a Japan Exchange Group, Inc. (JPX) subsidiary on July 27, 2020. All listed commodity component products on the Precious Metals, Rubber, and Agricultural Products Markets (except energy-related products such as Crude Oil and Electricity) were transferred from TOCOM to The Osaka Securities Exchange (OSE).

How does a Listed Futures Contract Work?

There are many types of a particular commodity (crude oil, for example), and the differences between them can be significant or minimal and range from quality and location to more specific physical or chemical properties (sulfur content, density, protein content, energy, viscosity, etc..). A futures trader wants to ensure that the futures they buy and sell reference the same commodity as other participants trade in that market. The underlying commodity on which the future trades must meet a strict list of specifications so that in the event of delivery, all parties know the quality, quantity, chemistry, delivery mechanism (delivered in one go or in parts over a set time frame) and location for when they will take or make a delivery.

Once a listed future is created, along with its specifications for the physical and chemical properties and its delivery mechanism and location, an exchange can set terms around margining (initial and variation margins are requested daily to make sure all participants can meet their obligations if market prices go against them) and what happens in the event of a Force Majeure (an unforeseen act, or an act of God, as opposed to the Chinese practice of price majeure) and thus extreme price stresses (sadly, think of 9/11, the NYMEX, where WTI trades, was next to the Twin Towers and had to evacuate. It was unable to open the next day for trade.)

The core contract specifications of the WTI contract that most market participants will consider are listed below. Not all are included; some refer to technical trading mechanisms beyond this book’s scope. However, to fully appreciate the thought that goes into a contract, I recommend reading Chapter 200 of the NYMEX rulebook (online) for an exhaustive overview of the chemical and physical properties of what is acceptable as a deliverable oil in the event delivery is to be made. It includes a more in-depth treatment of all aspects of the summary below.

Specifications (from the CME website, no less):

i. Contract Unit: The units the underlying commodity is traded in, for oil it is barrels, and one future is 1,000 barrels of WTI Crude Oil

ii. Price quotation: Crude oil is traded in U.S. dollars and cents per barrel

iii. Trading Hours: The times and platforms that the different trading sessions occur

iv. Minimum Price Fluctuation: $0.01 per barrel = $10.00 per Futures contract

v. Product code: The contract's unique Ticker, WTI, is CL on the NYMEX (and Brent is B on the ICE)

vi. Listed contracts: A futures market has futures for many dates in the future (for delivery of the same commodity). For the CL contract, there are monthly contracts listed for the current year and the next ten calendar years

vii. Settlement Method: Deliverable (that is it will eventually pass from seller to buyer as per the mechanism outlined in Rulebook chapter 200). Many contracts also settle for cash at the expiry of the contract.

viii. Termination of trading: As the future becomes closer to the spot or cash markets, there is a date when a future can no longer be traded. After this time, physical delivery will occur. For a given CL future, trading of the future terminates three business days before the 25th calendar day of the month before the contract month. If the 25th calendar day is not a business day, trading terminates four business days before the 25th calendar day of the month before the contract month.

ix. Position limits: depending on whether a participant is a bona fide hedger or speculator, there are limits to how many futures they can have a position in. As the future comes closer to expiry, those positions are reduced to allow orderly exits for most participants.

x. Exchange Rule book: for crude oil, here it is NYMEX 200

xi. Price limit or circuit breaker: prices can rise and fall dramatically during extreme volatility. This is limited, and we say markets limit ‘up or down’ when this happens. Trading is often stopped, and the market can catch its breath before starting again. Circuit breakers are similar occurrences and are there to avoid total market meltdowns.

xii. Delivery procedure: How the seller will deliver and the buyer receive the crude oil, so to start with WTI: Delivery shall be made free-on-board ("F.O.B.") at any pipeline or storage facility in Cushing, Oklahoma, with pipeline access to Enterprise, Cushing storage, Enbridge, Cushing storage or Plains, Cushing storage. Delivery shall be made under all Federal executive orders and all applicable Federal, State and local laws and regulations.

xiii. Delivery period: The time frame and mechanism for the above procedure. For example, part (A) of many parts states that delivery shall take place no earlier than the first calendar day of the delivery month and no later than the last calendar day of the delivery month.

xiv. Grade or quality: See the Rule book to discuss a host of physical properties of an acceptable deliverable crude oil.

Remember, the complete, unabridged specifications are in the NYMEX RULEBOOK chapter 200.

OTC derivatives markets

Futures markets and their exchanges were created for producers and consumers to meet and agree on prices and terms for the delivery of commodities (and for the US exchanges, it was mainly for crops at the next harvest). However, while standardisation of contracts allows this market to function correctly, the sizes and fixed dates of expiry and delivery, as well as agreed mechanisms for delivery, only suit some.

The Exchanges require participants to demonstrate financial strength by requiring margining at the time of trading and a further variation margin as the value of the hedges bought and sold change due to the changing value of the futures markets. Exchanges calculate this daily and can also make intraday requests, which, if not met, may result in liquidating your portfolio of trade positions!

Many hedgers and speculators want to avoid taking contracts to delivery, so financially settled contracts make more sense. They might need more time and resources to roll out future positions as they near expiry or to handle the daily posting and receiving of margins. They may also have positions that cannot be rounded up to a 1,000 bbl increment and may want price protection based on an average period rather than the fixed expiry schedule of an exchange-listed future.

Such a market exists for these participants; it has developed alongside the listed markets and caters for almost any type of contract providing an underlying price signal (say, a December crude oil future or a gold spot price or a published ‘assessed price’ of a commodity in Argus or Platts) can be agreed upon.

This market is called the Over-The-Counter derivatives market. It does not have to have a physical location (although the New York Stock Market is an exchange that trades in the spot market for stocks, they are delivered T+2). Still, it exists because many financial services companies are willing to make prices in financially settled OTC swaps and options for their client bases and other dealers. The participants' behaviour in this market is governed under ISDA(International Swaps and Derivatives Association), and these agreements are as legally binding as any future. However, in the event of a default or a dispute, the remedies can differ as an Exchange always has enough margin buffer to cover any shortfalls they may be owed. In the OTC market, this is only sometimes the case.

OTC markets fall into two main categories: Spot and forwards. These markets differ from future markets as follows:

Spot markets trade commodities or other assets for immediate (or very near-term) delivery. The word "spot" refers to the trade and receipt of goods made "on the spot".

Spot markets are also referred to as “physical markets” or “cash markets” because trades are swapped for the asset effectively immediately. While the official transfer of funds between the buyer and seller may take time, such as T+2 in the stock market and most currency transactions, both parties agree to the trade “right now.”

The spot price is the current quote for immediate purchase, payment, and delivery of a particular physical commodity. This is important since prices in derivatives markets, such as futures and options, usually converge to these values. Spot markets also tend to be incredibly liquid and active for this reason. Commodity producers and consumers will engage in the spot market and hedge in the derivatives market.

However, a disadvantage of the spot market is the delivery of the physical commodity. If you buy spot pork bellies, you now own some live hogs. While a meat processing plant may desire this, a speculator probably does not. Another downside is that spot markets cannot effectively hedge against future production or consumption of goods, whereas derivatives markets are better suited.

A forward market is not a future.

A forward contract is a customised contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.

Unlike standard futures contracts, a forward contract can be customised to a commodity, amount, and delivery date. Commodities traded include grains, precious metals, natural gas, oil, and poultry. A forward contract settlement can occur on a cash or delivery basis.

Forward contracts do not trade on a centralised exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customise terms, the lack of a centralised clearinghouse also gives rise to a higher degree of default risk.

The market for forward contracts is enormous since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller—and are not known to the general public—the size of this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.

Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?

In this case, the financial institution that originated the forward contract is exposed to a greater risk in the event of default or non-settlement by the client than if the contract were marked to market regularly.

Pricing by Assessment

Price assessment is determining the prevailing market price for a crude oil or refined product at a point in time. The most important price assessments are for the spot market for crude oil and products, as these are the best indicators of overall market conditions and are used as benchmarks for many crude and product transactions.

Several price assessment agencies perform price assessment. The most important being:

? Platts - Assesses prices for spot trades of most major crude and product grades around the world

? Argus - Assesses prices for spot trades of most major crude and product grades around the world

? OPIS - primarily assesses prices for rack (wholesale) and retail product markets

These agencies assess and publish prices daily based on observed transactions and/or player postings. Each has its method for collecting transaction data, judging which transactions to include, adjusting for differences (e.g., quality, location, deal size), and reporting prices to the market.

Now that we have looked at what a market is and why it exists, we should consider its primary use: hedging! This is an excerpt from my published article about managing risk during COVID-19.

C. The role of hedging in major financial decisions – a very brief history and example

Modern commodity price hedging practices are largely acknowledged to have started in the mid-1800s with American farmers meeting at the newly formed Chicago Board of Trade, initially to deal in the cash markets for grains and then later agree with dealers and consumers to commit to buying fixed amounts of a specified grain at a specified price. These contracts became known as futures. Dealers or consumers thus knew their grain costs, and farmers could be assured of known future cashflows for a given crop. This certainty enabled all parties to plan their economic decision-making better: consumers knew their input costs for food products or feedlots, and farmers made better planting decisions based on the costs of various crops.

In early 1981, the US government ceded oil price control to market participants, marking the beginning of the physical West Texas Intermediate (WTI) crude oil spot market. The ensuing volatility of the price led to the WTI Futures market in 1983. This market became an essential hedging product for oil producers, refiners and later, the transportation sector. It also led to several other listed futures (Brent, Gasoil, Heating Oil, Gasoline, etc.) and the creation of the Over the Counter (OTC) commodity swaps and options markets. Furthermore, the OTC market led to a whole new industry in bespoke hedging solutions by banks and investment companies for any company that had fixed price exposures to commodity prices.

The cashflow certainty that commodity price risk hedging gives has led to the development and proliferation of whole commodity-based and dependent industries. The legendary oil and gas entrepreneur and former CEO of Chesapeake Energy, Aubrey McClendon, almost singlehandedly developed the US natural gas drilling business (and later shale gas production) by perennially hedging his natural gas production. By selling his company’s future production into the contango curves that the natural gas futures market presented to all participants, he financed greater drilling programs and technological advancements that fed significant parts of the American economy, helped create a cleaner environment from electricity generation and reversed America’s dependence on LNG.

And finally, for the history buffs…

D. Some events of historical and commercial importance in the development of Commodity markets

The need for commodities has been relentless throughout human history, but the record of commodity market development and trading can be broken into three distinct periods.

i. 4500 BCE – 1980 CE

? Between 4500 BC and 4000 BC, people in Sumer or modern-day Iraq used clay tablets to denote the number of goods delivered at a predetermined date. The first evidence of a ‘futures contract.’

? The code of Hammurabi (a collection of 282 rules that included standards for commerce and trading) in 1700 BC in Babylonia contained the closest references to modern-day futures and options.

? In 1180 AD, the Champagne fairs in Northern France served as networking places for traders where OTC derivatives trading took place. Ironically, Champagne was dumped initially on the English as the French thought it was inferior wine.

? 1530 and 1608, the Amsterdam Stock Exchange originated as the world’s first exchange for commodities.

? Around 1636, the demand for tulips grew so much that tulips traded on the Amsterdam Stock Exchange. This led to the first commodity bubble.

? In 1730, the Dojima Rice Exchange in Japan started spot trading rice bills and futures trading for various rice grades.

? In 1848, the Chicago Board of Trade (CBOT) was established to standardise forward contracts for grain trading.

? In 1856, the Kansas Board of Trade served as a clearinghouse for grain exchange.

? 1870, the New York Cotton Exchange was established to facilitate trading in cotton contracts.

? In 1877, the London Metal Exchange (LME) was formally established. However, its origins are often traced back to the reign of Elizabeth I.

? In 1882, the Butter and Cheese Exchange of New York became the New York Mercantile Exchange (NYMEX).

? In 1921, the Future Trading Act was enacted to regulate futures trading in grain (oats, rye, etc.). In the same year, the Grain Futures Act was also passed.

? In 1933, The Commodity Exchange (COMEX) was primarily the largest exchange for metal trading.

? Also, in 1933, the Glass-Steagall Act was signed into law; it effectively separated commercial banking from investment banking. The Act responded to the 1929 Stock Market crash and would hold most commercial banks back from direct commodity-related activities for decades.

? In October 1933, The Dow Jones Commodity Futures Index was created.

? The Commodity Exchange Act (CEA) was passed in 1936 to regulate the trading of commodity futures in the United States.

? In 1955, two onion traders cornered the onion futures market on the Chicago Mercantile Exchange. The resulting regulatory actions led to the Onion Futures Act on August 28, 1958. Futures trading in onions is illegal and remains so to this day.

? Oil and gas had been in limited quantities in the North Sea since the 1850s. However, commercially viable wells were found in the 1960s, which led to oil being piped onshore in England and Scandinavia in the 1970s.

? In October 1973, members of the Organization of Arab Petroleum Exporting Countries (OAPEC), led by Saudi Arabia, proclaimed an oil embargo against certain Western countries. These targeted nations that supported Israel during the Yom Kippur War.

? In 1974, the Commodity Futures Trading Commission (CFTC), a regulatory body, was established in Washington, DC.

? The first widely traded oil financial contract to be sold through an organised, regulated exchange was a heating oil futures contract offered on the New York Mercantile Exchange (NYMEX) in 1978

? The 1979 Oil Crisis -The Iranian Revolution saw oil output from Iran fall, causing prices to double over the next 12 months. The onset of the Iran-Iraq war in 1980 did not help either.

? On Thursday, March 27, 1980, following the attempts by brothers Nelson Bunker Hunt, William Herbert Hunt, and Lamar Hunt to corner the silver market, the price of silver plunged precipitously, bankrupting the Hunts.

ii. 1981 – 1999: Liberalized oil markets, the Kyoto Protocol, and the repeal of Glass-Steagall

? In early 1981, the US government ceded oil price control to market participants, marking the beginning of the physical West Texas Intermediate (WTI) crude oil spot market. The ensuing volatility led to the need for and the creation of the WTI Futures market in 1983.

? The movie Trading Places was released, and the then 10-year-old author knew he wanted to trade commodities.

? A gasoline contract started trading on the NYMEX in late 1984. In 1988, the Brent contract started trading in Europe on the International Petroleum Exchange, an open outcry market formed in 1980 in response to the oil shocks and volatility of the preceding decade.

? The Goldman Sachs Commodity Index was created in 1991. It allowed passive investors access to a basket of commodities as a diversified investment opportunity.

? The German Industrial Behemoth Metallgesellschaft AG implodes, losing over $1.3billion on its hedge book

? In 1996, Yasuo Hamanaka, Sumitomo's chief copper dealer, engaged in fraudulent trading activities that created trading losses (and legal settlements) that topped 2.8 billion dollars.

? Bre-X Minerals, initially a mining penny stock listed in Toronto that grew to a market capitalisation of nearly CAD 6 billion, collapsed in 1997 after the gold samples were found fraudulent. Dishonesty even exists in Canada.

? The Kyoto Protocol was adopted on 11 December 1997. However, owing to a complex ratification process, it entered into force on 16 February 2005. Currently, there are 192 Parties to the Kyoto Protocol.

? The Financial Services Modernization Act of 1999, called Gramm-Leach-Bliley, was signed into law in November 1999. It repealed large parts of the Glass-Steagall Act, allowing financial holding companies to participate in multitudes of financial products and markets, including commodities.

iii. 2000 – present: China joins the WTO, Commodities demand explodes, and US Investment banks are forced out of physical commodity trading and asset ownership

? In May 2000, The Intercontinental Exchange (ICE), an American company that owns and operates financial and commodity marketplaces and exchanges, was founded by Jeff Sprecher and backed by Goldman Sachs, Morgan Stanley, BP, Total, Shell, Deutsche Bank and Société Générale.

? China became a World Trade Organization (WTO) member on 11 December 2001. Soon after, their economy accelerated, as did their need for raw materials.

? On December 2, 2001, the Enron Corporation filed for Chapter 11 bankruptcy protection, sparking one of the largest corporate scandals in U.S. history.

? The first EU Emissions Trading Scheme trading period lasted three years, from January 2005 to December 2007. The second trading period ran from January 2008 until December 2012, coinciding with the first commitment period of the Kyoto Protocol.

? On 21 September 2006, Amaranth Advisors, the $9.5 billion hedge fund, announced that it had lost almost 65% of its assets on a bet on the natural gas market.

? The global financial crisis (GFC) refers to extreme stress in global financial markets and banking systems between mid-2007 and early 2009. It sent most assets and many commodity prices plunging.

? After the GFC, new regulations of financial markets included the Volker rule (prohibiting proprietary trading) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly referred to as Dodd-Frank). This United States federal law was enacted on July 21, 2010.

? Bank Regulators in the USA started assessing Section 4(k) of the Bank Holding Company Act of 1956 (BHC Act) to explore if Physical Commodities Trading is complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

? Nov 20-21, 2014, the main commodity heads of the big Wall Street banks are hauled before Congress for a hearing on 4(o) of the BHC Act, which covers the ability of banks to engage in merchant operations.

? At the end of 2014, Goldman Sachs sold their LME storage company Metro to the Reuben brothers, and Morgan Stanley divested all their physical oil assets to Castleton Commodities Inc. (CCI)

? The crash in demand that followed the spread of COVID-19 and a price war between oil giants Saudi Arabia and Russia in early March 2020 caused oil prices to plummet.

? On April 20, 2020, West Texas Intermediate crude futures dropped by almost 300%, trading at around negative $37 per barrel. Due to the delivery mechanism governed by the Exchange, every seller must have a buyer, and when no one is buying, you may have to pay someone to take your commitment to purchase physical oil off your hands, hence the negative price.

? 2021 sees the world partially recover from COVID-19 lockdowns, demand rise, OPEC and Russia finally align interests and most commodity prices rally.

? Russia’s invasion of Ukraine on February 24th, 2022, upends global commodity markets, causing dislocations of supply chains and shortages of natural gas, oil and food. In addition, severe price increases fan the flames of global inflation, driving central banks to raise interest rates significantly for the first time in over a decade.

? Russia weaponises natural gas: It reduces then cuts off large parts of Europe from natural gas supplies through its pipelines, causing huge spikes in regional gas and power prices. Germany’s overreliance on Russian natural gas is brutally exposed as a national security failure. The era of "Wandel durch Handel," or "change through trade", is over, For Germany at least.