Global Commodities: Physical, Financial, and Sustainability Aspects 3030640256, 9783030640255

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Global Commodities Physical, Financial, and Sustainability Aspects Murad Harasheh

Global Commodities

Murad Harasheh

Global Commodities Physical, Financial, and Sustainability Aspects

Murad Harasheh University of Bologna Bologna, Italy

ISBN 978-3-030-64025-5 ISBN 978-3-030-64026-2 (eBook) https://doi.org/10.1007/978-3-030-64026-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover illustration: © John Rawsterne/patternhead.com This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

To my parents To my wife

Preface

For many people, including professional managers, academics, and students, the field of commodities is a black box, and, in some cases, people try to avoid it having already a prejudice of its complexity. I think such prejudice is due to the lack of a simplified book or manual trying to explore commodities in a fluid and holistic manner without compromising the substance, and that existing related books are too technical in professional or academic orientation. The concepts presented in this book are usually treated separately in different books, hence in this book, I treat Global Commodities from multidisciplinary business and financial perspectives offering a panoramic view on Global Commodities Business and Markets. In this book, I present core issues related to global commodities in a smooth way trying to demystify Global Commodities for different types of readers relying on recent data including the COVID-19 initial period. I start by introducing the key physical commodities traded globally and some related issues such as the global supply chain, global trading in the physical commodity, transportation, storage, and how to finance global commodity trades. Then, I discuss how global commodity businesses and traders manage global risks related to commodity production (generation or extraction), transportation, storage, the final delivery, and risks related to currency exchange since commodities are moving globally. Later, I lead the reader to the financial commodities, the origins of global commodity derivates and exchanges, the rationale behind the birth

vii

viii

PREFACE

of commodity futures and trading, then hedging, speculation, financialization, and manipulation of commodity markets, and how financial trading is executed in global commodity derivates offering some technical analysis examples. The last two parts of this book differentiate it from others in which I integrate the sustainability issues related to global commodities and the financial valuation aspects of the global commodity businesses owning natural resources supported by real cases with recent data. This book appropriate as a special module in the courses of International Finance, International Economics, International Business, Global Supply Chain in the advanced undergraduate courses, for MBA students, and Master courses in the related fields. It’s also appropriate as a special training course offering a quick introduction for business managers and for those who seek a career in global commodity analysis and consulting. Four main novelties of this book that differentiate it from others: 1. The topics I am covering had usually been dealt with separately, some books describe only the physical supply chain of commodities, others focus on financial aspects and financialization of commodities in technical manners. In this book, I aggregate the topics in one fluid book offering a quick introduction to global commodities for the target readers. 2. Financial valuation issues are almost only covered in Corporate Finance books, here I integrate this topic offering valuations for commodity business from real cases using recent data. 3. The sustainability part is an important emerging topic especially in commodities due to their negative ESG externalities, so I think, integrating this topic adds value to the book since little literature talks about sustainability in commodities. 4. Finally, I adopt and analyze recent commodity data covering the COVID-19 pandemic.

Murad Harasheh University of Bologna Bologna, Italy

PREFACE

ix

Acknowledgments This piece of work wouldn’t have been released without the support of many people, first I would like to thank the editor, the editorial board, and the technical staff for their hard work to make the publication process more efficient. Special thanks to the three anonymous reviewers for their positive feedback and suggestions to improve the book. Finally, I am highly grateful for Monserrath Lascano for her key technical and format support.

Contents

1

Overview of the Global Physical Commodities What is a Commodity Why Commodities are Important Key Characteristics of Commodities Categories of Physical Commodities Traded Globally Metal Commodities Agricultural Commodities Energy Commodities Main Historical Spots in the Oil Industry Why Prices in the Global Commodity Markets are Volatile References

1 1 2 4 5 6 10 14 20 22 24

2

The Global Supply Chain of Commodities The Structure of the Supply Chain in Global Commodities Who Is Responsible for the Delivery of the Commodity? Physical Trading in Commodities Commodity Transformation How Arbitrage in Physical Commodities Works How Arbitrage Eliminates Arbitrage Financing Commodity Trading Digitalization and Trade Finance Further readings

25 25 31 32 33 34 36 38 45 46

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CONTENTS

47 47 50 52 55 55 56 59 71 74 74

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Risk Management in Global Commodities The Concept of Risk Risk Tolerance and Analysis Risk Categories Managing Risks in Global Commodities Diversification and Integration to Reduce Risk Insurance for Risk-Sharing Commodity Price Risk (Flat Risk) Hedging Payables and Receivables Other Related Risks Further readings

4

Financial Aspects of Commodities The Development of Commodity Exchanges Regulatory Bodies and Policies Commodity Derivative Contracts Financialization of Commodity Markets Commodity Derivatives on Organized Exchanges How Commodity Trading Works Features of Commodity Trading How to Trade in Commodity Futures Examples of Margin Trading in Commodity Futures Arbitrage Opportunities in Futures Markets Speculation and Manipulation in Commodity Markets Technical Analysis Chart Application in Technical Analysis References

77 77 80 81 81 86 91 94 96 98 100 101 103 105 107

5

Financial Valuation Aspects Financial Valuation Approaches to Valuation Discounted Cash Flow (DCF) Real Option Valuation Option Pricing Methods The Binomial Model The Black–Scholes Model Valuation Applications Natural Resource Valuation

109 109 111 112 114 116 116 118 119 119

CONTENTS

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Valuing a Commodity Company with Options Valuation with Discounted Cash Flow and Normalized Commodity Price Further Readings

121

Commodities and the Sustainability Transition Why We Need a Change Global Efforts to Combat Climate Change Sustainability Issues in Commodities Global Actions to Enforce Sustainability in Physical and Financial Commodities Environmental, Social, and Governance (ESG) Reporting ESG Rating References

129 129 135 137

124 128

146 149 151 153

Conclusions

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Index

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List of Figures

Fig. 1.1 Fig. 1.2 Fig. 1.3 Fig. 1.4 Fig. 1.5 Fig. 1.6 Fig. 1.7 Fig. 1.8 Fig. 1.9 Fig. 1.10 Fig. 1.11 Fig. 2.1 Fig. 2.2 Fig. 2.3

Metal commodity production (Data source [Thrurtell et al. 2020]—CC-BY-4.0) Copper prices and global manufacturing PMI (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0) Copper index during different crises (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0) Top metal ore producers in 2019 (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0) Selected global agricultural commodities (Data source [World Bank Group 2020a]—CC-BY-4.0) World prices for selected agricultural commodities (Data source [World Bank Group 2020a]—CC-BY-4.0) Rice and wheat global prices (Source [World Bank Group 2020b, p. 31]—CC-BY-4.0) Maize and soybean global prices (Source [World Bank Group 2020b, p. 31]—CC-BY-4.0) Prices of the main energy commodities—(Data source [World Bank Group 2020a]—CC-BY-4.0) Three main oil producers in million barrels/day (Source [World Bank Group 2020a]—CC-BY-4.0) Reaction of commodities before and during crises (Source [World Bank Group 2020a]—CC-BY-4.0) Global supply chain FOB and CIF Copper transformation

8 10 11 11 13 14 14 15 19 20 22 28 32 35

xv

xvi Fig. Fig. Fig. Fig. Fig. Fig. Fig. Fig. Fig. Fig.

LIST OF FIGURES

2.4 2.5 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2

Fig. 4.3

Fig. 4.4

Fig. Fig. Fig. Fig. Fig. Fig. Fig. Fig.

4.5 4.6 5.1 5.2 5.3 5.4 5.5 6.1

Fig. 6.2 Fig. 6.3 Fig. 6.4 Fig. 6.5 Fig. 6.6 Fig. 6.7 Fig. 6.8 Fig. 6.9

Arbitrage opportunities Bank financing for commodity trades Risk matrix in commodities Impact analysis Hedging effect with bilateral contacts Normal and inverted future curves Contango and backwardation Three integrated markets OTC derivatives (Data source BIS [2020, p. 1]) Product composition by share of the total volume (Data source World Federation of Exchanges [2020, p. 11]) Volumes of commodity options and futures (millions of contracts) (Data source World Federation of Exchanges [2020, p. 31]) Share of total volume by commodity type and region in 2019 (Data source World Federation of Exchanges [2020, p. 36]) Daily gold future chart Monthly gold future chart Payoff from a call option Payoff from a put option Tree sequence of the binomial model Payoffs from developing natural resource Sensitivity of stock price to oil price Aggregated global macrotrends (Source Author’s elaboration based on [EEA 2015]) Global temperatures anomaly (Data source [Our World in Data 2020]—CC-BY-4.0) Atmospheric CO2 concentration (Data source [Our World in Data 2020]—CC-BY-4.0) Natural gas supply chain and the environment Global annual CO2 emissions by fuel type (Source [Our World in Data 2020]—CC-BY-4.0) Annual CO2 emission from coal by country (Source [Our World in Data 2020]—CC-BY-4.0) Annual CO2 emission from oil by country (Source [Our World in Data 2020]—CC-BY-4.0) Annual CO2 emission from gas by country (Source [Our World in Data 2020]—CC-BY-4.0) Global annual GHG emissions by sector (Source [Our World in Data 2020]—CC-BY-4.0)

37 40 49 51 62 67 68 72 85 88

88

91 105 106 115 116 117 120 127 132 133 133 137 138 139 140 140 141

LIST OF FIGURES

Fig. 6.10 Fig. 6.11 Fig. 6.12

Annual global methane emission by sector (Source [Our World in Data 2020]—CC-BY-4.0) Annual global N2O by sector (Source [Our World in Data 2020]—CC-BY-4.0) Global GHG emission of mine production—2016 (Data source [Our World in Data 2020]—CC-BY-4.0)

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142 143 145

List of Tables

Table 1.1 Table 1.2 Table 1.3 Table 3.1 Table 4.1 Table 4.2

Table 4.3 Table 4.4

Table 4.5 Table 5.1 Table 5.2

Prices of main metal commodities—Data source (World Bank Group 2020b)—CC-BY-4.0 Energy sources—Data source (World Bank Group 2020a)—CC-BY-4.0 Historical prices of energy commodities—Data source (World Bank Group 2020a)—CC-BY-4.0 Risk categories Commodity derivative contracts Commodity exchanges by number of options and futures contracts—Data source World Federation of Exchanges (2020) Top 10 commodity contracts traded in 2019—Data source World Federation of Exchanges (2020) Breakdown of volumes by the underlying commodity—Data source World Federation of Exchanges (2020) Technical signals and trading horizon The value of Conocophillips at low oil price The value of Conocophillips at a normalized oil price

9 16 18 53 82

89 89

90 104 123 124

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CHAPTER 1

Overview of the Global Physical Commodities

Abstract In the first chapter, I present an overview of the physical commodities traded globally, the various categories and commodities within agricultural, metal, and energy commodities. The importance of global commodities. A little history about the birth of global commodities exchanges. And updated historical prices and quantities, the behavior of the prices of different commodities to shocks, crises, and emergencies such as COVID-19. Keywords Commodities · Energy commodities · Metallic commodities · Agricultural commodities · Price drivers

What is a Commodity Commodities are naturally extracted materials that can be traded in bulks, oil, steel, and grain are examples of commodities. They can be considered basic products used as production inputs for producing other goods or they can be directly consumed such as agricultural commodities. • Commodities form the basic input that is converted into the food we eat, the industrial goods we use, and the energy that fuels our

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_1

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M. HARASHEH

transport and heats and lights our lives and is one of the oldest forms of economic activity.1 • For many of us, we take things around as guaranteed by nature, but we ignore the hidden complicated story behind it. Starting from our food, our clothes, the different forms of energy, and in every single object around us there is a big story related to global commodities. Even though global commodities enter every single detail of our lives, yet it is one of the most ignored or misunderstood disciplines. • Physical commodities are the heart of the real economy. They are traded globally in massive quantities. We depend on them for the basics of everyday life. Commodities must also meet specified minimum standards, also known as a commodity grade.

Why Commodities are Important Various aspects that make global commodities important at different levels, as I have previously mentioned, commodities form the daily life of everybody, therefore, it is essential to show how commodities are important at different levels: 1. Social aspect: some commodities have the characteristics of a public good, this means that they must arrive to every resident regardless of the economic or social situations, thus, a certain level of government intervention is needed to guarantee the commodity supply. For example, national regulatory authorities and local authorities work together to guarantee the supply of electricity and gas to their residents. 2. Political aspect: even though operating in the global commodity business is considered a free market activity (means liberal market), yet certain national aspects of global commodities are centrally decided at the political level. For example, the decision of the quantities of exports and imports for certain commodities are set by law, many countries around the world including Europe and the United States set fixed quotas for importing and exporting agricultural commodities to protect local farmers. The limits of greenhouse

1 Rembert the “Barter”: exchanging a commodity for another commodity before the development of what we call “Money”.

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OVERVIEW OF THE GLOBAL PHYSICAL COMMODITIES

3

gas (GHG) emissions are also centrally decided and have to be respected by the market players which influence the activity in the global commodities. The European Green Deal that was approved in January 2020 regarding the EU sustainability strategy to be achieved by 2050 is a good example. 3. Environmental and public health aspects: every step in the supply chain of the commodities implies environmental and health issues; from the production to the transportation and then to the consumption of the commodity, there is a degree of pollution. For example, imagine the pollution produced in the exploitation of oil fields both onshore and offshore. Then in the huge shipment of oil in the sea, and finally, in the treatment and the final consumption of oil for electricity generation. As we well discuss later, the energy sector contributes to the majority of carbon dioxide (CO2 )—around 70%—emitted in the atmosphere. Therefore, commodity companies (especially energies) have to comply with new guidelines for the sustainability transition adopted by the Paris Climate Agreement (COP21) in 2015 and its subsequent climate summits. 4. Economic aspect: commodity buyers, sellers, and traders usually engage in huge transactions for buying or selling commodities globally in which sometimes the value of one transaction exceeds the value of the business itself as in the case of commodity traders. Global commodity transactions can also be considered leverage for the global economy because they involve other vital economic sectors such as global shipping companies, storage facilities, and insurance companies. Therefore, global commodity business contributes significantly to global real economics production, economic growth, and employment. 5. Law & regulatory aspect: before the wave of privatization and the market liberalization in the early 1990s, one company was controlling2 the whole supply chain from production to transportation and storage, to the final distribution, then after the liberalization, national regulatory authorities obliged companies for the separation of managerial and ownership in each business in 2 This is called “Vertical integration” in which one company owns the whole supply chain and controlling the market by owning almost 100% of the market share. For instance, only one energy company was operating in the economy for generating electricity, transmission, and the final distribution.

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M. HARASHEH

the supply chain. Global commodity companies are usually giant Multinational Corporations (MNCs), therefore, an efficient level of regulation is always needed to keep them operating within the rules of the game without creating market distortion. For example, Anti-Trust Authorities worldwide keep watching the activities of big commodity companies to prevent increased market share and any market abusive behavior. Other aspects of regulations include efficient laws to guarantee the security of supply of the commodity at the national level, and regulations of the sustainability transition without hindering economic growth. 6. Storage and storability aspect: almost all commodities can be stored even for a long time, and commodity storage is a vital mechanism against sudden market shocks, a sudden shock in the supply for grain due to atmospheric hazards can be absorbed by the efficient release from the storage which prevents price hikes. The situations where there is excess supply, storage plays an important role in containing the excess supply and prevents price collapse. However, some commodities are not storable such as electricity (until we invest the intelligent commercial battery that stores electricity for a long time), in this case, the Transmission System Operator (TSO) and the national regulatory authority play crucial roles in the real-time balancing of the electricity grid to prevent power outages.

Key Characteristics of Commodities Unlike other finished products in the market, commodities enjoy some characteristics that make them suitable for global trading. 1. Globalization aspect: they form a global need for all countries around the globe since they are essential for the production cycle and personal needs. They are transported by land, air, and sea using large shipments. 2. Large delivery and cost: commodities are transported in large quantities depending on huge fixed costs, the greater the amount transported, the lower is the average cost per unit (the economies of scale), for example, crude oil tankers are huge carriers that require very large fixed operating costs, therefore, using it to the maximum capacity for shipping crude oil would reduce the average cost per

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OVERVIEW OF THE GLOBAL PHYSICAL COMMODITIES

5

barrel. That’s why the cost of transportation makes the destination a significant pricing factor. 3. Commodities with similar physical characteristics are exchangeable: commodities can be very similar but not the same in terms of quality characteristics, for example, two of the global oil benchmarks Brent oil and Dubai oil are not the same in terms of viscosity and sulfur contents but they can be exchangeable to meet some demand needs. In other cases, melting copper to create concentrates may influence price and quality due to the transformation. 4. No branded goods: unlike other products, commodities are basic and essential products extracted from nature, so there is no one paying extra for the brand name, consequently, price is determined by product quality and availability.3 5. Storage: commodities can be stored for long periods, as we have mentioned earlier, commodity storage plays an important role in smoothing consumptions between the present and the future, and a shock-absorbing mechanism. 6. Inelastic goods: since commodities are vital for our daily life, and they feed the economic growth, the demand for commodities is somehow inelastic, which means we need them at any cost.

Categories of Physical Commodities Traded Globally If we look around us, we notice that everything we use or consume comes from commodities, either a primary commodity such as grains or natural gas or a derived one such as gasoline. All of the following categories of commodities are traded on global exchanges worldwide in a continuous mode with real-time prices that can be controlled at any time and from anywhere. • Energy commodities: they have always been a vibrant driver for production, consumption, and economic growth. Crude oil,

3 These are characteristics of a completive market where products are identical, however, in terms of the number of market participants, some global commodity businesses are controlled by few multinational corporations.

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natural gas, coal, uranium, electricity, and ethanol as primary energy commodities, and gasoline as a secondary commodity. • Metal commodities: they are one of the oldest human activities served as an engine for human and economic development. Precious metals such as gold, silver, platinum, and palladium; base metals such as steel, aluminum, copper, lead, nickel, tin, and zinc are examples of metal commodities. • Agricultural commodities: they for the basic substance for the food we eat. They include commodities extracted from the land such as corn, soybean, wheat, rice, cocoa, coffee, cotton, and sugar, and livestock commodities such as lean hogs, pork bellies, live cattle, and feeder cattle. Commodities can be classified as • Primary commodities: which are extracted directly from nature, such as crude oil and grains. • Secondary commodities: which are produced or derived from the primary commodity to meet certain market needs, such as gasoline from oil, and concentrates of smelted metals. They can also be classified as • Hard commodities: such as crude oil, gold, and silver. • Soft commodities: such as agriculture products, corn, wheat, and coffee. In the next section, I show the details of each category of commodities.

Metal Commodities Metallurgy, as one of the oldest human activities, goes back to the bronze age around 3000 B.C. An ancient civilization is considered in the Bronze Age either by producing or smelting different metals. Bronze has durable characteristics compared to other metals, allowing Bronze Age civilizations to gain a technological advantage. Then Trading metals originated with the Phoenicians around 1500 B.C in the Levant region of the Middle East and continued with the Romans.

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OVERVIEW OF THE GLOBAL PHYSICAL COMMODITIES

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However, modern metal trading can be traced back to the midnineteenth century in Great Britain to feed the British industrialization. British companies started to demand massive amounts of copper to feed British high growth rates. They started to stipulate forward contracts of copper from Chile with 3-month delivery (the time needed to transport the copper from Chile to Britain), this, was the first initiative to create London Metal Exchange established in 1877, which is now the most important metal exchange in the world. In this context, history is important in explaining why certain places are the core avenue for global trading in certain commodities. Traditionally, until the end of the twentieth century, metal trading had been directed from east to west or from south to north. However, the rapid growth in Chinese demand in the late twentieth century and early twenty-first century has changed the global structure of metals and minerals trading. The remarkable industrial growth of China in the twenty-first century transformed the trade in minerals and metals. Rapid growth in Chinese demand created supply pressures, enhanced the development of new sources of production and trade routes, shifted the direction of imports to the east and the BRICS, and led to unprecedented market volatility. China’s share of metal imports rose from less than 10% in 2002 to 46% in 2014. For the same period, China has an exponential growth in the monetary value of metal commodities imports, they jumped from $2.77 billion to $88.4 billion making 33.45% annual geometric growth. The main partners of China’s metal imports are Australia, Chile, Brazil, Peru, and Canada. More Chinese smelting capacity has been built to meet the demand for metal concentrates especially copper.4 Due to weight and transportation issues, the initial treatment for most metal commodities is performed in the mine area. Metals such as copper, lead, nickel, and zinc ores are transformed into concentrates to increase the quality, while bauxite is turned into alumina. The basic mined metals and their concentrates are treated as primary commodities, whereas

4 Copper ores (the basic raw material of copper) contain about 0.5–4%, then in most

of the cases, copper ores are processed into concentrates in the mine to save process and transportation costs. The concentrate is a finely milled, dark gray material containing about 30% copper (Cu), 30% iron (Fe), and 30% sulfur (S). The concentrate also often contains small amounts of precious metals and a range of other elements, which are processed in the smelters.

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refined metals can sometimes be considered secondary commodities after refinement occurs at the smelters. Figure 1.1 demonstrates the main metal commodities traded around the globe. It shows the annual production in 2019—here we refer to the metal production (the secondary commodity rather than mine production), crude steel captures most of all traded metals. Precious metals (mine production) are also important in the global metal commodity business, as of 2019, 3300 and 27000 metric tons of gold and silver produced, respectively, China alone produced almost 10% of the world’s gold and around 6.2 million ounces of platinum. Table 1.1 shows the trend in the last two years for the prices of main metal commodities. We can notice that the prices of the basic metals and minerals are declining in early 2020 due to the COVID-19 pandemic that forced a complete lockdown in the major industrial cities around the world resulting in a significant drop in the demand. To give more emphasis on the impact of the COVID-19 global pandemic, the following figure shows the price of copper for the last 4 years (2016–2020) jointly with the Global Manufacturing Index (PMI). We can see that both indexes soared in 2018 followed by a negative trend

13

2.4

ALUM IN IA

13.5

STEEL

23.6

132.5

1845

MAJOR ME TAL COMMODIT IE S PRODUCT I ON 2019 (IN MIL L IO N TO NS )

COPPER

ZINC

LEAD

NIKKE L

Fig. 1.1 Metal commodity production (Data source [Thrurtell et al. 2020]— CC-BY-4.0)

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Table 1.1 Prices of main metal commodities

Aluminum Copper Iron ore Lead Nickel Tin Zinc Gold Platinum Silver

19

Q1 19

Q2 19

Q3 19

Q4 19

Q1 20

Jan 20

Feb 20

Mar 20

1794 6010 93.8 1997 13,914 18,661 2550 1392 864 16.2

1863 6226 83.6 2035 12,412 21,038 2709 1304 823 15.6

1794 6113 100.9 1885 12,244 19,774 2759 1310 843 14.9

1764 5803 102.1 2031 15,651 17,139 2350 1475 883 17.1

1757 5898 88.7 2035 15,349 16,693 2383 1482 908 17.3

1691 5634 90.8 1844 12,690 16,267 2124 1583 902 16.9

1773 6031 95.8 1924 13,507 17,029 2354 1561 987 18.0

1688 5688 87.7 1873 12,716 16,480 2113 1597 961 17.9

1611 5183 89.0 1734 11,846 15,291 1904 1592 759 14.9

Data source (World Bank Group 2020b)—CC-BY-4.0 Note The prices of metals and minerals is measured in USD/million ton The price of precious metals is measured in USD/ounce

in 2019. However, at the beginning of 2020 with the unveiling of the COVID-19 in China and the complete lockdown in Wuhan as one of the industrialized cities has negatively affected the copper demand and price, after that, with the spread of the infection to Europe and the United States and the shutdown of the industrial activity, both the copper price and the manufacturing index had sharply declined (Fig. 1.2). Now let’s look at the behavior of the copper index during different crises as shown in Fig. 1.3. The first upper (gray) line is during the SARS pandemic, we notice that the copper price and the industrial activity had not been affected severely during the SARS pandemic in 2003 due to the limited expansion of the infection. The lower (orange) line represents the copper index during the Global Financial Crisis (GFC) 2008/2009 with the spark of the crisis was in September 2008 with the collapse (bankruptcy) of Lehman Brothers, it is evident that for the 100 days following that bankruptcy, copper index and the global indusial activity had suffered severe consequences. The middle (blue) line shows the copper index during the COVID-19 global pandemic, after almost 50 days of the announcement of the pandemic, a negative shock has hit global markets due to the complete closure of the most industrialized cities in Asia, Europe, and the USA. However, it is worth mentioning here that the effects of the GFC and the COVID-19 on the global economy are different, COVID-19 has introduced a sudden short-term shock on

M. HARASHEH

US$/mt

Copper price

Index

Global manufacturing PMI (RHS)

6,200

50

5,700

47

5,200

44

4,700

41

4,200

38 2020

53

2019

6,700

2018

56

2016

7,200

2017

10

Fig. 1.2 Copper prices and global manufacturing PMI (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0. Note PMI [purchasing managers’ index] above [below] 50 indicate an expansion [contraction])

the industrial activity, and industries are ready to re-open once health effects are contained. Whereas the GFC had created medium-term negative effects causing a recession, and that COVID-19 could resemble the GFC if stays for a longer time without any radical solution because even with some government assistance to businesses, businesses can’t tolerate a long time closure of industrial activities (Fig. 1.3). Figure 1.4 presents the top metal ore producers. We can notice that the production of the main metal commodities in the world is concentrated in a few countries located in the south or east of the world. This explains how the routs in the last three decades have been changing, China is leading the production and consumption of the main metals.

Agricultural Commodities Agricultural commodity trading forms one of the ancient economic activity and can be referred to the agrarian societies. Agrarian societies have existed in various parts of the world as far back as 10,000 years ago and continue to exist today. They have been the most common form of socio-economic organization for most of recorded human history.

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OVERVIEW OF THE GLOBAL PHYSICAL COMMODITIES

Index

COVID-19

GFC

11

SARS

110 100 90 80 70 60 50 40 30 t=0

10

20

30

40

50 Days

60

70

80

90

100

Fig. 1.3 Copper index during different crises (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0. Note Horizontal axis represents the number of days after the crisis start date [t=0]. For COVID-19 and SARS, t=0 is the date first reported to the World Health Organization [December 31, 2019, and February 10, 2003, respectively]. For the global financial crisis [GFC], t=0 is the date Lehman Brothers filed for bankruptcy [September 15, 2008]) Percent of global mine production 50 40 30 20 10

Copper

Lead

Nickel

Tin

Australia

Peru

China

Myanmar

China

Indonesia

New Caledonia

Philippines

Indonesia

Peru

Australia

China

China

Peru

Chile

0

Zinc

Fig. 1.4 Top metal ore producers in 2019 (Source [World Bank Group 2020b, p. 37]—CC-BY-4.0)

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However, in modern history as an organized exchange, we refer to the Chicago Board of Trade (CBOT) founded in 1848 to fulfill agricultural trading needs for farmers in the area of Chicago. In the context of global commodities, history plays a role in explaining why certain places are considered the main hubs specialized in certain commodities. Here is the story of the birth of CBOT. Chicago is located in the heart of the agricultural part of the Midwest. Early nineteenth century, Chicago was the destination where farmers from neighboring regions come to sell their crops, and mills owners were also looking for buying grains to feed their mills. However, despite the central location, timing and logistic issues created inefficient means of making transactions and thus inflated commodity prices. Additionally, the lack of developed storage facilities had elevated the farmers’ problem, and even with some storage facilities, traveling to Chicago with the crop in the hard winter made it very challenging to sell the crop at Chicago annual meeting. Thus, during harvest seasons, when there was an excess supply of grain, farmers were forced to dump the grains in the lack of Michigan or ask to sell the grain at almost zero price, for lack of means to transport and store unsold portions. In this case, the fundamentals of a market system were missing. As a response to this problem, a group of grain traders came up with a solution to establish the first organized exchange for grain trading known as the Chicago Board of Trade (CBOT), which is today a part of the Chicago Mercantile Exchange Group (CME Group). Now the CME Group consists of three main divisions: the CBOT, CME, and the New York Mercantile Exchange (NYMEX), while Intercontinental Exchange (ICE), which was established in 2000, remain the largest competitors to the CME Group. It is worth noting here that prices of agricultural commodities are subject to global events, especially climate-related disasters. One of the remarkable events in the twentieth century that caused great distortions in global grain prices was the exponential growth in agricultural commodities trading in the 1970s due to the Soviet Union failing harvest. In 1972 there was a drought across Europe and the Soviet Union. The mismanagement of the situation led to catastrophic wheat crop failure. In July 1972, the Soviet Union purchased 10 million tons of grain (mainly wheat and corn) from the United States at subsidized prices, which caused global grain prices to soar more than 30% creating global disorder in the grain market.

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Figure 1.5 shows the common agricultural commodities traded globally, maize, wheat, rice, and milk are on the top at the global level in terms of production and consumption. Figure 1.6 shows the global prices for selected agricultural commodities, prices are expressed in US-dollar per ton for the year 2019. Prices vary from one commodity to another due to product availability. Prices can also vary from one year to another depending on fundamental factors such as excess supply, climate disasters, or shipping disruptions, and also on speculations in the global commodity market. Agricultural commodities have also suffered from the COVID-19 global pandemic but with heterogeneous effects depending on the level of necessity of the commodity, for example, rice and wheat are considered essentials, so the demand has increased during the pandemic and their prices as well. However, other less essential agricultural commodities have experienced a reduction in the prices due to the lower demand, the sufficient supply, and saturation of storage capacities. The following two figures illustrate the price trends of selected agricultural commodities (Figs. 1.7 and 1.8). Agicultural commodities - World production 2019 (million tons) 1400 1151.5

1200 1000

848.9 800

766.4

600

526.9 429.4

400

299.1

357 210.6

200

179.7 70.4

117.8

125.6 11

24

26.4

0

Fig. 1.5 Selected global agricultural commodities (Data source [World Bank Group 2020a]—CC-BY-4.0)

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Agricultural commodities prices - 2019 (USD/ton) 6000 4790

5000

4066 4000 3000 2010

2000 1000 212

170

Wheat

Maize

420

370

Rice

Soybean

1730

280

0 Beef

Chicken

Butter

Suger

Cotton

Fig. 1.6 World prices for selected agricultural commodities (Data source [World Bank Group 2020a]—CC-BY-4.0) Rice

USD/mt

Wheat (RHS)

USD/mt

560

280

530

260

500

240

470 220

440

Apr-20

Jan-20

Oct-19

180 Jul-19

380 Apr-19

200 Jan-19

410

Fig. 1.7 Rice and wheat global prices (Source [World Bank Group 2020b, p. 31]—CC-BY-4.0. Note Last observation is April 17, 2020)

Energy Commodities Before the discovery of oil, for ages, the world was depending on coal and shale oil to fuel global economic growth. However, after its discovery in

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USDmt

USD/mt

Maize

Soybean (RHS)

140

300

120

280 Apr-20

320

Jan-20

160

Oct-19

340

Jul-19

180

Apr-19

360

Jan-19

200

Fig. 1.8 Maize and soybean global prices (Source [World Bank Group 2020b, p. 31]—CC-BY-4.0. Note Last observation is April 17, 2020)

sufficient commercial quantities in Pennsylvania in 1859, it penetrated almost all aspects of our life and has changed the whole world economically, politically, and socially. Energy commodities have been pivotal in the development of globalized markets. In recent decades, global trading firms have emerged and specialized in primary and secondary energy commodities. Trading firms paly a crucial role in the global physical supply chain of oil and oil trading, they are active financial market players seeking funds to finance their enormous transactions and global investment facilities and to hedge their positions, they also maintain tight relationships with banks operating in many countries and in all continents to raise immediate funds to finance transactions and other urgencies. To perform these activities, trading firms have to carefully watch global financial markets, global geopolitics, and other strategic partners. Primary energy commodities such as crude oil and natural gas are processed to extract and derive other secondary energy products such as fuels, gasoline, biodiesel, and LNG (liquefied natural gas). Energy has a crucial role to play in the global development context. The potential for energy to improve living standards, increased productivity; improved

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healthcare and education services; or digital connections to local, regional, and global networks. The inconclusive evidence can be partly attributed to the fact that the link between energy and prosperity is not always unidirectional. Gaining access to electricity and other energy sources may provide an initial increase in GDP but having higher GDP may in turn drive higher energy consumption. Additionally, progress in development outcomes can be complex: several parameters may be improving at the same time. If, for example, energy access and consumption, nutrition, education, health, and sanitation are all improving simultaneously (and having complex relationships with one another), it can be hard to directly attribute the improvement in living standards back to a single parameter. Table 1.2 gives an overview of the global quantities produced and shares of the main energy commodities from 1973 to 2017. We can notice that there has been less dependence on crude oil in favor of natural gas due to costs and environmental considerations, however, the share of coal has almost been stable regardless of the calls to cut its use as one of the most polluting sources. As of 2017 data, some European counties still depend heavily on coal for electricity production such as Estonia, Poland, Czech Republic, Bulgaria, and Germany. From 1973 to 2017, the total production of energy commodities has been growing at 1.9% annual geometric growth which corresponds to the long-run global economic growth. Table 1.2 Energy source

Coal Crude oil Natural gas Nuclear Hydro Bio & waste Other Total

Energy sources Production in Mtoe

Share of each source

1973

2015

2018

1973 %

2015 %

2018 %

1474.0 2938.0 991.0 53.0 110.3 638.2 6.1 6210.6

3871.5 4416.3 2975.7 670.7 334.4 1319.0 202.4 13,790

3893.7 4552.6 3293.1 706.8 362.3 1324.2 288.4 14,421

24.5 46.3 16.0 0.9 1.8 10.4 0.1 100

28.1 32.0 21.6 4.9 2.4 9.6 1.5 100

27.1 32.0 22.2 4.9 2.5 9.5 1.8 100

Data source (World Bank Group 2020a)—CC-BY-4.0 Note Mtoe is Million tons of oil equivalent

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Prices of energy commodities traded globally are presented in Table 1.3. It is evident that prices are very volatile reflecting economic, political, and financial factors. For instance, during the 2008/2009 financial crisis, real economic activity had been affected translating into lower demand for oil products that pushed prices down. During 2015/2016, commodities prices fell again reflecting China’s lower economic growth prospects as China is the biggest net demander for almost all energy and metal commodities, other factors have contributed to the lower oil price during the same period: the nuclear agreement between the Obama administration and Iran, and lifting the ban on the US oil exports. However, in some cases, price volatilities are due to market speculations or manipulations by commodity and non-commodity businesses. Figure 1.9 demonstrates the prices of selected energy commodities since the 2008/2009 financial crisis to March 2020. In the graph, we can notice the effect of the financial crises and the 2015 lower China’s growth prospects. During the first three months of 2020 and due to the COVID-19 pandemic, main the industrial cities in the world were shut down causing a sharp decrease in the demand followed by price falls. However, special attention has to be made for the crude oil price, there are two important factors caused the price collapse, at beginning of the pandemic (when it was limited to China), oil price started to fall partially due to COVID-19 but mainly due to the oil war among the most important players in the global market, Russia, Saudi Arabia, and the United States. Here is the story: there is a conflict between Russia and Saudi Arabia from one side, and Russia and the United States from the other. In the Russia-Saudi conflict, Saudi Arabia wants to cut the production to increase the price because it is registering huge budget losses since Saudi has built its budget at almost $80/barrel while Russia has built its budget at almost $40/barrel, so, Russia can tolerate short-run losses while Saudi Arabia can not on the other side, Russia has the intention to keep prices down to influence the US role in the global oil market due to US competitive technology in the shale oil5 business in the last 15 years. 5 Shale oil refers to hydrocarbons that are trapped in formations of shale rock. Shale oil is closer to a finished product than oil shale, but it’s still an involved process that involves drilling and fracking. It is an unconventional oil produced from oil shale rock fragments by pyrolysis, hydrogenation, or thermal dissolution. Shale oil was one of the first sources of mineral oil used by humans, its was used by Arabs in the tenth century, then in Europe and the US from the fourteenth to the twentieth centuries. When the conventional oil was discovered in economics quantities, shale oil was abandoned for the high production

96.99 61.76 79.04 104.01 105.01 104.08 96.24 50.75 42.81 52.81 68.35 61.41 61.60 53.30 32.20

97.64 61.86 79.64 110.94 111.97 108.86 98.94 52.37 44.05 54.39 71.07 64.03 63.60 55.00 33.00

93.78 61.75 78.06 106.03 108.90 105.43 96.66 51.18 41.20 53.12 69.15 63.18 63.80 54.50 33.80

($/bbl) 99.56 61.65 79.43 95.05 94.16 97.94 93.11 48.71 43.19 50.91 64.82 57.01 57.50 50.50 29.90

($/bbl)

Data source (World Bank Group 2020a)—CC-BY-4.0 Note bbl=barrel; mt=metric ton; mmbtu=million British Thermal Unit

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Jan. 2020 Feb. 2020 Mar. 2020

($/bbl)

($/bbl)

Crude oil, WTI

Crude oil, Brent

Crude oil, average

Year

Crude oil, Dubai

Historical prices of energy commodities

Table 1.3

127.10 71.84 98.97 121.45 96.36 84.56 70.13 58.94 66.12 88.52 107.02 77.89 69.70 67.60 66.10

($/mt)

Coal, Australian

120.60 64.68 91.62 116.30 92.92 80.24 72.34 56.71 63.95 85.15 97.64 71.94 82.10 80.00 67.90

Coal, South Afican ($/mt) 8.86 3.95 4.39 4.00 2.75 3.72 4.37 2.61 2.49 2.96 3.16 2.57 2.03 1.92 1.79

($/mmbtu)

NG US

13.41 8.71 8.29 10.52 11.47 11.79 10.05 6.82 4.56 5.72 7.68 4.80 3.63 2.91 2.72

($/mmbtu)

NG Europe

12.53 8.94 10.85 14.66 16.55 15.96 16.04 10.93 7.37 8.61 10.67 10.56 9.89 9.89 9.89

($/mmbtu)

LNG, Japan

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Prices of energy commodities Crude oil, average ($/bbl)

Coal, Australian ($/mt)

NG US ($/mmbtu)

LNG, Japan ($/mmbtu)

140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Jan. Feb. Mar. 2020 2020 2020

Fig. 1.9 Prices of the main energy commodities— (Data source [World Bank Group 2020a]—CC-BY-4.0. Note bbl=barrel; mt=metric ton; mmbtu=million British Thermal Unit)

So, at the beginning of the pandemic, political discords mainly caused prices to fall, then followed by the dramatic impact of the pandemic as it has been spreading all over the world. In April 2020, the price of the West Texas Intermediary oil (WTI) collapsed to -37, reflecting the fact that the storage capacity has reached a historical saturation rate. In the last decade, observing negative prices is not uncommon especially in the electricity market, this means that generators are getting paid to shut down their plants. This fact is associated with the growing share of renewable energy sources. Renewables are intermittent sources that have been changing the electricity generation profile in which on sunny days, the amount of electricity generated from photovoltaic sources exceeds the demand for the same trading (consumption) period. In Fig. 1.10, we show the top three players (producers) in the oil market, we can notice the increasing influence of the United States in the

cost, some countries used it again the 1970s during the Arabic nations’ embargo on oil exports, then was abandoned again until the beginning of the twenty-first century when the US developed technologies to extract shale oil at lower and competitive cost.

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United States

Mb/d

Russia

Saudi Arabia

13 12 11 10 9

Apr-20

Jan-20

Oct-19

Jul-19

Apr-19

Jan-19

Oct-18

Jul-18

Apr-18

Jan-18

8

Fig. 1.10 Three main oil producers in million barrels/day (Source [World Bank Group 2020a]—CC-BY-4.0. Note Last observation is March 2020. April to June 2020 are based on IEA estimates and OPEC+ announcements)

oil market even though it is not part of the OPEC which proves political tensions among the main producers. Russia is not an OPEC member but since 2016 it leads a cartel called OPEC+ countries that cooperate in fixing the global crude oil prices.

Main Historical Spots in the Oil Industry • The discovery of oil in 1859 in Pennsylvania. • Late 1800: a formal oil-trading exchange is established. Mass production techniques and technologies help the oil-trade become a large-scale industry. • 1940: the 7-sisters6 were founded: the biggest oil and petroleum corporations, they controlled the whole market and the value chain from upstream to downstream (vertical integration). • 1948: the discovery of the biggest oil field in the world in Saudi Arabia.

6 Standard Oil Company of New Jersey, Standard Oil company of New York, Standard Oil of California, Texaco, Royal Dutch Shell, Anglo-Persian Oil Company, Gulf Oil.

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• 1960: OPEC (Organization of Petroleum Exporting Countries) was founded in Baghdad, Iraq to coordinate the activities of oilproducing countries. • 1973: The Arab oil embargo on exports to the US causes prices to rise from $2.90 to $11.65 per barrel, the oil embargo was a vivid demonstration of the oil producers’ ability to exert pressure by constraining supply. At the time of the embargo, OPEC controlled half of global crude production and 80% of proven reserves. Throughout the 1970s and 1980s, many oil majors’ upstream concessions were nationalized. Producing countries established national oil companies (NOCs) to market production. • 2008/2009 global financial crisis during which oil prices fell below $34/barrel reflecting lower global demand for oil reflecting the economic recession. • 2015: lifting the ban on US oil exports: The Energy Policy and Conservation Act of 1975 (EPCA) was enacted as a US response to the 1973 oil crisis, the United States began to increase production, improve efficiency, build large storage facilities, and banning oil exports. This ban was lifted in 2015. • 2018/2019: the breach of the US–Iran nuclear agreement by Trump administration, which caused a slight increase in oil price. • 2020: the COVID-19 pandemic and the oil war which caused dramatic oil price drops. In this context, it is worth noting that oil price elasticity to certain events has been changing, especially to chocks that cause price jumps, for example, the breach of the US–Iran agreement had a slight impact on oil price, if the same event happened 30 years ago, the price could have been affected more severely; this is mainly because the global oil market has developed a lot and now can absorb such shocks, United States has huge reserves with developed storage facilities, it is the most important oil producer nowadays and dominates the shale oil business. Figure 1.11 shows the reaction of the different commodity categories before and during crises and recessions. Among agricultural, metal, and energy commodity categories, metal commodities are the most affected by the crises, this is due to the level of necessity of this commodity category; agricultural commodities are considered necessities, thus during the crises, we continue to demand such commodities. Oil and energies are

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Percent

Range

10

Average

5 0 -5

Oil

Metals

During

Before

During

Before

During

Before

-10

Agriculture

Fig. 1.11 Reaction of commodities before and during crises (Source [World Bank Group 2020a]—CC-BY-4.0. Note Dates of recessions taken from Kose, Sugawara, and Terrones [2020]. Four recessions are included: 1974–75, 1981– 82, 1990–91, and 2008–09. “During” shows average annual growth rates in recession years. “Before” shows average annual growth rates in commodity consumption over the three preceding years with the exception of the 1981– 82 recession. In this instance, “Before” refers to the period 1977–79. While technically not a recession, the economic slowdown in 1980 had similar negative growth rates in consumption)

also important for residential and personal use (heating oil and gasoline), however, during the crises, metal commodities suffer absolute demand reduction due to lower demand from industries that is not offset by any personal or residential use.

Why Prices in the Global Commodity Markets are Volatile Prices of commodities in the global markets are subject to volatility, this volatility can be due to: • Fundamental factors that influence the current or future demand and supply: Irregular production and harvests due to natural or technical reasons, draughts, cold, plant diseases affect agricultural

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23

activities which leads to global shortages that drive prices high. A sharp increase in global food and fuel prices during 2007/2008 resulted in food riots in many developing countries. Explosions in gas or oil fields or the sink oil shipment increase the price as the fear of future shortages soar. • Speculations in both physical and futures commodity markets, but mostly futures (speculation is buying/selling future commodity contracts without owning the commodity). Speculation has always existed but nowadays is mostly linked to the financialization of commodity markets in which non-commodity businesses (mainly financial) are allowed to trade futures contracts of commodities without being involved in any physical transaction, for example, banks and other financial institutions hold a significant share of commodity futures traded Over-The-Counter (OTC-products), these enormous holdings are said to be part of the 2000 corporate scandals (Enron energy company and the California electricity crisis) and the 2008/2009 financial crisis. Therefore, the US Dodd-Frank Act of 2010 and the European MiFID-II directive, and EMIR regulation came out to regulate commodity derivatives and OTC trading to reduce volatilities and prevent market distortions. The sharp swings in prices (price volatility) is one of the key problems associated with commodities, it can contribute to a worsening of the trade balance and current account deficits in many oil-importing/exporting and food-importing developing countries. Volatility evokes risks for both producers and consumers. Volatile prices can have a devastating impact on economies, for example, some oil-exporting countries have, many times, built their budgets at optimistic oil price, and when the oil price falls, they incur huge budget losses that, sometimes, the state has to cut subsidies or impose taxes to offset budget losses from oil.7 As the nature of prices in the global markets is volatile (for fundamental or speculative reasons), global energy companies and traders usually transact in enormous quantities, therefore, a tiny price change or any global event could provoke huge business losses. Therefore, here comes 7 This happened to Kuwait and Saudi Arabia when they built their budgets at high oil price in 2014 then oil prices suffered huge losses. The same in 2020 when Saudi Arabia built the budget at $80/barrel while the price dropped to $24/barrel leading Saudi Arabia in thinking to cut subsidies or increase taxes.

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the crucial role of risk management and hedging against price volatility and quantities in global commodity markets. Global commodity businesses use sophisticated risk management techniques including hedging transactions to mitigate price risk and to secure a certain quantity. We will discuss this in Chapter 3.

References Thrurtell, D., Pitts, N., Gibbons, M., Coghlan, J., Philalay, M., Nguyen, T., et al. (2020). Resources and Energy Quarterly (D. Thurtell, Ed.; Vol. 10, Issue 3). Australian Government—Department of Industry, Science, Energy, and Resources. www.industry.gov.au/oce. World Bank Group. (2020a). Commodity Markets. Research & Outlook. https:// www.worldbank.org/en/research/commodity-markets. World Bank Group. (2020b). Commodity Markets Outlook: Implications of COVID-19 for Commodities. In Worldbank (Issue April). https://ope nknowledge.worldbank.org/bitstream/handle/10986/33624/CMO-April2020.pdf?sequence=9&isAllowed=y.

Further Readings Arezki, R., & Matsumoto, A. (2018). Shifting Commodity Markets in a Globalized World. Washington, DC: International Monetary Fund. Bouchentouf, A. (2007). Commodities for Dummies. Hoboken, NJ: Wiley. Trafigura. (2019). Commodities Demystified a Guide to Trading and the Global Supply Chain Second Edition. https://www.commoditiesdemystified.info/ pdf/CommoditiesDemystified-en.pdf.

CHAPTER 2

The Global Supply Chain of Commodities

Abstract In this chapter, I present how the physical global supply chain is structured. The role of commodity traders in matching buyers and sellers from different parts of the globe. How commodities are transformed in space, time, and shape to meet participants’ needs and make a profit and arbitrage opportunities. Then, how international transactions in commodities trading are financed. Keywords Commodity supply chain · Commodity trader · Commodity transformation · Commodity arbitrage · Financing commodity trades

The Structure of the Supply Chain in Global Commodities A well-managed commodity supply chain promotes productivity and economic growth by ensuring the smooth transmission of the raw materials necessary to boost our civilization. The market-based mechanism is an effective way to aligns supply and demand. The global supply chain is highly related to national policies and strategies, nations usually decide the quantities of imports or exports of certain commodities to guarantee the security of supply or to protect national production, and the amount

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_2

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to be stored as a strategic reserve of the country, here are some attributes related to the global supply chain in commodities: • The physical supply chain includes the upstream (production), midstream (transportation), and the downstream (distribution and final client supply): The physical supply chain of commodities represents the core activity for trading businesses. Traders manage the matching between buyers and sellers, transportation, and complex logistics to ensure safe mobility, storage, and the blending of commodities around the globe. • Connected markets: The global supply chain comprises numerous interconnected supply chains thanks to the established traders’ networks and digitalization; the supply is a 24-hour active connecting different continents in real-time data from Tokyo to London then to New York. • Storage enhances market stability: Storage acts as a shock absorber. Given the degree of inelasticity in certain commodities’ supply and demand, storage helps to stabilize the market volatility by absorbing the excess supply and release storage when there is a shortage or extra demand. • Traders and volatility: volatility is a risk embedded almost in all assets, markets function appropriately under the consistent and deep liquidity condition, commodity prices in liquid markets better reflect the commodity fundamentals. Traders are market makers who help create liquid commodity markets by active transactions and thereby lower transaction costs, that’s why traders are more active in volatile markets. Given the vital role of commodities at the global level, ensuring the effective and efficient mobility of commodities across continents is highly important, this is realized through the efficient structure and management of the global supply chain. Different direct players are usually involved in the supply chain when transacting commodities globally1 :

1 In this part, we talk about the direct player in the upstream and the midstream parts of the supply chain.

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• The producers or the suppliers/exporters of the commodity: they are in the first line in contact with the commodity production, they are the big farming companies, big oil extraction companies, and the mining companies. They can be multinational corporations or national ones (either state-owned or private). • The traders of the commodity: traders are usually specialized in one category of commodities such as traders of energy products or metal traders. Commodity traders stay between the buyers and sellers and always do their best to match them to make the market and gain a tiny margin, they can transact for their account to make the market, traders are the vibrant player in the supply chain since they make it, they maintain global networks with other traders, and among all other players in the supply chain especially banks. • The buyers of the commodities or the importers: the buyers are also big national companies or companies transacting on behalf of the state or multinationals engaged in huge transactions, for example, in a liberal market, oil and gas importing nations are doing so either through their state-owned companies or through a special license granted for the private sector. • The transporters: they are global companies specialized in moving commodities from one location to another around the globe; this includes land, air, and sea transportation. Within the same connected geographical area, commodities are transported through land using roads and railroads, while inter-continental movements are done through cargo flights and sea bulk shipment characterized by high volume and low frequency. • The storage facilities: storage facilities can be separate companies or can be owned by producers, importers, or traders. Storage as a mechanism is vital in the global chain as it allows to smooth consumption of seasonal commodities all over the years, it also helps to absorb shocks in demand by releasing the commodity from storage. Rember that electricity as a commodity is yet a non-storable commodity that calls for the crucial role of the transmission system operator to balance the flow and supply and demand on a real-time basis. • The banking system: the banking system is highly important in the process of financing international commodity transactions, it includes the buyer’s banks, the seller’s bank, and the trader’s bank.

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It is essential to secure the transaction payment. In bilateral transactions, buyers and sellers are from far locations and they have no established relationships, to reduce the counterparty risk, the transaction is paid for through the banks, we will see this later in the section on financing global trades. • Insurance companies: insurance works as a risk management tool in global commodity transactions by sharing the risk among the big pool of insured agents. It plays an important role in all phases of the supply chain, producers ensure their facilities and production, transporters protect themselves from adverse events during the transportation by insuring the commodity in transport, the commodity in storage is also insured which makes part of the carrying cost of the commodity. (Fig. 2.1) We can notice an important role of commodity trading companies in managing the whole supply chain, they match buyers and sellers, and they arrange transportation and storage. Traders have significantly leveraged digitalization and big data management in managing the global supply chain. The players in the diagram are the direct ones in the

Fig. 2.1 Global supply chain

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global supply chain, however, there many other indirectly related players such as governments (policies, strategies, and actions), international agencies such as World Trade Organization (WTO), environmental agencies that sets limitations for environmental damage related to the production, consumption and transporting commodities. Supply chain management is the life engine to commodity trading; commodity traders dedicate sufficient efforts in developing risk mitigation plans and strategies. The classical hedging strategy wouldn’t work alone to mitigate the total risk, because, at the end of the day, commodity trading requires moving commodities across the supply chain. Therefore, effective supply chain management is important to maintain sustainable economic performance for trading firms. In this regard, we can divide effective supply chain management into two key activities. One: Enhancing Supply Chain Logistics Connected and synchronized data is an important element for enhancing and optimizing the supply chain. To effectively utilize the supply chain, players in the physical market need to know all related information at the right time, players need to know the status of all commodities in realtime. What commodities in transit and where? How much is available in storage, the storage capacity, and where is stored? Technology, the internet, and smartphones have been providing great leverage for commodity companies and commodity traders. Modern technologies enable real-time shipment tracking, and commodity and inventory balances. In this sense, enterprise-based data systems offer all agents a complete and accurate picture of all commodities in storage or transit. It also enables trading companies to optimize scheduling, blending, transportation, and storage. In recent years, there has been a development in the commodity trading platforms, they enable partners around the world to be connected, exchange commodity-related information, and secure payments. Imagine the owner of a copper mine, with real-time visibility across the supply chain, the owner knows exactly which storage containers have capacity available, which copper ores are ready to be transformed into concentrates, and what orders the owner need to fulfill. With realtime access throughout the whole supply chain, the copper producer can satisfy those orders by matching the suitable transportation method,

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different storage facilities to reduce the transaction cost and assuring higher margins. Two: Effective Management of Supply Chain Disruptions Effective management includes using appropriate techniques to reduce or minimize the disruptions and applying effective measures to reduce their impacts when they occur. In this regard, a real-time data flow is an indispensable tool to reduce either the probability of disruption occurrence or the severity if it happens. Monitoring the commodity supply chain on a real-time basis offers the time to react in case of hazardous events, the faster we know about the hazard, the quicker we react to mitigate it, then the lower is the negative consequence. Real-time data combined with advanced software analytics offer prompt simulated solutions (options) in managing the risk or to avoid the danger, for example; how quick are we in switching the transportation mean or route? Should we keep the commodity in the shipment to avoid the storm? This type of advanced analysis allows commodity business and trader to draw their margins for the reaction against hazardous events and to calculate the tolerable risk translated in economic terms. Additionally, commodity management platforms are used as risk management tools to mitigate the downside risk in the supply chain, players can monitor any disruption occurs so they can act fast to mitigate it. Using advanced analytics and specialized platforms offer simulation options for different disruption scenarios, this also provides a risk mitigation tool in which commodity players can have enough time for preparing possible solutions for different disruption scenarios. Simulation can be applied to changing weather patterns, global politics, fuel prices, and trade wars in real-time and choose the best options to keep the commodity trading profitable. Effective commodity trading requires a well-managed supply chain. Big data and advanced analytics foster supply chain efficiency and help traders maximize their performance.

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Who Is Responsible for the Delivery of the Commodity? Commodities move in all directions on earth with many connection points, thus it’s important to know when to consider the commodity as the property of the buyer, the seller, or the trader? Where is ownership handed over? Who is liable for risk and costs while the goods are in transit? Shipping agreement are international agreements between the contracting parties establish answers to these questions in a legally binding way based on The International Commerce Terms (Incoterms) of CIF and FOB. Cost, Insurance, and Freight (CIF) and Free on Board (FOB) are international shipping agreements used in the transportation of goods between buyers and sellers. They are among the most common of the 12 (Incoterms) established by the International Chamber of Commerce (ICC) in 1936. FOB and CIF both describe overseas shipping agreements that specify whether the buyer or the seller is responsible for the commodity along the transit line. FOB can be classified as origin or destination: FOB origin means that the buyer assumes the title of the commodity at the origin. The moment that the shipper loads the commodity onto the freight carrier, the buyer is responsible for the commodity. FOB destination means that the buyer assumes the title of the commodity at the point of destination and that the exporter is responsible for the commodity while in transit. FOB origin is a much more common form of FOB, where buyers take all responsibility for the commodity the moment it leaves the seller’s area. FOB is usually a cost-effective option for buyers. Buyers don’t have to pay a high fee to their sellers as they might with CIF. Buyers also have more control over the freight timing and cost, because they can choose their freight forwarder. If anything happens to the commodity, they hold the title and responsibility, so they can better access information and solve concerns. Sellers also like FOB because they are not held responsible for the commodity. Once the commodity leaves their stores, sellers consider the sale as “complete” and they don’t worry about any additional costs or problems. On the other hand, in CIF, sellers keep owning the commodity until its destination. This means that the seller is responsible for risk and insurance costs until the commodity reaches the point of destination. Ownership and liability transfers from the seller to the buyer the moment

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Fig. 2.2 FOB and CIF

the commodity is switched to the buyer’s transportation means. In this way, sellers are responsible for everything involved with shipping. They must provide the necessary customs documents for both countries, pay for insurance costs, and are liable for the safe delivery of the commodity. Figure 2.2 shows the possible arrangements for the responsibility of the commodity in transit.

Physical Trading in Commodities Trading is a vital economic activity stimulating physical and financial markets. In this sense, traders can be seen as the invisible hand in the classical economic theory, they allocate resources to their valuable destinations reacting to price signals and market conditions. Physical commodity trading is an OTC negotiation, it brings buyers and sellers together from all over the globe. OTC trading is more appropriate for the physical trading in commodities due to different commodity grades, uses, and locations which allows customizing the bilateral contract, whereas centralized exchanges are suitable for standardized future commodity contracts. For example, the WTI oil contract

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is traded on an organized exchange, it is also standardized in terms of quantity, grade, and the delivery destination in a small town (Cushing) in Oklahoma. Futures contracts are not designed to fulfill the physical needs of the commodity, instead, they are useful instruments for price discovery and hedging price volatilities. Standardization is important in providing a market benchmark; Brent, WTI, and Dubai are three different oil benchmarks around which spot physical oil can be priced either at a premium or discount, according to quality, transport, and location. Future contracts also allow buyers, sellers, and traders of physical oil shipments to hedge the risks and exposures on OTC contracts. Therefore, bilateral OTC contracts allow for customizing the properties in the physical trading that they can’t be achieved through standardized commodity futures. In summary, physical commodity players are usually engaged in parallel transactions, one in OTC bilateral deal for the physical delivery and another hedging position in the futures market corresponding to the same commodity with similar (but not necessarily exact) characteristics. Physical trading is a multidimensional discipline: commodity traders need to perfectly watch over the global tape to understand the interconnected nature of the global economy. Conditions in commodity markets can change rapidly and traders have to remain alert to many micro and macro factors. Economic cycles and the seasonality in commodities, geopolitical developments, technical factors, transportation, storage, cost of financing, and the shape of the commodities future’s curves.

Commodity Transformation Commodity trading businesses are usually involved in three commodity transformation processes, and traders add value by transforming commodities in space, time, and form to make profits (spread). Transformations are considered arbitrage opportunities at the global level with enormous quantities and tiny margins. • Transformation in space: or locational transformation, means transporting commodities from where are produced to the consumption places, traders must gain by moving the commodity from one place to another after paying for the transportation and insurance costs. • Transformation in time: or temporal transformation, moving the commodity from the present to the future through storage, traders also gain by storing the commodity and sell it at a higher future

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price after deducting the cost of carry (storage and insurance costs), e.g., when supply exceeds demand, the commodity is stored until equilibrium is restored (storage reduce volatility by smoothing fluctuations). • Transformation in form: commodities are basic products extracted from nature, they are similar but are not exactly the same, sometimes traders perform an industrial process to blend or mix different grades to create a newly transformed commodity, e.g., extracted copper is transformed into copper concentrates to increase the copper concentration to meet certain demand then is blended to further upgrade it. Transformation is also performed to petroleum products such as blending different grades of gasoline or the removal of Sulphur to create sweeter oil. Also, in this case, traders gain from transformation because the price of the transformed commodity is higher than the price of the untransformed one to cover blending cost. For example, oil is usually classified as sweet or sour based on the Sulphur content (low or high), and heavy or light based on API gravity2 , therefore, processes from separation to purification are performed to get a better oil to meet customer needs. As for copper, initial processes are performed at or near the mine, the copper ore contains a very low concentration of copper, then concentration is done at the mine to create concentrates with higher copper content, afterwards, copper continues to be subject to treatment to upgrade the quality to pure copper to be finally used to make electric wires, laptops, etc (Fig 2.3).

How Arbitrage in Physical Commodities Works Arbitrage is profiting from price discrepancy in spaces, times, and forms due to mispricing related to market inefficiencies. Space arbitrage is the purchase and sale of a commodity to profit from a difference in the commodity’s price between markets. Arbitrage is a legal activity and it enhances market efficiency by promoting price discovery through liquidity. Traders take the opportunity, fill the gap, and make profits. 2 The American Petroleum Institute gravity, or API gravity, is a measure of how heavy or light a petroleum liquid is compared to water: if its API gravity is greater than 10, it is lighter and floats on water; if less than 10, it is heavier and sinks.

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Fig. 2.3 Copper transformation

Now let’s demonstrate the following simplified examples of how arbitrage opportunities in global commodities occur: Locational arbitrage: price differences of the same commodity in different markets, traders move the commodity from production locations (where they are valued at a lower price) to the consumption locations (where they are valued at higher prices). In a no-arbitrage situation (equilibrium), take bushels of soybean as an example: price in market 2 = price in market 1 + transportation cost Imagine that P1 = $10, P2 = $12, and transportation cost = $1, commodity traders buy soybean bushels from market 1@$10, pay $1 for transportation cost, and sell them in market 2@$12 making $1 risk-free profit3 . Temporal arbitrage: mispricing of the same commodity between the present/spot and the future, traders move the commodity from the present to the future consumption through storage. In a no-arbitrage situation: Future price4 = Spot price + cost of carry (carrying cost is the cost related to storing commodities for future dates). 3 We say free profit because prices after transportation, storage, or transformation are agreed upon previously in bilateral contracts, so that the future payoff from the transaction is guaranteed (certainty-equivalent cash flow). 4 Here we are presenting a simplified example ignoring the opportunity cost (risk-free) and the convenience yield, we assume they cancel out but later we show more details on this issue.

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Imagine the same soybean bushel, SP = $10, FP = $12, cost of carry = $1, in this case, it is convenient for traders to buy spot@$10, store it for $1, then sell future@$12 making $1 risk-free profit. • Quality/form arbitrage: an opportunity arises from the price differences between the transformed and the untransformed commodity. In some situations, traders need to transform or blend the commodity to upgrade the quality and to meet certain demand needs. In an equilibrium situation, Blended price (BP) = unblended price (UBP) + blending cost Imagine the copper ores that need to be transformed in concentrates to upgrade the quality, BP = $50, UBP = $30, blending cost = $15, trader buy the copper ores@$30, transform them incurring $15 then sell copper concentrates @$50, making $5 free profit. Commodity traders add value to the commodity transaction through cost efficiency using excellent logistics, risk management using hedging, insurance, and other risk management tools, and finally, through commodity transformation in space, time, and form. Now, let’s present the following example in which the three types of arbitrage are executed. The trade flow is as follows: 1. The trader buys copper concentrates with an offtake agreement from an Australian mine. 2. The trader arranged to deliver copper concentrates to an Italian smelter in two months. 3. The trader also agreed to deliver copper concentrates to a Chinese smelter in nine months. (Fig. 2.4)

How Arbitrage Eliminates Arbitrage Arbitrage opportunities usually emerge from the following market conditions which in themselves help to eliminate the created arbitrage opportunity. Unequal Information: Assets are valued based on the relevant information available to the participants in various markets, participants usually receive different information and thus value the asset differently. This is much less common in modern trading than it once was. Communications’

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Fig. 2.4 Arbitrage opportunities

technology has created an instant global network of publicly available information and price changes in an asset are communicated around the world immediately. Inefficient Markets: “Inefficiency” is when the market price doesn’t incorporate all relevant asset information. This can be due to unequal information, speculation, political conditions, and much more. Uncertain Valuation: In some cases, markets spread the information efficiently but still prices for the same asset are not equal. This often happens when there is no common agreement on the value among traders. Detecting the arbitrage opportunities in less efficient markets is a core function of commodity traders in which they capitalize on the differences between commodity values in different markets, different times, and different forms. They react to price signals to move the commodity to where it is valued. By doing so, they reduce the market mispricing and help price discovery, and they make markets more competitive in exchange for a profit. Arbitrage depends on exploiting pricing anomalies, but practicing arbitrage causes the anomalies to disappear, HOW? • Arbitrage: traders buy the commodity where it is underpriced and sell it where it is overpriced making a risk-free profit when the prices in both locations are agreed on (fixed in a forward bilateral contract). • The transaction pushes the demand for the commodity in the first market, this action drives prices up.

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• The second market experiences an increase in the commodity supply which drives prices down so that prices in both markets are converging. • The implications of arbitrage overtime on the market fundamentals move the two markets into a new balance and the anomalies disappear. • More arbitrage leads to price discovery and increases market transparency by limiting anomalies and makes markets more efficient.

Financing Commodity Trading Merchandise trade, i.e., exports and imports of commodities is the oldest international business and bears a certain degree of risk. Trade of physical commodities is executed through bilateral contacts between importers and exporters. One concern to the exporter is the risk of non-payment by the importer of the commodity. The importer is also concerned about the risk that the exporter may not ship the commodity that has been paid for. One way to reduce or even eliminate this counterparty risk in global commodity trades is by involving intermediaries to guarantee the process and work on behalf of both parties. Banks act as intermediaries to ensure that the exporter gets paid while the importer receives the commodity. Although banks also finance domestic commercial transactions, their role in financing global commodity trade is more extensive due to the additional complications involved. First, the exporter might question the importer’s ability to make payment. Second, even if the importer is creditworthy, its government might impose exchange controls that prevent payment to the exporter. Third, the importer might not trust the exporter to ship the commodity ordered. Fourth, even if the exporter does ship the commodity, trade barriers or time lags in international transportation might delay arrival time. Financial managers of global commodity firms must recognize methods to use to finance international trades so that their companies can export or import in a way that maximizes the value of their companies. In other cases where commodity traders are involved, they stay between importers and exporters and they can add more credibility to the global commodity transaction. Anyway, traders have also to execute the trade through their banks by adding another intermediate channel. In this part, we will concentrate on how commodity traders fund huge

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commodity transactions which can generally apply to other cases of financing trades. Commodity trading firms execute huge global transactions. Traders’ activities require substantial capital resources for processing, storing, and transporting commodities around the globe. They may invest in all parts of the global supply chain. Therefore, financing models need to fit the trader’s activities. Diversification of financing sources among regions with different scheduled payments would enhance trader’s large and long-term activities. The inventory of commodities serves as collateral for shortterm bank financing. The following financing sources are used by global commodity traders to secure the flow of short-term and long-term funds to guarantee that operations are moving smoothly: • Financing the trade: financing the value of commodity traded (the transaction). • Financing the hedge: there is also a cost related to hedging the transaction and need to be financed. Initial margin and maintenance margin are required by the clearinghouse to keep the hedged position open. • Going public to secure long-term funding. • Securitization: setting up a special purpose vehicle (SPV) to transform long-terms commitments into short-terms inflows. • Selling assets to reduce cash outlay but enforce the control over the supply chain by logistics and networking. Here we describe how each method works: Financing the trade: banks are considered the pillar for financing the commodity transaction. Banks provide short-term credit facilities secured by the commodity in the form of letters of credit, which are made available to the seller. These facilities are self-liquidating in the sense that debt is repaid immediately from the proceeds of the sale of the commodity being financed. Traders rely on short-term secured lending facilities to support their commodity purchasing activities. Figure 2.5 shows the flow of processes by which banks finance global commodity trades. Keep in mind that some commodity transactions are executed directly between importers and exporters through their correspondent banks without involving commodity traders. The diagram is based on a hypothetical oil transaction based on a selling price by the exporter of

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Fig. 2.5 Bank financing for commodity trades

$70/barrel, the trader works as a buyer from the exporter, and a seller to the importer (Fig. 2.5). How it works: This method is used for bilateral trade finance using two important documents as collaterals: 1- The Letter of Credit or known as LCs: a letter issued by the buyer’s bank backing up the buyer by guaranteeing that the bank is willing to cover the cost of the deal on behalf of the buyer. It serves as collateral of payment for the seller, in this case, it helps reduce the counterparty default risk. 2- The Bill of Lading or BL: a document of the ownership of the commodity of the deal. The party that receives the guarantee of payment (LC) releases the BL to the counterparty. It also serves as collateral for both buyers and sellers of the commodity. The flow of processes in Fig. 2.5 are explained as follows: • Step One: the trader as a middle point guarantees the payment of $70/barrel by sending to the exporter the LC issued by the trader’s bank. • Step Two: in exchange for the LC received by the exporter, the exporter sends a copy of the BL to the trader through his bank, giving the trader the title to the barrels of oil in question.

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• Step Three: now the transaction is between the trader and the importer. The importer issues the LC to the trader guaranteeing payment of $71 per barrel. This gives the trader the security that the counterparty is able and willing to pay. The trader presents the BL to the buyer’s bank and gets paid. This process reduces the risk that one party to the transaction is not fulfilling its obligations, the one who pays gets the ownership of the commodity. The trader as a mediator executes the transaction and matches buyers and sellers for a small margin, in this case, the trader bought the barrel at $70 and sold it at $71. Other techniques are also used by commodity traders to finance commodity deals, such as, • Inventory collateral: the trader aggregates all inventory stock of different commodities and uses it to get continuous bank finance. • Repurchase agreements: the trader sells the commodity to the bank and agrees to buy it back after a short time, usually a week, to get bank finance. • Syndicated loans: are used to negotiate a syndicated lending agreement with a group of international banks. Financing the hedge: hedging is an important risk management tool in global commodity transactions, it works as a risk transfer mechanism to protect the value of the commodity transaction. However, hedging has a cost that adds to the total cost of the transaction (similar to the cost of bank finance). After the 2008/2009 global financial crisis, the cost of hedging has been increasing as regulators are imposing more stringent regulations5 on OTC derivative contracts to bring them to more transparent trading arenas. These regulations intend to create more transparent marketplaces and reduce risk-related derivative trading by introducing obligations. These obligations include reporting of all derivative contacts, mandatory centralized clearing of standardized OTC derivatives, risk mitigation

5 We refer to the US Dodd-Frank Act (Pub.L. 111–203) of 2010, and in Europe: MiFiD II (Markets in Financial Instruments Directive: Directive 2014/65/EU) and EMIR (European Markets Infrastructure Regulation: Regulation (EU) No 648/2012).

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techniques for non-centrally cleared derivatives, and enhanced collateral requirements. The imposed obligations have increased the hedging of commercial businesses. Central cleaning is performed by organized exchanges as a way to mitigate the counterparty risk, and the participants have to fulfill two types of financial obligations: 1. Initial margin: is a certain percentage of the transaction value that should be deposited in cash by the market participant in the clearinghouse, it is usually 10% of the value of contract traded. For example; a trader wants to hedge his physical oil position and buys one standard contract of oil future with 1,000 barrels, if the oil price is $70/barrel, then the total contract value is $70,000, so the trader has to deposit $7,000 as an initial margin as a guarantee. 2. Maintenance margin: is the minimum amount of equity balance that a commodity trader must maintain in the margin account after the purchase has been made. The maintenance margin is usually around 70% of the initial margin. The investor may be hit with a margin call if the account equity falls below the maintenance threshold which may require him/her to liquidate the position or satisfy margin requirements. When traders use hedging, they are usually engaged in two transactions, one in the physical commodity (buy or sell) and another in commodity derivatives through financial markets. In a perfect hedge, hedgers should not make a profit because the profit (loss) made in the physical trade is offset by loss (profit) made through the hedging derivative contact in financial markets. The part of hedging and risk management is covered in the next chapter. A perfect hedge in price, quantity, and time is very difficult to attain and the mismatch is a feature of hedged positions, this means that a financing gap exits and traders usually refer to their banks to secure continuous and immediate financing to fill these financing gaps and to fund the initial and maintenance margins. Financing the trade and financing the hedge are both short-term oriented, however, for the continuity of business in commodity trading, trading firms need to secure long-term financing. Going public is an option to access capital markets to guarantee long-term equity funding.

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Global commodity businesses such as large producers (exporters) and large consumers (importers) are publicly traded firms, so they have easier access to capital markets, however, commodity trading firms are usually private partnerships and most of them prefer to keep this legal form of business rather than going public. Another way to secure long-term financing continuity is by Securitization through the Special Purpose Vehicles (SPVs). Securitization Through SPVs A Special Purpose Vehicle (SPV) is a separate legal entity created by an organization. The SPV is a distinct company in terms of asset structure and legal status. Usually, they are created for a specific objective, often which is to isolate financial risk. As it is a separate legal entity, if the parent company goes bankrupt, the special purpose vehicle can carry its obligations. SPVs are designed as a risk-sharing entity using securitization, asset sale, and property sale. Securitization of loans and receivables is a common reason to create an SPV. For example, when issuing mortgage-backed securities from a pool of mortgages, a bank can isolate the loans from its other balance sheet obligations by creating an SPV. The SPV allows investors in the mortgage-backed security to receive payments for these loans before the other debtors of the bank. In the case of commodity trading SPVs, several trading firms set up SPVs that issue long-term bonds backed by trade receivables. Institutional investors acquire these asset-backed securities. SPVs financing works in the following way: the firm receives a payment promise for the future. Instead of waiting that long for the payment, the trading firm sells the invoice immediately to its securitization vehicle. The SPV uses the funds raised from its bond issue to acquire these receivables. The receivables are used to support the bond issue securing a constant line of credit for the trader. In more general terms, other financing methods are used in global commodity transactions such as: 1. Accounts receivable financing: if the exporter needs funds immediately, it may require financing from a bank. In what is referred to as accounts receivable financing, the bank provides a loan to the exporter secured by an assignment of the account receivable. The

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bank’s loan is made to the exporter based on its creditworthiness. In the event the buyer fails to pay the exporter for whatever reason, the exporter is still responsible for repaying the bank. 2. Factoring: When an exporter ships the commodity before receiving payment, the accounts receivable balance increases. Unless the exporter has received a loan from a bank, it is initially financing the transaction and must monitor the collections of receivables. The exporter may consider selling the accounts receivable to a third party, known as a factor. In this case, the exporter transfers the risk of default to the factor and receives immediate financing for the transaction. Factoring is somehow related to the securitization using SPV in which the SPV acts as a factor in buying the receivables then securitize them. 3. Banker’s Acceptance: a banker’s acceptance is a bill of exchange, or time draft, drawn on and accepted by a bank. The accepting bank must pay the holder of the draft at maturity. In the first step, the importer orders the commodity from the exporter. The importer then requests its local bank to issue an L/C on its behalf. The L/C will allow the exporter to draw a time draft on the bank in payment for the exported commodity. The exporter presents the time draft along with shipping documents to its local bank, and the exporter’s bank sends the time draft along with shipping documents to the importer’s bank. The importer’s bank accepts the draft, thereby creating the banker’s acceptance. If the exporter does not want to wait until the specified date to receive payment, it can request that the banker’s acceptance be sold in the money market at discount in exchange for immediate cash. 4. Working Capital Financing: a banker’s acceptance can allow an exporter to receive funds immediately yet allow an importer to delay its payment until a future date. The bank may even provide shortterm loans beyond the banker’s acceptance period. For the importer, the purchase from overseas usually represents the acquisition of inventory. The loan finances the working capital cycle that begins with the purchase of inventory and continues with the sale of the commodity, creation of an account receivable, and cash conversion. 5. Countertrade: the term countertrade represents all types of foreign commodity trade transactions in which the sale of commodities to one country is linked to the purchase or exchange of commodities from that same country. Some types of countertrade, such as barter,

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have existed for thousands of years. Only recently, however, countertrade has gained popularity and importance. The growth in various types of countertrade has been fueled by large balance-of-payment disequilibrium, foreign currency shortages, the debt problems of less developed countries, and stagnant worldwide demand. As a result, many global commodity businesses have encountered countertrade opportunities, particularly in Asia, Latin America, and Eastern Europe. The most common types of countertrade include barter, compensation, and counter purchase. For example, barter is the exchange of commodities between two parties without the use of any currency as a medium of exchange. Most barter arrangements are one-time transactions governed by one contract. An example would be the exchange of 1,000 tons of copper from Chile for a million barrels of oil from Ecuador.

Digitalization and Trade Finance Digitalization and smart payments have been receiving great attention at practical and academic levels. The application of Blockchain technology in the field of Trade Finance has resulted in a whole series of improvements, not only in terms of simplifying existing processes but also regarding the creation of new products, services, and types of transactions. The “Rethinking Trade & Finance” report-published in 2017 by the International Chamber of Commerce Banking Commission-evaluates the current trends and provides forecasts on the future of the global trade finance industry. Trade Finance experts are beginning to embrace new forms of digital technology, such as artificial intelligence, smart contracts, and other solutions that make use of the Blockchain. This distributed ledger technology allows to digitally exchange information relating to Trade Finance transactions, while “smart contracts” can automate payments once all previously agreed conditions have been met. The Internet of Things (IoT) is also destined to play a fundamental role in Trade Finance. In the future, the IoT will be able to provide importers and exporters with real-time information about the conditions of the goods shipped and consequently reduce the risks associated with the trade. The solutions offered by the Blockchain reduce the barriers to entry to the market, offer transparency and security, and ensure that the data is authentic, verifiable, and protected from fraudulent alteration, cancelation, or destruction.

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In conclusion, through the use of the “blockchain,” the Trade Finance mechanisms would become much more efficient in the following aspects: 1. international transactions would take place directly, without the involvement of intermediaries; 2. access to commercial documents in real-time would reduce the time and costs of document and customs checks; 3. transactions would be easily traceable, thus reducing fraudulent activities and making procedures more transparent; 4. complex encryption systems would ensure the authenticity of the transaction data; 5. smart contracts would automate the process, avoiding dependence on banks and the payment of commissions; 6. collaboration between the parties would be enhanced.

Further readings Arezki, R., & Matsumoto, A. (2018). Shifting Commodity Markets in a Globalized World. International Monetary Fund. Bouchentouf, A. (2007). Commodities for Dummies. Wiley Publishing, Inc. International Chamber of Commerce Banking Commission. 2017. 2017 Rethinking Trade & Finance. Paris. https://cdn.iccwbo.org/content/upl oads/sites/3/2017/06/2017-rethinking-trade-finance.pdf (July 9, 2020). Kouladis, Nicholas. 2006. Principles of Law Relating to International Trade Principles of Law Relating to International Trade. Springer US. https://link.spr inger.com/book/10.1007%2F0-387-30699-4 (November 9, 2020). Trafigura. 2019. Commodities Demystified A Guide To Trading And The Global Supply Chain Second Edition. https://www.commoditiesdemystified.info/ pdf/CommoditiesDemystified-en.pdf (July 9, 2020).

CHAPTER 3

Risk Management in Global Commodities

Abstract In this chapter, I present a variety of tools used in managing and mitigating different types of risks in the global commodity business. For example, insurance is a risk-sharing technique that is used to mitigate event and operational risks, diversification is a risk-reduction technique to mitigate strategic, operational, and financial risks, while hedging is a risktransfer technique used to mitigate price and quantity risks. We will see more details on how hedging works using different types of commodity derivatives and the different kinds of markets interacting globally for risk management in commodities. Keywords Risk management · Insurance · Hedging · Diversification · Price risk · Currency risk · Contango · Backwardation

The Concept of Risk In doing business, there is no activity without risk. Modern risk management discipline calls for changing how we look at the business activity, a change from purely economic, financial, and social activity to a risky activity that needs to be managed according to risk management principles. In the past, various business risks had been managed separately and mostly on an ad hoc basis, however, modem Enterprise Risk Management © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_3

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(ERM) advocates a risk management activity coordinated at the corporate level allowing executive managers to have an overview of what types of risk the corporation is facing and the ways to mitigate or treat risks and the continuous reporting and evaluation. All firms are subject to risk from a variety of sources: loss of customers risk, financial risk including the variations of the cost of raw material concerning global commodity prices, loss of personnel risk, strategic risk and competition, cyber and sustainability risks, and endless types of risks a firm might face. Business owners and managers are willing to be compensated with higher required returns to maximize the business value. But as with any other cost, firms should manage risks appropriately to reduce the downside effect of risk on the value of the firm. In this sense, global commodity firms are not an exception, rather, they face a wider range of risks with greater magnitude. Commodity prices fluctuation is one of the major risks for both producers and consumers of the commodity, quantity risk as a guarantee for the security of supply, logistics risk during the shipment and the storage, weather and catastrophic risks, and geopolitical risk since commodity firms are multinationals operating in different countries. Geopolitical issues are highly considered in the global commodity business since most of the global commodities are produced in developing or underdeveloped countries where economic and political instabilities are persistent. Imagine the gold, diamond, and uranium mines in Africa, the oil in Iran, Iraq, and Venezuela, and so many other similar commodities originated from unstable places. The definition of risk has appeared in many places and originated from different sources. But, the two main features or elements of risk that are common in all definitions; the uncertainty (probability of occurrence), and the effect (magnitude of loss). Other attributes of risk are the downside (negative) and upside (positive) effects, for example, getting better or worse than the expected is considered a risk. In this sense, we can distinguish between risk and danger, the danger is always associated with negative consequences as the high voltage zone and the danger of rockfalls, while the risk is associated with positive and negative effects. Consequently, assuming an acceptable level of risk should be compensated with a higher possible outcome (this is the making-business activity). As we have seen earlier, risk is characterized or defined by two metrics, the probability, and the consequence, in different situations, we use the

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term risk as a general term to refer to different combinations of knowledge about the probability and the consequence. However, technically, as shown in the following risk matrix, the technical term is different according to different combinations. As shown in Fig. 3.1, the issue is not in the value of the consequence (high or low) or the probability (high or low), the issue is embedded in our knowledge about the probability and the consequence, the matrix shows four situations:

Fig. 3.1 Risk matrix in commodities

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• Risk: the simplest combination in which we have no problem to quantify both the consequence and the probability, for example, a shipment technical malfunction. • Uncertainty: uncertainty is different from risk in terms of the knowledge about the probability. When it’s harder to estimate the probability while we know more about the consequence, here we face an uncertain situation, for example, earthquakes that might destroy oil fields or gold mines. • Ambiguity is the opposite side of uncertainty in which there no problem in finding the probability, but we are unable to quantify the loss, for example, nuclear disasters. • Ignorance is when we are unable to be aware of both probability and outcome, for example, the GMOs1 20 years ago in agricultural products, or the environmental consequences of certain commodity activities. It is crucial to classify the risks the company is facing according to this matrix because every situation has different techniques for mitigation.

Risk Tolerance and Analysis As an early step in risk management, drawing the risk tolerance is important in drawing the border lines or the threshold for accepting or rejecting risks. Usually, risk tolerance is drawn according to corporate broad goals, for example, an aggressive global commodity company is willing to expand its global share can accept risky projects and business relations expecting a higher return on investment, so, they can invest in risky and unstable countries. Whereas, a conservative company accepts lowrisk investments and business relationships expecting a low return on investment. In this manner, each company stabilizes its broad lines for risk. After that, the risks that fall within the risk tolerance are registered and analyzed, the analysis or the assessment is an important phase in risk management to assign priorities for various risks, risk prioritization is essential in showing which risks to be treated or mitigated first. 1 Genetically Modified Objects: a theme was hot until almost 10 years ago when research and technologies have advanced in showing the impacts of GMOs and prohibit them in many countries.

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Fig. 3.2 Impact analysis

Now, how risks are analyzed? remember the two main risk parameters, the probability and the outcome or consequence, risk analysts use qualitative, semi-qualitative, or quantitative analysis to assign the appropriate scale or magnitude for risk. One of the important tools for prioritizing risks is the impact analysis matrix.2 It shows the location of different events on a map according to the impact and the event probability, Fig. 3.2 shows how it works.

2 In other contexts, similar tools are used such as the radar or the heat map locating events and assigning different signals for the event importance.

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The likelihood and the consequence are usually firm and sector-specific values, the likelihood situations are classified according to how many times a certain event may occur. The consequence is based on the value of the risk category, for example, economic losses are measured in monetary values, human losses are measured in lives lost or injured, regulatory risk is measured in the time of non-compliance, and a cyber risk can be classified by the number of attacks the firm experience. The matrix is divided into three parts: • The upper right zone where adverse risks are intolerable and risk reduction measures are essential at whatever cost, so, in that zone cost–benefit analysis is less relevant. For example, an oil spill by major oil companies has to be treated immediately without looking at costs because it can be considered a disaster and is directly linked to human and environmental safety. • The probable zone where costs and benefits are taken into account and opportunities are balanced against potential adverse consequences, for example, a risk manager is not willing to pay $10 million to mitigate risk with a potential loss of $5 million. • The lower left zone where positive or negative risks are negligible, or the costs associated with implementing treatment actions outweigh the costs of the impact of the risk, should it occur and treated expost. In the same regard, besides the event probability and the outcome, a third element can be introduced in the risk analysis and valuation process, it is the probability of detection—it measures the firm’s ability to early detect the risk or the danger—, and the earlier we are able detect, the easier would be the risk mitigation. Global commodity businesses utilize sophisticated software and data management techniques on real-time basis allowing the early detection of the danger so that they can activate mitigation options.

Risk Categories There is no risk-free business, both domestic and global corporations face risks but with different exposures and different risk categories. Globalization is considered an attribute of any business rather than a strict

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classification of businesses as domestic or global. The following matrix presents the major categories of risk and the different risks included in each category (Table 3.1). Financial and operational risks are the classical and most common categories of risks, however, with the evolution of the risk management discipline and the emergence of the Enterprise Risk Management, other categories of risk have also become a priority at the corporate level. Regarding the global commodity context, currency, commodity price, contract, catastrophic, supply chain and logistics, and environmental risk, are among the most relevant risks that need to be managed and treated properly to reduce the risk impact and maximize the firm’s value. Risk managers in global commodity firms use different risk mitigation approaches and tools: 1. Risk acceptance: when the risk falls within the tolerance margins of the firm and the risk has no significant consequence on the firm’s value and reputation. Table 3.1 Risk categories

Financial risk

Operational and hazard

Strategic risk

Currency exchange Credit and default Debt covenants

Contract performance Customer satisfaction

Competition

Injury and catastrophic

Reputation

Commodity price

R&D Resource

Supply chains

HR risk

Environment risk

Technology risk

Personnel loss

Wars

Turnovers

Political stability

Stock ownership

Sustainability

New technologies Security and cyber Infrastructure adequacy

Regulatory

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2. Risk avoidance: applied for hazardous and catastrophic events that the firm might face; it can be done by using effective measures such as changing the route of the commodity shipment to avoid marine natural events or pirates. 3. Risk transfer: finding someone willing to bear the risk you are willing to transfer; this is usually achievable when markets are heterogeneous and market players have different expectations. Two main tools are used to transfer the risk, hedging using commodity derivatives, and product or service outsourcing. (Later, we will discuss hedging more in detail.) 4. Risk reduction: by reducing the severity and/or the probability of occurrence. This is achieved through assuming effective measures as mentioned earlier, using diversification of business activities within different markets to eliminate the specific risk of a single market, for example, big electricity generation companies and aviation companies diversity their oil and gas sources with different long-term bilateral supply contracts to mitigate the interruption of the supply line. In general terms, the primary method of risk management is prevention. Commodity firms can avoid or at least reduce many potential downside effects of risk by increasing safety standards at the workplace by making prudent investment decisions, and by conducting appropriate due diligence when entering into long-term bilateral business relationships. But some risks are too costly to prevent and are inevitable consequences of running a business. The financing side of the balance sheet of the firm is the channel through which business risks are shared and born by equity and debt holders. Both types of investors can reduce their risk by holding the firm’s securities in a well-diversified portfolio in which they can reduce or eliminate the firm’s specific risk. However, not all risks need to be passed on to the investors. Insurance and financial markets allow firms to trade risk and shield their investors from some types of risk. For example, the loss from fire in the business facility is covered by the insurance company, the insurer covers the direct physical losses and the indirect loss of opportunities. In this case, much of the loss from the fire was thus borne by the insurer rather than by corporate investors. In 2008, Southwest Airlines received $1.3 billion from financial contracts that compensated it for the rise in the cost of

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jet fuel. In July 2015, Cisco held contracts to protect nearly $3.5 billion worth of projected foreign revenues from fluctuations in exchange rates, and General Electric held contracts, with a total market value exceeding $5 billion, designed to reduce its exposure to interest rate fluctuations.

Managing Risks in Global Commodities Risk management is a core competence for global commodity businesses and traders. They produce, store, and transport physical assets across the globe and earn little margins on high-value, high-volume transactions. Global commodity firms use sophisticated risk management techniques to manage operations and match financial inflow and outflows in volatile markets. In this section, we will focus on three techniques mainly used to manage risks in the global commodity business; diversification and integration, insurance, and hedging.

Diversification and Integration to Reduce Risk Global commodity companies handle a variety of operations across the supply chain adopting effective management and intensive logistics. Diversification of global operations reduces country-specific or transaction-specific risks. Diversification does not totally eliminate all related risks even though it offers partial price hedge through which price effects in different markets cancel out creating a normalized price. Integration means owning or controlling the supply chain, mainly storage to reduce risks of volatile supply and demand, commodity businesses and traders, in many cases, are vertically integrated and they own other businesses in the supply chain. For example, in 2005 Japanese tire maker Bridgestone purchased a large Indonesian rubber plantation to control its costs. As the price of rubber increases, so will the profits of the rubber plantation, offsetting the higher costs of making tires. Similarly, airlines could offset their oil price risk by merging with an oil company. Controlling the operation over the entire supply chain (integrated operation) offers another natural hedge for business activities. For instance, controlling the storage facility would absorb any decline in the final demand of the commodity, therefore, the loss from the lost demand for commodity consumption is offset by the increased demand for storage. In

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the same context, the surge in the demand for the storage facility offsets the decline in the demand for shipping the commodity. A related strategy is the long-term storage of inventory. A national electricity generation company is concerned about the rising oil price, could purchase a large quantity of oil today, and store the fuel until is needed. By doing so, the firm locks in its cost for oil at today’s price plus storage costs. For many commodities, storage is expensive or sometimes unavailable. Storage requires also large amounts of cash for the commodity purchased and for the storage and insurance. Finally, maintaining large amounts of inventory would dramatically increase working capital requirements which are considered an additional corporate cost. However, the strategy of diversification and integration work well to eliminate the specific risk but they are less optimal where the systematic risk is dominant. For example, the 2008/2009 financial crisis and the lower demand from China had affected commodity businesses, in this case, hedging could integrate other risk management tools for mitigating such risks. It is also worth noting that integration is less frequent at the global level for two considerations: one is a regulatory aspect in which many countries prohibit the vertical integration and the anti-trust authorities try to break-down vertical ownerships to reduce any potential market abuse due to the market power, second is a cost issue, owning intermediate processes such as shipment and storage incur huge cost especially for commodity traders who have limited capital. Therefore, the way to deal with those issues is to enter long-term partnerships that, sometimes, gives the right to control the facility without owning it.

Insurance for Risk-Sharing Insurance is a risk-sharing technique, it works according to the “law of large numbers ”; a large pool of insured persons or entities reduces the share of risk each insured bears and consequently reduces the insurance premium. Insurance activity is considered the oldest form of nondepository financial institutions. It appeared to be practiced by Chinese and Babylonian traders dated back to 3000 and 2000 BC, respectively. Chinese merchants traveling across dangerous waterfalls would redistribute the commodities across many shipments to minimize the potential loss from a single vessel’s damage. After that, the Babylonians are regarded as the developers of an insurance system that was incorporated in the Code of Hammurabi in 1750 BC and then was spread

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and practiced by early Mediterranean sailing merchants. Their insurance mechanism states that the lender guarantees the safety of the shipment in exchange for additional charges over the initial loan paid by the merchant (borrower). In global commodities, insurance is used to mitigate operational and hazardous risks emerging from producing, transporting, and storing the commodity. Common types of insurance are used for different purposes such as: • Property insurance is used to protect the physical facility and the commodity in transition and storage against hazardous events. • Business liability insurance covers the third party any damage caused by the business, for example, an oil spill damages private and public property, oil companies are insured against such events. • Business interruption insurance when a fire hits oil fields or earthquake hits a gold mine, the business loses the income due to interruptions. Businesses are also insured against such events. Example: Consider an oil company insuring its oil field/refinery, experts and calculations provide that there is a 1 over 10,000, or 0.01%, the chance of being destroyed by a fire in the next year. If it is destroyed, the firm estimates that it will lose $300 million in rebuilding costs and lost business. We can calculate the expected loss as the product of (probability and outcome) for each scenario (fire and no-fire) • No-fire scenario: 99.99% × $0 damage = $0 • Fire scenario: 0.01% × $300 million = $30,000 Given this probability distribution, the firm’s expected loss from the fire each year is     99.99% × $0 + 0.01% × $300 million = $30, 000 The firm would follow any strategy to mitigate such risk at a cost lower or at least equal to the expected loss. In this case, an insurance premium of $30,000 is an optimal solution to get full coverage of the oil facility. Premium estimation: insurance is estimated to incorporate the related risks and the time value of money. Risks can be purely firm-specific (not systematic risk), purely systematic risk, or a mix. Specific risk such as a fire

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in an oil field, whereas an earthquake is considered a systematic risk that affects everyone. The insurance premium can be determined according to the following formula: Pr emium =

Pr obabilit y × maximium damage payment 1 + Kc

Probability and damage payment are the two elements of loss, and 1 + Kc is the discount factor that reflects the time value of money since the premium is paid on annual basis, but if an insured is paying more than a year in advance, this could be reflected in the discount factor dividing by (1 + K c)2 . Let’s take our previous fire example, where the fire is specific (means its correlation with the market is zero, beta = 0), in this case, the discount rate is the risk-free rate, Kc = Rf = 3%: Pr em. =

0.01% × 300 = $29, 126 1 + 3%

$29,126 is the annual insurance premium paid by the oil company to the insurance company incorporating the risk and the time value of money. Theoretically, with fair insurance pricing, no one can benefit from insurance and should be a zero-sum game in which the value (cost) that the oil company could have paid to mitigate the fire by itself has been transmitted to the insurance company resulting in a zero net value for the oil company. Now imagine another example where the risk is not firm-specific such as earthquakes, when an earthquake happens it systematically affects everyone, so that its outcome is related to the market with a beta coefficient = 2, in this case, a risk premium is added to the Rf to reflect the systematic component of the risk. One way to estimate the cost of capital is by the CAPM (Capital Asset Pricing Model) in which the cost of capital equals the risk-free rate plus a risk premium that incorporates how the event outcome is related to the market: K c = R f + B(Rm − R f ) where B is the measure of market risk, Rm is the market return. If the market return is 10%, Rf = 3% and beta = 2, Kc equals: K c = 3% + 2(10% − 3% ) = 17%

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So that the new insurance premium is: Pr em. =

0.01% × 300 = $25, 641 1 + 17%

The coefficient 1 + 17% reflects the time value of one year and the different types of risk embedded in this kind of event. So, $25,641 is also a fair insurance price given the systemic feature of this risk. In reality, insurance markets are not perfect, frictions such as moral hazards and adverse selection are classical insurance frictions. The insured tries to benefit from insurance by hiding relevant information from the insurer or causing intentional damage to his property to collect the insurance coverage. However, the insurer is aware of those issues and specific articles are introduced to the insurance policy to minimize the probability of such fictions. The insurer introduces the deductible that represents the portion of the loss to be borne by the insured, and policy limits that represent the upper limit that the insurance company would pay regardless of the calculated damage. So far, we have seen how commodity businesses manage and mitigate operational and hazardous risks using integration, diversification, and insurance, in the following section, we will see how financial risks in global commodity business are managed, in particular, the commodity price risk.

Commodity Price Risk (Flat Risk) For many firms, especially large producers and consumers of commodities and commodity traders, changes in the market prices of the raw materials they use and the goods they produce may be the most important source of risk against their profitability. For example, an oil trader suffers huge losses when the price of the oil benchmark falls if it is in a net long position. The year 2020 has been experiencing such price plummets due to the COVID-19 pandemic causing huge losses for oil and other commodity businesses. The airline industry and electricity generation companies suffer huge losses from the increase in energy prices especially when the input price is not linked to the revenues (no passthrough or natural hedge). In some cases, companies enjoy a degree of a natural hedge when the cost of inputs such as oil is linked to the sale price, in this case, companies can avoid hedging costs by choosing not to exercise hedging strategies. In this section, we discuss the ways firms use to reduce or hedge their exposure to commodity price risk.

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Price Hedging with Long-Term Bilateral Contacts Remember what we have mentioned earlier about buying the commodity and storing it and the critical issues related to this approach. Instead, commodity players may use long-term bilateral contracts fixing the price of the commodity today for future delivery. Power generators sign bilateral supply contracts with oil and gas companies. Such contracts are used to fix prices and thus stabilize or normalize the profits of both parties. This is what we refer to as hedging: Hedging works to reduce risk exposures to price fluctuations so that both parties to the contract agree on a fixed price at the present. Hedging, in this case, works as a risk transfer instrument in which both parties sign the contract expecting to transfer the risk to the counterparty according to the expectations, for instance, both parties agree on e25/MWh of natural gas, the buyer (power generator) does so expecting gas prices to rise, while the seller does the same expecting prices to fall. Let’s take the following simple illustrative case: Spot price of gas TTF3 = e20/MWh, a big power generation firm wants 1000 MWh in 3 months and wants to lock in a price now expecting the gas price benchmark to rise (the firm wants to fix a forward price 3 months from now with 3 months actual delivery). Now, what are the possible options for the power generation firm: One: buy the gas now at low price (e20) and store it for 3 months: but we have said earlier that finance is not always available, or the storage facility is not under control. Two: enter in a deal with the supplier fixing a future price at e25/MWh, both parties agreed on this price reflecting the future equilibrium price which incorporates the storage cost and the heterogeneous expectations of both parties. Now imagine the following future scenarios: Case 1: After 3 months: the spot price is e30/MWh: for the buyer, the contract is worth $5/MWh because the market price is e30 while the firm is buying at e25. The consequences of this case: the buyer executes the contract by asking the supplier to transport the gas at e25 saving e5/MWh.

3 TTF is the Netherlands’ Title Transfer Facility, Europe’s most liquid virtual gas trading point.

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Or, the buyer buys from the market at $30 and the supplier pays the difference of e5/MWh: this type of forward contract is called Non-Deliverable Forwards (NDFs). Or the generation firm buys from the market at e30 and sells the contract which is worth e5/MWh to somebody else (assuming for simplicity that this type of contact is marketable). In all cases, both the buyer and the seller guaranteed a fixed future price of e25. The opposite happens if the spot price after 3 months is less than the price agreed on, let’s say e20/MWh, the buyer pays e25 to the seller, or buys from the market at e20 and pays e5 difference to the seller (NDF contract). In all cases, both parties mitigated the commodity price fluctuation by entering a bilateral supply contract. This type of deal is called a bilateral Forward contract for hedging price risk. It is worth noting that, bilateral contracts are also important for quantity hedge and the security of supply, buyers can customize the exact quantity of the commodity to be delivered guaranteeing both price and quantity. However, forward contracts are not standardized, they are not exchange-traded, and the counterparty risk exists since the contract is not centrally cleared. Figure 3.3 demonstrates how hedging using bilateral contacts helps to smooth earnings so that it would become easier for financial managers to project cash flows and design their budget with fewer variations. The firm is not worried about any fluctuation in the gas price. The forward supply contracts are bilateral contracts negotiated between the buyer and the seller; however, certain limitations and drawbacks are associated with long-term bilateral supply contracts: • First: the counterparty risk, they expose each party to the risk that the other party may default and fail to live up to the terms of the contract. Thus, while they insulate the firms from commodity price risk, they expose them to credit risk. • Second, such contracts cannot be stipulated anonymously; the buyer and seller know each other’s identity. This lack of anonymity may have strategic disadvantages. In certain times, commodity traders are positioned in the middle to facilitate the transaction for a commission, which adds to the total cost of the trade. • Finally: no trading market, the market value of the contract at any point in time may not be easy to determine, making it difficult to

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Fig. 3.3 Hedging effect with bilateral contacts

track gains and losses, and it may be difficult or even impossible to cancel the contract if necessary. Bilateral contracts are also used to secure the supply of the physical commodity besides guaranteeing a fixed price. Forward contracts reduce price risk only if both parties to the arrangement live up to their end of the agreement. In other words, there is no protection against default. As you can imagine, a farmer who locks in a price to sell his crop in the spring through a forward contract and later discovers that he can sell the product for considerably more in the open market might choose to default on the forward contract. Historically, the default issue started with the exchange of agricultural commodities. To resolve the issue of merchants and farmers defaulting on forward contracts, the exchanges began requiring that each party of the transaction submit a good-faith deposit, or margin, with an unre-

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lated third party. In the case of failure to comply with the contract, the party suffering the loss would receive the funds deposited in good faith to cover the inconvenience and at least part of the financial loss. Therefore, forward trading has been developed to reach the form of standardized futures contracts which will be covered in the next section. Commodity Future Contacts Given the limitations in the forward bilateral trading, players in the global commodity markets refer to financial markets trading commodity financial derivatives (futures) to hedge commodity price risk. A commodity future contract is a standardized derivative contract for the future delivery of the commodity at a certain price agreed upon today called “future price.” It is called derivative because it derives its price from the spot price of the underlying physical commodity. Commodity futures contracts are considered financial contracts and are traded on financial markets and regulated by financial authorities. Futures contracts are exchange-traded on an anonymous basis, they are liquid contracts, thus, prices are transparent and usually reflect commodity fundamentals. The market mechanism offers flexible trading and exit points for both buyers and sellers in which they can exit their positions in the contract at any point by selling it to another trader at the prevailing market price. Finally, the design and the nature of the contract allow to eliminate both price and default risks and to separate the commodity physical position from its financial position. The standardization was a great development to derivatives trading. In its simplest form, a futures contract is a forward contract that is standardized in terms of size, the deliverable grade of the commodity, delivery date, and delivery location. The standardization made the trading of futures much more convenient than attempting to negotiate a forward contract with an individual. The concept of standardization has allowed the futures markets to flourish into what they have become today. Although the commodity futures contracts traded represent an obligation to take or make delivery, more than 90% of futures contracts are not physically settled. Instead, traders simply offset their holding before the expiration date. This is because the rationale behind the futures market is to offer an open and transparent arena for hedging the physical positions. However, the delivery clause is always added to the contract to give

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stronger incentives to both parties to behave well and fulfill their obligations to the contract. For example, the physical delivery of WTI oil futures is in a small town in the Texas area, in case the buyer or the seller tries to violate the terms of the contract, the exchange might require the physical delivery of the oil in that remote town. The commodities contracts traded on global exchanges are derivatives, mostly futures since it is the most liquid commodity derivative, commodity futures contracts can appear in codes. Each futures market is identified by a ticker symbol followed by codes for the contract month and the year. For example, crude oil futures have a ticker symbol—CL. The full ticker symbol for December 2019 Crude Oil Futures would be— CLZ9. Gold has a ticker symbol—GC and the full ticker symbol for June 2019 Gold would be GCM9, M and Z represent the expiration month, and 9 represents the year of contract expiration—2019 in this case. Due to the standardization of each contract and the marketability, the convenience trading systems, and a lack of default risk, futures trading has attracted price speculation. Participation is no longer limited to those who own or would like to own the underlying physical commodity. Instead, unrelated third parties, such as financial institutions, can easily be involved and trade commodity futures aiming to make profits due to price fluctuations.4 Physical and Future Markets of Commodities Under the current commodity trading system, two parallel commodity markets exist, they are highly associated and they work in tandem; the physical market (the cash or the spot market) where the physical commodity is traded and delivered, and the commodity futures market (the derivative or the market for financial commodities) where the commodity financial derivatives, such as futures, are traded. Now, how the two markets are related? Remember the time arbitrage in chapter two (ignoring the opportunity cost of financing at this stage and the convenience yield), we can construct the following relationship: f utur e price = spot price + cost o f carr y

4 This is part of what is called “financialization of commodity markets” that will be covered in the next chapter.

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Now, let’s consider the accurate relationship between future and spot prices where we take into consideration the cost of financing and the convenience yield: F P = S P(1 + R f + SC − CY ) where FP is the future price, SP is the sport price, Rf is the risk-free rate, SC is the storage cost, and CY is the convenience yield. The rationale behind this is that the difference between buying commodities today and buying commodity futures is more complicated. First, because payment is again delayed, the buyer of the future earns interest on the money. Second, he/she does not need to store the commodities and, therefore, saves warehouse costs, wastage, and so on. On the other hand, the futures contract gives no convenience yield,5 which is the value of owning the real commodity, it is the benefit or premium associated with crying out the underlying physical, rather than holding the future contract. It’s interesting to compare this formula with the formula for the futures of financial products. Convenience yield plays the same role as dividends or interest foregone (y) on securities. But financial assets cost nothing to store, and storage costs do not appear in the formula for financial futures. Usually, we can’t observe storage cost or convenience yield, but you can infer the difference between them by comparing spot and futures prices. This difference, convenience yield less storage cost, is called net convenience yield (NCY) (net convenience yield = convenience yield − storage costs). Let’s take this example: let’s say that a trader wishes to calculate the net convenience yield of West Texas Intermediate (WTI) oil with a one-year delivery time. The annual cost of financing is 3%, the spot price of WTI is $30.50/barrel and the one-year futures price is $37.50/barrel. Applying the spot-future equilibrium formula, we get 37.5 = 30.5(1 + 3% − N CY ) Net CY = −19.95%, this means that evidently, the cost of holding crude oil inventories was greater than the convenience yield provided by those inventories. 5 A convenience yield is an implied return on holding inventories. It is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints.

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If the interest rate is continuously compounding, the following formula is applied: F = S.e(r −ncy)T   37.5 1 .(ln( )) N CY = 3% − T 30.5 N CY = −17.7% In some particular cases where the commodity is not storable, such as electricity, the link between the spot price and the futures price is evident through the storage cost, so that the net convenience yield is ignored, and large electricity generators and consumers use consensus and forecast analysis about the future growth and prices of electricity generation mix (oil, coal, and gas). In normal market conditions, the future price of the commodity is higher than the spot price reflecting the cost of carry, this referred to as “normal future curve.” However, in some situations markets are seen to be inverted in which futures commodity prices are less than the spot or nearer futures contracts, this is called “inverted future curve,” this can be due to the expectation of lower future demand or other speculative factors. Normal and inverted future curves are shown in the following Fig. 3.4. It is worth noting that many refer to contango and backwardation as the same concept of normal and inverted curves, but they are two different concepts. • Contango is when the expected spot price falls below the future price for the same maturity. A contango market is often confused with a normal futures curve. Thanks to spot-future convergence, contango implies futures prices are falling over time as new information aligns the future price to the expected spot price. • Normal backwardation is contrary to contango, it is when the futures price falls below the expected spot price of the commodity. A backwardation situation is often confused with an inverted futures curve. This situation creates possible speculative opportunities (or arbitrage depending on how certain we are) in which speculators buy the futures contract now and sells it at a future date when the

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FUT URE PRICE S AT DIFFE RE NT MAT URIT IE S

OIL PRICE

Normal

Inverted

80 70 60 50 40 30 20 10 0 NOW

1-MONTH

3-MONTH

9-MONTH

12-MONTH

MATURITY

Fig. 3.4 Normal and inverted future curves

price has already converged to the spot, which means a higher price (given the backwardation curve). So, normal backwardation is when the futures prices are increasing. Contango and backwardation curves are demonstrated in the Fig. 3.5. Why would the future curve take a certain shape? Normal or invested: the answer depends mainly on commodity fundamentals, recall the formula relating future and spot prices, fundamentals like storage cost, financing cost, and the convenience yield, they inform the supply and demand. The market is in equilibrium when participants are willing to have a common agreement on the expected spot price. The consensus view sets the futures price which results in changing the futures price over time. And depending on the availability of fundamental information, market participants update their views about the expected spot price. Another important consideration is that, in an efficient, at the expiry date, the futures price equals the spot price (price convergence due to the zero cost of carry). If they don’t converge on maturity, where markets are not efficient in terms of information, market participants could make free money with an easy arbitrage by trading between spot and future commodity contracts.

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Contango and backwardation 80 70 60 50 40 30 20 10 0 Now

1-month Contango

3-month Expexted spot

9-month

12-month

Backwardation

Fig. 3.5 Contango and backwardation

Hedging with Futures Contracts A commodity futures contract is a type of long-term contract designed to avoid the disadvantages related to forward contracts. A futures contract is a derivative contract that allows trading the asset on some future date, at a price fixed today called future price. Futures contracts are traded on organized exchanges at a market price observed by the public, future contracts are relatively very liquid compared to the forward contracts. And the market mechanism allows both parties to the contract to get out of the contract at any time by selling it to a third party at the prevailing market price. Finally, the trading mechanism is designed to eliminate credit risk. Futures exchanges use a margin mechanism to reduce the default by both parties to the contract. First, traders are required to deposit an initial margin before trading the commodity futures. This collateral serves as a guarantee that traders will meet their obligations. Second, the maintenance margin is set as a percentage of the initial margin but its value is connected to the market price of the commodity, and in case the market value of the position falls below a certain level, the commodity trader receives a margin call requiring him/her to reinforce the account by depositing more money, otherwise, the transaction is liquidated without

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incurring any loss by the central exchange. The maintenance margin is usually set at 70% of the initial margin. Commodity futures markets, in particular, provide valuable information to commodity producers and users. For example, an oil firm can lock in the future price of oil before it spends millions of dollars on drilling a new well. A farmer is unsure of future crop prices can lock in the futures price of wheat when deciding the quantity to plant. Additionally, the market mechanism of futures contracts offer more transparent avenues for trading and hedging and almost free of moral hazards and adverse selection as in the insurance market. How hedging works in real life: Hedging is the protection against commodity price fluctuations. Hedging is used by market players who deal with the underlying physical commodity such as large producers, large consumers, and commodity traders as well. Hedging with commodity futures involves two positions: 1. trading the physical commodity for real activity purposes such as selling crude oil by large refineries or buying crude oil by large consumers. 2. trading the financial commodity through the commodity future contract, which is considered a financial contract. And, in a perfect hedge,6 the net benefit from both positions after closing is zero, which means that the profit realized by one position is offset by the other, and the profit of one party is the loss of the other. Remember that the Net Present Value from hedging activity is zero and no one should benefit from hedging. Now let’s consider the following examples of hedging with futures: Example one: buying 7 crude oil. Imagine a large electricity generation company wishes to buy 1000 barrels of crude oil in 3 months, the spot (cash) price is $50/barrel, and the futures curve is normal, to hedge its position against crude oil price fluctuation during this period, the company buys a future oil contract for 3-month delivery at $60/barrel,

6 Hedging does not often result in a perfect hedge. The partial hedge is when the value of the futures contract does not perfectly correspond with the firm’s exposure, this is referred to “Basis risk.” 7 In trading, we refer to “buy” as a “long position” and “sell” as a “short position.”

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the standard oil future contract is 1000 barrels, so the company manages to make a perfect hedge. The following table shows the payoffs from each position and the overall hedge. If after 3 months, the spot price is $70/barrel, we get: Physical position

Future position

What to do now Do nothing After 3 months, spot = $70 By cash at $70 A loss of $10/barrel

What to do now Buy future at $60 After 3 months: convergence between spot and future Sell the future at $70 A gain of $10/barrel

Cash position: companies intending to hedge using futures don’t intervene in the spot market at the time of contract stipulation. Then, when the actual delivery comes (after 3 months), the company buys the crude oil at the prevailing market price of $70/barrel, incurring a loss of $10/barrel. Future position: today, the company buys a futures contract at $60/barrel leaving it until the expiration when the future price tends to converge the spot price of that day ($70/barrel), the company sells the futures contract at $70/barrel, making $10 gain per barrel offsetting the loss in the spot market. In this case, the company has locked in a fixed price of $60/barrel: buying from the market at $70 while gaining $10 in the sale of the futures contract so that the net gain is zero. The opposite happens if the spot price falls below the future price of $60 at the delivery date, the payoffs are: Physical position

Future position

What to do now Do nothing After 3 months spot = $50 By cash at $50 A gain of $10/barrel

What to do now Buy oil future at $60 After 3 months: convergence Sell the future at $50 A loss of $10/barrel

We can see that in both cases of spot price fluctuations (increase or decrease), the company is making zero net profit and fixing a buying price at $60/barrel.

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Example two: selling soybean crop. A farmer wants to cover the sale of bushels of soybean. The commodity will be ready for sale in 6 months. To mitigate the commodity price risk, the farmer enters into a future contract selling the soybean crop. • The future price of the contract is $10/bushel: the farmer now is guaranteed a sale price of $10/bushel regardless of the future fluctuations in the soybean price. • Case 1: after 6 months, spot price is $13/bushel: Action: sell physical commodity at the market price of $13/bushel making $3 profit. Close future contract at $13 making $3 loss, so the effective sale price = $13 (from physical) menus $3 (future loss) = $10/bushel. • Case 2: after 6 months, the spot price is $7/bushel: Action: sell the physical commodity at the market price of $7/bushel making a $3 loss. Close future contract at $7 making $3 profit, so the effective sale price = $7 (from physical) plus $3 (future gain) = $10/bushel. In this situation, the farmer was able to fix the sale price by hedging the transaction in the future market and smooth the earnings.

Hedging Payables and Receivables Buying and selling commodities globally imply dealing with more than one currency. In this section, we introduce currency risk which is not negligible in international transactions. The effective rate of return on international transactions explicitly consider currency returns: net r etur n = r etur n f r om r eal deal ± curr ency r etur n When currency risk is hedged, the net return from currency should be zero, and the return on the transaction should come from the real deal. However, if the currency risk is not properly hedged, this would add a negative component to the return and might erode the return generated by the real deal. To avoid another risk factor in the global commodity transactions, firms and traders tend to hedge the foreign currency to be paid or received. In this sense, we can imagine three integrated markets when dealing with global commodity transactions; physical, financial, and the FOREX:

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1. The physical market: where the physical commodity is traded on spot for cash. The players in this market are the companies dealing with the physical commodity such as producers, consumers, traders, and transporters. 2. The derivative (futures) market is a financial market where commodity futures contracts are traded. Traders other than hedgers may trade commodities without owning it such as financial institutions. 3. The foreign exchange market (FOREX): a market where currency derivative contracts are negotiated or traded. It is vital in international transactions to hedge payables, receivables, and investment value (Fig. 3.6).

Fig. 3.6 Three integrated markets

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Hedging Techniques Global commodity firms may decide to hedge part or all their cash flows from international transactions that are denominated in foreign currencies so that they are insulated from the possible depreciation/appreciation of those currencies. It may select from the following hedging techniques to hedge its payables: Futures hedge: buying or selling currencies in the currency futures market. Forward hedge: buying or selling currencies in the currency forward market through financial institutions. Money market hedge: it involves two transactions in the money market, a short position and a long position in different currencies, in the case of payables hedge: borrow funds in the home currency and invest in the foreign currency. Currency option 8 hedge: buying put or call options of the foreign currency. In case of hedging payables: buy a call option to buy the foreign currency at a specified strike price. Example of hedging payables: A US company is importing steel from a European steelmaker, the deal value is EUR 125,000 to be paid in 6 months, the current exchange rate is EUR = 1.10 USD, the importing firm is worried about the possible appreciation in the EUR/USD exchange rate costing it more dollars to be converted. Instead, and to eliminate any FOREX risk, the US firm has the following alternatives: 1. Negotiate a forward contract with the bank to convert USD into euros in 6 months at a fixed price called the forward price, both parties agreed on 1.12 euro exchange rate, so, when the payment comes due, the importer is sure of the exchange rate and the payment to be made: in this case, USD 140,000 to obtain EUR 125,000. 2. Buy one EUR/USD futures contract from the open FOREX market, one contract has a standard value of EUR 125,000 (in this case we have a perfect hedge), the future price is 1.12. After 6 months, if the actual exchange rate rises to 1.14, the importer

8 Options are derivatives like forwards and futures, they are standardized and exchangetraded, but they give the option rather than the obligation to exercise the contract.

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converts at 1.14 in the spot market but he gains 0.02 from the future contract resulting in a net exchange rate of 1.12. 3. Borrow (short position) the funds needed in US dollars, convert them to euros, then deposit (long position) them in a money market account. 4. Buy a euro call option at 1.12: an option to buy euros in 6 months. On the payment date, if the actual exchange rate is 1.10. the importer prefers to buy euros from the spot market rather than exercising the option (in this case the company loses the option premium).

Other Related Risks Other risks related to global commodity trading need to be also managed properly: • Basis risk: when the value of the real exposure does not perfectly correspond to the value of hedging contracts. • Hedging freight: fixing transportation and freight costs by freight agreements. • Managing operational risk: investing in modern equipment and software with real-time data surveillance to manage such risks. • Third-party risk: minimizing harm to people and the environment to enhance reputation. • Credit risk and political risk: the risks arising from the default of the counterparty and political or country risk (i.e., government actions to impede payments). • Liquidity Risk: hedging companies should retain enough liquidity to margin calls on their futures positions and protect themselves from sharp market swings.

Further readings Berk, J., & DeMarzo, P. (2017). Corporate Finance (4th ed.). Harlow: Pearson Education Limited. Brealey, R., Myers, S., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). New York: McGraw-Hill Education.

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Trafigura. (2019). Commodities Demystified a Guide to Trading and the Global Supply Chain Second Edition. https://www.commoditiesdemystified.info/ pdf/CommoditiesDemystified-en.pdf.

CHAPTER 4

Financial Aspects of Commodities

Abstract In this chapter, I discuss the various financial aspects related to global commodities. In particular, I cover the role and development of organized exchanges of commodities. How trading in commodities’ financial derivatives is executed through trading systems. The concept of financialization of commodity markets. And manipulation practices in global commodities. Keywords Commodity derivatives · Financial trading · Financialization · Technical analysis · Commodity manipulation

The Development of Commodity Exchanges Commodity markets can be defined as places where buyers and sellers of commodities meet to conduct their trades. In all countries, commodity markets exist at different levels and they differ in terms of sizes and levels of sophistication. Starting from local rural markets that provide a place for the exchange of food and other agricultural commodities. Nationwide and global markets for specific products or groups of products are also common as we have described in the first chapter. From a temporal perspective, there are two commodity markets, spot transactions

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_4

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with immediate physical delivery that usually dominate the trade activities in commodity markets, and there are the forward deals, involving the delivery of the commodity in the future. Commodity exchanges are distinguished from other types of markets by having developed features in response to a variety of specific needs. So far, there is no common agreement on the exact history of commodity exchanges and commodity future trading. However, the most known form of commodity derivative exchange dates back between 4500 BC and 4000 BC in Sumer.1 It is believed that Sumerians initiated the first futures trading in commodities, they used clay tablets to specify the amount of the commodity to be delivered such as goats and beers, and the future delivery time. This basic form of derivatives trading resembles the futures trading nowadays. This kind of trading was popular in many ancient civilizations due to the barter system that depends on using commodities for exchange as money. Since then, many developments and sophistications have been introduced to futures trading in commodities, but the basic notion is unchanged which is price hedging and the security of the physical supply. Later, commodity derivative trading was also documented in the Greek stories. Around 500 BC, some scripts of Aristotle were considered a basic form of options contracts for olive oil in which the price of the spring olive from the oil presses was negotiated in winter without an obligation to buy the oil. The principle behind is to hedge olive oil price and to guarantee a secure supply all over the year avoiding market swings. In recent history, the Amsterdam Stock Exchange is regarded as the first stock exchange dated back to 1530, that was specialized in commodity trading using commodity derivatives with sophisticated trading techniques including the short sale. However, specialized commodity exchanges are recent phenomena that go back to Chicago in the nineteenth century for agricultural commodities. Commodity exchanges are usually located in key cities worldwide. As we have seen in chapter one, The Chicago Board of Trade (CBOT) was founded in 1848 to fulfill agricultural trading needs for farmers in the

1 Sumer is the earliest known civilization in the historical region of southern Mesopotamia (now southern Iraq), emerging during the Chalcolithic and early Bronze Ages between the sixth and fifth millennium BC. It is also one of the first civilizations in the world, along with Ancient Egypt, Norte Chico, Minoan civilization, Ancient China, Mesoamerica and the Indus Valley.

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area of Chicago. By 1864, any agricultural and animal-derived commodities were traded with a standard contract on the CBOT. During the 1930s and 1940s, the CBOT has expanded the range of agricultural commodities traded to include rice, butter, Irish potatoes, soybeans, and other products. To have successful commodity markets, the market has to offer a wide range of commodities fulfilling the needs of different traders (here we refer to the concept of depth and width of the market), this mechanism enhances liquidity and improves price transparency. In this regard, standardization of the commodity-grade, amount, and delivery time has fostered the expansion of commodity exchanges. The twentieth century has witnessed the growing importance of exchanges, especially for commodities. A successful exchange has to provide innovative solutions to facilitate the trading of the financial commodity and the flow of the physical commodity along the entire supply chain. However, exchanges in the nineteenth century played a crucial role in offering platforms for trading physical commodities to feed the industrialization of western economies. In the same regard, the twenty-first century is the high-tech mark, one great leverage is the use of advanced technologies and the internet, the advancement in the ICT has greatly enhanced global trading through the management of big data and the use of blockchain technologies. Investors around the globe can access commodity markets everywhere seeking investment in purely financial transactions in commodities. As we have mentioned in the previous chapter, the physical (or spot) commodity market is restricted for registered market players who deal with a physical commodity such as producers, consumers, and dealers. However, with the development and the diffusion of the financial products related to commodity trading such as futures and options contacts, participation in the market is not anymore restricted to physical players, other institutional investors, financial institutions, and retail investors are also involved (this is regarded as an aspect of the financialization of commodity markets that will be covered in later sections).

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Regulatory Bodies and Policies The Commodity Futures Trading Commission (CFTC) is the primary regulatory body for the futures markets in the United States. In 1976, the National Futures Association (NFA) was formed as the market’s autoregulatory body with its first piece of regulation emerged in 1982 under the Commodity Exchange Act of the CFTC Act. In the aftermath of the 2008/2009 financial crisis, the US regulator has approved a more stringent financial regulation. The Dodd–Frank Act that entered into force in 2010 responding to the pitfalls that provoked the financial crisis. It urged for stronger measures to limit speculative activities in commodity futures, and additional position limits for the physical market operators. Furthermore, it also called for more transparency in OTC trading. Similar regulations have been adopted by the European regulator. The most prominent piece of regulation is the Markets in Financial Instruments Directive (MiFID-II) that was revised in 2012, the final version was approved in 2014 and entered into force in January 2018 after one year of delay. This directive has an earlier version called MiFID-I that was binding from 2004 until the second directive was enacted. The European Parliament (EP) and the Economic and Financial Affairs Council (ECOFIN) were responsible for revising and approving the directive. Similar to the Dodd–Frank act, MiFID-II provides stringent provisions on position limits in commodity derivatives to prevent market abusive behaviors and enhance price transparency and investors’ rights. The European Securities and Markets Authority (ESMA) is the EU’s financial authority responsible for applying MiFID-II besides other regulations. For example, ESMA is in charge of calculating position limits in different commodity derivatives, it sets the tests for speculative trading by commercial firms. Speculation in commodity trading is one of the core issues addressed by the European legislator, speculations were responsible for creating bubbled and volatile commodity markets especially in food and agricultural commodities. Many politicians considered such speculations as immoral as commercial firms capitalizing on the basic human needs. Another important regulation governing European derivatives is the European Market Infrastructure Regulation (EMIR) aiming at reducing systemic counterparty and operational risks and enhances the system’s immunity against crises. EMIR is focusing on the regulation of over-thecounter (OTC) derivatives, central counterparties, and trade repositories.

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It was originally adopted by the EU legislator in July 2012 and came into force in August 2012. The regulation includes requirements for reporting of derivative contracts and implementation of risk management standards. It established common rules for central counterparties and trade repositories.

Commodity Derivative Contracts In addition to the spot2 or cash contracts for commodity trading, commodity derivatives are common forms of contracts negotiated either on an organized exchange or OTC, they require specified standards to make the transaction clearer until the future settlement date. Derivative contract: is an agreement between two parties to exchange a quantity in the future at a price agreed upon now called the future price, its value is derived from the value of the underlying commodity. The most common forms of commodity derivatives are Forwards, Futures, Option, and Swaps. The following table explains the features of each contract (Table 4.1).

Financialization of Commodity Markets A term that has emerged in the last 20 years with increasing popularity, leading to a lot of debate on its existence, definition, and economic implications. From this point of view, the financialization of commodity markets is defined in two dimensions: the increased interrelations between physical and financial sides of commodities. Others define the financialization of commodity markets as the increased presence and importance of financial investors in the commodity markets. Financialization is introducing new regimes and considerations for both financial and commercial investors in which new rules and regulations are governing commodity derivatives trading by all types of traders (commercial and speculative). Another considerable aspect of financialization of commodities that can be considered a definition or an implication and is less tackled by many is widening the definition of financial commodity derivatives to include more physically-settled commodity forward contracts. Regulators

2 A spot contract is an agreement between the buyer and the seller to exchange/deliver a certain amount of commodity for payment either immediately or within few days.

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Table 4.1 Commodity derivative contracts Forward contracts Non-standardized Customized: can negotiate all terms, price, quantity, and delivery date Bilateral: between the buyer and the seller without the exchange OTC: Are traded over-the-counter Physical delivery: they are designed for physical future delivery

No central clearing: since they are bilaterally stipulated there is no central clearing obligation Counterparty risk: there is a risk that one party to the contract is not fulfilling his/her obligations imposing higher risk Option contracts Are contracts that give the owner the right, but not the obligation, to buy or sell an agreed amount of a commodity on or before a specified future date They are standardized and traded on exchanges Classified into call and put options

Future contracts Standardized contracts in terms of price, quantity, and delivery time Regulated exchange: they are traded on organized exchanges Centrally cleared: the exchange is responsible for clearing the deals No negotiation: price and quantity are public and standardized No counterparty risk: since the exchange is in the middle, it guarantees the good behavior of both parties by imposing margins Probable physical delivery: there is always the clause for physical delivery as a disciplinary condition

SWAP contracts An agreement between two parties to exchange cash (flows) on or before a specified future date based on the underlying value. Not exchange-traded instruments. Designed by banks that also arrange the trading of these bilateral contracts.

Call: gives the right to the buyer to buy the commodity Put: gives the right to the buyer buy sell the commodity

in the United States and Europe have considered more stringent regulations following the 2008/2009 financial crisis, Both Dodd–Frank act and MiFID-II have extended the definition of the financial derivatives to include more physically related contracts, an action by regulators to limit the speculative activity by commercial players, but, increases the vulnerability of those contracts to be later traded by speculators (financial institutions). For example, according to the imposed thresholds by MiFID-II, any commercial business executing trading activities, not for hedging purposes, must register as an investment company if the ratio of the speculative trading exceeds a certain fixed limit (speculative tests).

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As discussed in the early chapters, two important factors influence commodity prices, fundamental factors related to supply and demand of the commodity, and speculative trading by commercial and noncommercial traders. Since around 75%3 of the trading in the future commodity markets is speculation, prices became mainly driven by speculative actions rather than fundamental factors. This concept has become important to the academic community and the world’s policymakers. Another implication of the financialization of commodity markets is that quantities traded in financial commodities—mainly for speculative activities—are becoming much higher than the physical underlying. This implies that the two markets are more linked and leading to bubbles in commodities prices. This is similar to the trigger of the 2008/2009 financial crisis that started with the mortgage crisis in which the value of financial mortgage-backed securities exceeded the value of houses backing those titles. The idea is that physical commodity markets are separated but highly connected to their financial reflections. As shown in the previous chapter, three integrated markets are related to commodity trading: cash, financial, and Forex markets. While the cash market is restricted to the participants who deal with the physical commodity, these participants use the futures (financial market) to hedge their physical positions against price risk. However, futures markets are open to all kinds of players—hedgers, retail investors, institutional investors, and financial institutions. The increased participation of all these institutions other than hedgers is related to the financialization of the commodity markets inducing speculative tradings. Here are the differences between hedgers and speculators: Hedgers buy or sell a futures contract to reduce the risk of loss through price variation. A short hedger sells a futures contract to protect from the possible decline in the actually owned commodity. A long hedger purchases a futures contract to protect from the possible advance in the value of an actual commodity needed to be purchased in the future. Speculators buy or sell the commodity derivative for short-term profit without the need to deal with the physical commodity. They are an important factor in the volume of futures trading today. They, in effect, assume the risk, which the hedger tries to avoid with the expectations of making a profit. They are like an insurance underwriter. The largest number of 3 Speculative trading has grown from almost 10% in early 1990s to more than 70% by the 2008/2009 financial crisis.

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traders on any commodity exchange are the speculators. For hedgers to participate, they must have continuous trading interests and activity in the market. This trading activity stems from the role of speculators because they involve themselves in buying or selling futures contracts with the idea of making a profit on price variations. The speculator tries to forecast prices in advance and is willing to transact on this basis. Speculators bear the market risk. Therefore, speculation within its vital and basic role is not a bad action in commodity markets, however, excessive speculation by financial actors becomes a sort of market manipulation that leads to market distortions and crisis. Financialization is, in fact, changing the share of the markets and is associated with the following characteristics: increased participation of financial investors and inflating volumes traded; prices are more volatile due to speculation rather than fundamental factor; futures curves are changing more often because financial investors are adjusting their expectations; and a stronger link between financial markets and commodity markets leading to limited diversification outcome. OTC derivatives trading considerations: financial and commodity derivatives are either traded on an organized exchange (exchange-traded derivatives) or Over-The-Counter. Reports document that from 80% to 90% of commodity derivatives are traded OTC while the rest are considered exchange-traded. OTC trading has grown more than 30 times compared to the mid-1990s level. OTC trading is considered shadow trading compared to the organized exchanges where transparency of prices, quantities, counterparties, and settlements are public and guaranteed by the exchange or its reporting agent. Many regulators and policymakers have accused trillion dollars OTC derivative tradings of causing the Global Financial Crisis as many banks held a tremendous amount of off-balance sheet derivatives that exceeded the value of their balance sheets. Therefore, the US and EU regulated have responded by introducing new directives to get OTC derivatives more regulated and more transparent. In the European context, EMIR requires transaction details to be reported to trade repositories by both counterparties for both OTC and exchange-traded derivatives. The trade repositories try to match transactions together based on Unique Transaction Identifiers (UTIs). The National Competent Authority’s (NCAs) and central banks use this data to perform their regulatory oversight of systemic risk. MiFID-II requires

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trade reporting to the public and transaction reporting to NCAs for equities, bonds, listed derivatives, and OTC derivatives. The NCAs use this data to perform their regulatory oversight including market abuse and competition. Figure 4.1 reports the trend in the notional amount and the gross market value of OTC derivatives. The second half of 2019 has witnessed a significant decline in the notional amounts to $559 trillion, partly reflecting the seasonal pattern evident since 2016. Specifically, these amounts have tended to decrease in the second half of each year, followed by a rebound in the following period, generating a volatile pattern. $14 trillion was the increase from 2018 to 2019 making a 2.6% growth rate, but the growth rate is more evident if calculated since 2016, it makes more than 15%. As for the gross market value which provides a measure of amounts exposed to risk, the second half of 2019 has shown a slight decrease from $12.1 trillion to $11.6 trillion, with interest rate contracts accounting for the bulk (72%) of that total. Gross credit exposures which adjust gross market values for legally enforceable bilateral netting agreements, also declined in the second half of 2019 (from $2.7 trillion at end-June 2019 to $2.4 trillion at yearend). The credit exposures are decreasing compared to the gross market value (from 25% in 2018 to 20% in 2019). This declining trend can be due to the increasing cost of central clearing. Central clearing lowers the

Fig. 4.1 OTC derivatives (Data source BIS [2020, p. 1])

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counterparty risk exposures (credit risk) in derivatives contracts by increasing the percentage of netting. Figure 4.1 highlights the enormous value of OTC derivatives mostly held by financial investors compared to exchange-traded derivatives.

Commodity Derivatives on Organized Exchanges While in the previous section we present an overview of the OTC derivatives, in this section, we analyze the general statistics and the performance of the commodity derivatives traded on organized exchanges based on the annual report (survey) of the World Federation of Exchanges (2020). 2019 registered record-high volumes of trading in derivatives. For the first time in the period under review (2010–2019), overall volumes exceeded 32 billion contracts traded with 9.4% growth compared to 2018. The overall increase in volumes was driven by the Asia and Pacific (APAC) region (26.4%) and the Americas (1.4%) while Europe, the Middle East, and Africa (EMEA) registered a decrease of 4.9%. Both options and futures volumes increased. During 2019, the total volume of options increased by 12% to 14.76 billion, while that of futures by 7.4% to 18.1 billion. However, the performance was heterogenous among different asset classes as shown below: • Equity derivatives volumes witnessed a 17.2% increase with a total amount was just under 16 billion contracts representing the highest in the 10 years. Single stock options volumes were the only equity derivatives decreasing year-on-year by 3.4%, while single stock futures were up 16.1%, stock index options 41.5%, and stock index futures 13.2%. • Commodity derivatives have also experienced an increase of 15.3%. Options and futures performed differently, options volumes decreased by 8.1% while futures were up by 16.5%. The commodity trading volume was 6.83 billion contracts in 2019 compared with 5.92 billion in 2018 thanks to the APAC region’s high share of global commodity derivatives trading (62%). Energy and agriculture are significant (45.4 and 30.2%, respectively) in global commodity derivatives trading. While the volumes of energy and other commodities have shown a year-end increase (by 25.4 and 54.5% respectively), agriculture, precious metals, non-precious metals, and index commodity derivatives volumes fell by 20.9, 11.5,

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76.2, and 96.8%, respectively. Commodity futures remained the most actively traded derivatives product, representing 20% of overall volumes. A 16.3% decrease in the number of commodity derivatives contracts traded in the Americas region (which accounts for a 17.7% share of volumes) was offset by the 32.7% increase in the APAC, and in EMEA where the volumes were up by 16.3%. EMEA accounts for 20.3% of the traded volume. • Interest rate derivatives declined by 1.3% due to a decline in shortterm interest rate (STIR) options and STIR futures by 6.5 and 2.2%, respectively, which account for 11.3 and 38% of the interest rate derivatives volumes traded. Long-term interest rates (LTIR) futures volumes did a slight increase of 0.3% whereas LTIR options increased by 2.6. The share of LTIR is 7.5% of the interest rate derivatives in 2019, while LTIR futures accounts for the majority of interest rate derivatives (43.3%). • Currency derivatives experienced a minor 0.1% decline. Volumes peaked in 2018 at 3.673 billion contracts while 2019 saw 3.670 billion contracts traded. While futures experienced a 7.2% drop in volumes, options were up 15.4% due to the APAC region where a major share (63.2%) of the global currency derivatives trading takes place. • Exchange-traded fund (ETF) derivatives were down by 8.8%, due to the decline in ETF options (8.8%). 99.7% of ETF derivatives are traded in The Americas. Figure 4.2 shows the trend in the annual composition of total volume by product. While interest rate derivatives occupy most of the OTC trading, equity derivative dominates the exchange-traded derivatives. Commodity derivatives range from 13.5% to 21% of the total volume which represents a significant share especially during the period of commodity prices rise from 2015 to 2017. The following figure demonstrates the volumes of commodity derivatives (both options and futures) for the last 10 years. As shown earlier, commodity futures dominate commodity derivatives. Commodity options remain almost stable, while futures have demonstrated significant growth4 4 Average annual arithmetic growths are 15.8% and 7.4% for futures and options, respectively. While the geometric growths are 10% and 5.7% for futures and options, respectively from 2010 to 2019.

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100% 90%

13%

12%

80%

7%

8%

70%

13%

13%

60%

6%

8%

16% 9% 12% 7%

50%

19%

19%

9%

9%

16%

15%

7%

7%

22% 11% 13% 6%

40% 30%

60%

58%

55%

20%

48%

48%

45%

2013

2014

2015

24%

27%

11%

11%

20%

21%

12%

11%

15%

14%

6%

5%

14%

16%

7%

6%

39%

41%

45%

48%

2016

2017

2018

2019

10% 0% 2010

2011 Equity

2012 ETF

Int.rate

Currency

Commodity

Other

Fig. 4.2 Product composition by share of the total volume (Data source World Federation of Exchanges [2020, p. 11])

especially from 2015 to 2017. Commodity futures are considered the most liquid commodity derivatives and are considered financial contracts and traded openly on organized exchanges as well as OTC (Fig. 4.3).

Volumes of commodity options and futures (millions of contracts) 8000 7000 6000 5000 4000 3000 2000 1000 0

6882 5885

5392

2695

2714

3171

2877

2010

2011

2012

2013

Futures

5920

6827

3104

2014

2015

Options

2016

2017

2018

2019

Total

Fig. 4.3 Volumes of commodity options and futures (millions of contracts) (Data source World Federation of Exchanges [2020, p. 31])

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Table 4.2 shows the top global commodity exchanges in 2019. We can see that there are many rising commodity exchanges in the emerging countries such as India, China, Russia, and Turkey, and in terms of volume, Shanghai and Dalian exchanges have overpassed Chicago Mercantile Exchange and Intercontinental exchange. As we can see in Table 4.3, oil contracts (Brent, Crude oil, and Brent crude) are the most active globally in terms of volume, notional value, Table 4.2 Commodity exchanges by number of options and futures contracts Volume Shanghai futures exchange Dalian commodity exchange CME group Zhengzhou commodity exchange Moscow exchange ICE futures Europe Multi commodity exchange of India London metal exchange ICE futures US Borsa Istanbul Others Total

1,411,969,733 1,355,584,225 1,133,124,055 1,092,486,045 663,687,221 482,608,092 307,095,652 176,260,939 92,613,557 58,571,990 52,224,496 6,826,226,005

Notional value

Open interest

13,923,058 9,898,796 60,597,611 363,995 45,011 23,296,908 1,108,564 17,939,963 2,020,422 11,751 706,864 129,912,943

5,748,273 9,686,951 24,486,658 4,429,311 3,285,120 13,491,751 224,188 2,427,423 3,094,748 481,607 4,311,748 71,667,778

Data source World Federation of Exchanges (2020)

Table 4.3 Top 10 commodity contracts traded in 2019 Contract

Size (lot)

Volume

Notional value

Brent futures PTA futures Iron ore Crude oil Soybean meal Methanol Brent crude Rapressed meal Palm olein Crudeoilm

$10/barrel 1 ton/lot 100 metric ton 1000 barrels 100 short ton 10000 MMBtu* 1000 barrels NA 10 metric ton/lot 10 barrels

616,575,370 312,470,222 296,538,010 291,648,494 272,869,691 265,094,214 221,329,190 138,085,360 135,514,196 134,909,826

25,413,037 8,882,021 19,873,140 16,596,793 7,603,012 6,100,150 10,490,953 3,201,333 7,129,820 5,390,660

Note *Million British thermal units Data source World Federation of Exchanges (2020)

Open interest 2,684,190 918,896 702,827 2,146,037 2,925,246 877,821 2,594,785 329,954 88,838 45

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Table 4.4 Breakdown of volumes by the underlying commodity

Category Agriculture Energy Index comm. derivatives Non-precious metals Other commodities Precious metals Total

Volume 2019

Volume 2018

%

1,510,756,653 2,276,447,660 46,287

1,906,498,461 1,815,789,033 1,443,103

−20.90 25.40 −96.8

362,484,059

1,552,680,271

−76.20

618,893,530

400,669,143

54.50

240,700,687

271,817,771

−11.50

5,918,879,782

−15.4

5,009,328,876

Data source World Federation of Exchanges (2020)

and open interests. All contracts in the Table are Future contracts with standardized size. Table 4.4 shows the performance of the macro commodity categories: • Energy and agriculture represent the majority (45.4 and 30.2%, respectively) of global commodity derivatives volumes. While volumes of other commodities and energy-based derivatives were up by 54.5% and 25.4%, respectively, agriculture-based commodities fell by 20.9% from 2018. The same trend was recorded by index commodity derivatives, which fell by 96.8%, precious metals 11.5%, and non-precious metals (76.2%). • Volumes of agricultural commodity derivatives were up in the APAC region by 17.8%, the region captures 74.1% of contract trading. In the Americas, where 24.4% of the contracts were traded, volumes were down by 20.2%. EMEA also registered a decline in contracts traded by 95.5% in 2018. • Energy derivatives volumes were up 127% in the EMEA where 47.9% of contracts are traded. APAC and Americas regions capture about 52% of contracts are traded divided almost equally. • The volume of non-precious metals registered a fall in the three regions: APAC region where 93.1% of the contracts are traded, saw a decline of 74.2%, the Americas which with 6.9% trading registered a 24.8% decrease, while EMEA volumes fell to nearly zero.

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Share of total volume by commodity type and region in 2019 Americas

APAC

EMEA

1% 40%

48% 74% 26% 24%

26%

Agriculture

Energy

100%

93%

100% 60%

Index Commodity

7% Non-precious metals

Other Precious metals commodities

Fig. 4.4 Share of total volume by commodity type and region in 2019 (Data source World Federation of Exchanges [2020, p. 36])

• “Other” commodities, precious metals, and index commodity derivatives accounted for the remaining share of commodity derivatives volumes. While volumes of other commodity derivatives increased by 54.5%, precious metals and index commodity volumes decreased by 11.4 and 96.8%, respectively. Figure 4.4 presents the share of total volume for each commodity type per region. As mentioned earlier, Energy and agriculture capture more than 70% of the trading on commodities exchanges. Here we notice that there is a sort of trading concentration for some commodity types; agricultural commodities are in Asia a Pacific region thanks to the fast emergence of India and China agricultural markets and exchanges. Energy commodities are mainly traded in Europe and the Middle East due to Europe’s dependence on foreign energy sources and the share of oil production in the Middle East.

How Commodity Trading Works Commodity trading is an exciting and sophisticated type of investment. While this type of trading has many similarities to stock trading, the biggest difference is the asset traded. Commodity trading focuses on purchasing and trading commodities like gold rather than company shares

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as in stock trading. Like stocks, commodities are traded on exchanges where investors work as a group to purchase or trade products in an attempt to generate profit from the fluctuation of market prices or because they need that particular product. Equities, in general, represent an asset class with a certain risk profile, while each commodity can represent a different asset class according to the risk profile. Another factor that distinguishes commodities from other asset classes is that risk in commodities is mainly attributed to the market or macro risks while the dominant risk in equity investments is the specific risk of the companies issuing them. Commodity derivatives are traded on OTC or on an organized exchange. Trading is an open arena for all kinds of participants including hedgers, brokers and dealers, financial institutions and institutional investors, and retail or individual investors. The two main trading venues are: • Regulated market: organized exchanges where standardized contracts are traded (options, futures) and the exchange serves as the counterparty for the transaction to eliminate default risk. • Over-the-counter (OTC): is a network of brokers connected to execute orders on behalf of buyers and sellers without involving an organized exchange or a central clearinghouse. Forwards, swaps, and exotic options are examples of OTC contracts. OTC trading is characterized by: – Risky trading due to the high leverage (90%–99% of the value) and the lack of central clearing. – Huge quantities: more than 85% of derivatives are traded OTC mainly by financial investors. – Also called shadow trading: because it is less regulated, and information on prices and quantities is not publicly available. – Recent financial regulations such as MiFID-II and EMIR are trying to regulate it and bring OTC derivatives into the central clearing and publish related data. On the other hand, both the standardization of contacts and the exchange trading has the following advantages:

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• Marketability: easier for trading especially for newly issued commodity derivatives since the trading is supported by the exchange. • Price transparency: exchange-traded commodity derivatives are publicly negotiated, and the prices are continuously published by the exchange or its reporting agency, unlike OTC trading. • Counterparty default risk: unlike OTC derivative trading, trading on organized exchanges is supported by the clearinghouse of the exchange that guarantees each party is fulfilling his/her obligations by imposing initial margins and maintenance margins so that counterparty risk is avoided. • Negotiation: facilitate negotiation between buyers and sellers since prices are transparent and the counterparty risk is eliminated. In this regard, the main functions of the commodity futures exchanges are: • Price risk management: Hedgers use the futures market to protect themselves against price adverse changes and are often interested in taking or making physical delivery of the underlying commodity at a specified price. Initially, commodity futures were created as an arena offering hedgers appropriate tools to manage price risk. Then nonhedgers (speculators) dominated the futures market; speculators use derivatives to profit from the exposure to risk on price fluctuations. • Price Discovery: with enhanced liquidity and information availability, market participants can construct future curves that could be used as an estimate of the spot price of a commodity at some future date. The continuous flow of information makes the process of price discovery dynamic in a commodity futures market. And prices are determined based on fundamental supply and demand factors and speculation. However, technically, derivatives exchanges contribute to market stability by providing the following activities: 1. Providing and enforcing rules and regulations for uniform and fairtrading practice.

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2. Facilitating trading transparency by ensuring public access to information. 3. Recording trading transactions, including circulating price movements and market news, to the participating members. 4. Ensuring execution of contracts by providing a system of protection against default of payment (clearing system). 5. Providing a dispute settlement mechanism. 6. Designing the standardized contract for trading which cannot be modified by either party. Who are the market participants in futures markets? • Scalpers or day traders are those participants who take positions in futures contracts for a single day and liquidate them before the close of the same trading day; • Hedgers: are essentially players with an exposure to the underlying physical commodity to manage price risk; • Speculators are traders with no genuine commercial business to the underlying commodity; they do not hedge but trade to make profits from price fluctuations; • Arbitrageurs are traders who buy and sell to make money on price differentials across different markets or different times (locational or temporal arbitrage). • Dealers or traders, they trade commodity derivatives for their account, they are also called “market makers” since they can intervene to make the market. • Brokers, they execute trade orders on behelf their clients for commissions. They don’t trade for their accounts. • The exchange ensures smooth functioning, central cleaning, and design contracts. • Regulators design regulations, protect investors, and improve transparency.

Features of Commodity Trading There are various features of trading commodity derivatives on organized exchanges that make it easy, accessible, and less risky compared to OTC trading, these features offer an appropriate environment for retail

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(less sophisticated) investors, like many of us, for investing in commodity derivatives. Individual investors are also important for financial markets in providing liquidity and improving efficiency. The features are: • Organized: commodity futures contracts always trade on an organized exchange, NYMEX, LME, CME, and other exchanges worldwide are good examples. • Standardized: the same quality, quantity, and delivery date, being predetermined and standardized, while prices are publicly and continuously published. • Eliminates Counterparty Risk: commodity futures exchanges use clearinghouses to guarantee that the terms of the futures contracts are fulfilled through initial and maintenance margins. • Facilitates margin trading: commodity futures traders do not have to put up the entire value of a contract, they use leverage (margin) trading in which they just deposit 5–10% of the contract value while the rest is borrowing and incur an interest payment. • Closing a Position: Commodity Futures positions can easily be closed by placing an offsetting or opposite trade. This practice is common before the maturity date to avoid the commitment to the physical commodity (avoid physical delivery). • Regulated markets environment: futures markets are closely regulated by government agencies, for example, the Commodity Futures Trading Commission (CFTC) is responsible for regulating commodity futures in the United States. • Physical delivery: actual delivery of the commodity can be made or taken at the expiry of the contract. This clause is always mentioned in the future contract as a disciplinary tool when one party of the contract is avoiding his/her obligations. • Short sale: is a common feature and practice in derivatives trading, it allows selling the commodity in the future contract without owning it. A trading practice is used by speculators to benefit from a price decrease. When investors expect prices to decrease, they borrow the security from the broker, sell it at a high price, then, if their expectations come true, they buy it back at a lower price and give it back to the broker paying interest for the holding period. Various reasons attract investors to invest in commodity futures:

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• Leverage: Commodity Futures trading is done on margins. The investor only deposits a fraction of the value (deposit only 5–10%). However, margin trading is risky since the transaction is financed 90% by debt, therefore, tiny price changes might double the value of the investor’s equity or it makes him subject to a margin call. • Margin call: to protect all parties to the transaction, the exchange sets a maintenance margin which is the floor for the trading activity. When the deal value touches the minimum value (usually 70% of the initial margin), the investor receives a call to support the deal by depositing money, otherwise, the deal is liquidated. • Continuous trading time: it is 24-hour active trading, the same commodity starts trading in Asian markets for eight trading hours, then after the close, starts the European and Middle East trading time, and finally the Americas. • Liquidity: Unlike other investment vehicles like real estate, investments in commodity futures offer high liquidity thanks to the participation of various players, financial institutions, hedgers, and retail investors. • Diversification: In portfolio management, diversification works to reduce (eliminate) the specific risk related to certain investments. Diversification works well when investments in the same portfolio are low or negatively correlated. Commodities have proven to have a low or negative correlation with financial assets which makes them an appropriate asset class to be mixed in the investment portfolio.5 • Inflation Hedge: investors care most about the real return than the nominal. Investing in commodity futures can act as a hedge against inflation. Commodity investment has made a return higher than the global inflation rate which guarantees a positive real rate of return.

How to Trade in Commodity Futures With the advent of the internet and online brokerage, individual traders can now trade commodities in global markets to generate a profit from price variations without being involved in the physical market. To make a profit from the commodities market, investors must trade the commodity

5 However, the financialization of commodity markets has increased the level of integration with other financial assets which limits the diversification benefits.

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at the correct time depending on future expectations. The idea of trading is not exactly buying low and selling high, it’s more about expectations, I buy at this moment because I expect the price to rise and vice versa when I sell. Setting up the trading horizon is an important initial point; the trader decides to be a short-term, very short-term, or long-term trader. Longterm trades need more capital to be invested to absorb higher price fluctuations for a longer period without liquidating the account (receiving a margin call). The trading horizon decides also the gain/loss limits; how much loss can you support? And at what level of gain should you close the deal? The steps for commodity investing ar summarized below: • Choose your broker: a registered broker with the commodity exchange is a guarantee for a more transparent process. • Deposit the initial margin: it is usually 5–10% of the contract value with an organized exchange and 1% for the OTC trading. • Decide which commodity to trade (Such as Crude Oil Brent, Gold, or Natural Gas) after hearing from your trusted financial consultant, experienced friend, or you rely on your own experience. • Access to information: there are numerous free and easily accessed sources of information for commodity futures. • Fundamental and technical analysis: both types of analysis are necessary for successful commodity trading. Fundamental analysis is related to analyzing fundamental factors influencing commodity prices such as supply and demand factors, for example, OPEC announcement to cut oil production leads to a price increase. Whereas technical analysis (trends and charts) depends on predicting price directions (up or down) using trends and chart analysis. • Manage your risk: select from a range of stop-loss orders and other profit orders. • Close your position: cash out/liquidate after achieving the trading goal, be satisfied with the amount of gain achieved, and don’t be fooled by greedy ambitions. • Finally, who can trade commodities? The answer is easy, anyone. Every one of us with an internet connection can participate in commodity trading.

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Examples of Margin Trading in Commodity Futures One: Buying (long position) Brent oil future contract • Contract size = 1000 barrels and the price is $70.82/barrel. • Contract value = 1000 barrels × $70.82 = $70,820. • One tick change: a change in the last digit of the price (70.83): so, the value of the deal = 1000 × $70.83 = $70,830. • One tick (pip) value = $10: 1% change in price is worth $10 of profit/loss. • Now, to open an account, you need to deposit 10% of the deal value: Initial margin = 10% of contract value = $7082. • The maintenance margin = 70% of the initial margin = $4957, this means that your account supports only a $2.12 maximum price drop per barrel.6 • So, you will receive a margin call at $68.70 to support your account, otherwise, the deal will be closed. Two: Selling (short position) a Gold future contract • • • •

Contract size = 100 oz (ounce), price is $1286.4/ounce. Contract value = 100 oz × $1286.4 = $128,640. One tick change = 100 oz × $1286.5 = $128,650. One tick (pip) value = $10 of gain/loss, one base point change = $100 (corresponds to the change from 1286–1287). • Initial margin = 10% of contract value = $12,864. • Maintenance margin = 70% × 12,864 = $9000. • Margin call received when the price touches $1325.04.7 The two examples show how the accounts in commodity trading should be observed continuously to maximize the profit or to minimize the losses. We have seen that a tiny price change significantly influences the profit/loss of the account due to the high leverage levels (only 3% 6 7082 – 4957 = 2125 for the whole deal, now divide by number of barrels, we get $2.12 as a maximum price drop (3% price drop). And the margin call is received at $68.70 which is 70.82 – 2.12. 7 12,864 – 9000 = 3864 for the whole deal, divide by 100 oz, we get 38.64 as a maximum price jump (3% price jump). Margin call at 1286.4 + 38.64 = 1325.04.

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price variation tolerance). However, some trade orders are used to facilitate the trading and to maximize the benefits from the account especially in 24-hour trading: 1. Market Order: this is the most common order simply because it is the most convenient. A market order initiates the trade at the current market value or the best possible price at that time; 2. Limit Order: allows the initiation of the trade at a certain price decided by the trader, selling (short) order at a price greater than the prevailing market price, and buying (long) order at a price lower than the market price; 3. Stop Order: This order becomes a market order only when the specified price level is reached. It is used to limit the profit or loss from an open deal; 4. One Cancels the Other: this is also referred to as a contingency order because it requires that the broker cancel one of your orders to execute the other; 5. MIT (Market If Touched): this is somehow confusing because traders place a buy order above the market price and a selling order below the market price, the rationale is that, in technical analysis, there are support and resistance levels, if the market price hits the support level, means that price continues to drop, to benefit from this drop, traders place MIT orders to sell below the market price (conditional to hitting the support level). Some Specifications 1. Convergence: spot and futures prices tend to converge and to equal at the contract expiry date, this is due to the reduced cost of carry as the contract approaches the expiry date. Remember that: Future price = Spot price + Cost of carry (COC). COC tends to be zero at the delivery date. 2. Very few future contracts are physically settled, usually, they are closed out before expiry to avoid physical delivery, why? • Futures markets are not designed for merchandising, commercial traders can refer to the spot/physical market for this purpose.

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• They originally offered a platform for hedging purposes through which speculators assume the risk transferred by hedgers. Then, the market has become dominated by speculators. • Since futures are standardized, volumes of the futures contracts don’t correspond to physical trade needs. • A delivery clause is added to future contracts to impose a threat on the misbehavior of any party and helps to converge spotfutures prices.

Arbitrage Opportunities in Futures Markets We have earlier mentioned the various market participants in the commodity futures market. We have seen how hedging is executed by commercial players, and how speculators trade in the market. However, arbitragers profit from opportunities or gaps arising from market imperfections. Arbitrageurs buy and sell to make money on price differentials across different markets or different times (temporal arbitrage), arbitrage is considered a risk-free investment. Let’s demonstrate using the following example: • A gold future contract is sold at $1340/ounce in New York and at ¥160,800/ounce in Tokyo. • This means that the implied FX rate USD/¥ = 120. • If the actual spot price USD/¥ = 115, this means there is an arbitrage opportunity because the implied rate is different from the market rate, an arbitrageur does the following transactions to earn free money: 1. Buy gold in New York paying $1340/ounce. 2. Sell it instantaneously in Tokyo receiving ¥160,800/ounce. 3. Immediately change ¥160,800 to USD at the market rate of 115 receiving $1398. 4. Final arbitrage result: buy at $1340, receive $1398 making $58 risk-free gain, and the arbitrageur can multiplicate the gain by trading multiple contracts. • Remember that arbitrage opportunities are eliminated by the arbitrage itself, as more arbitrageurs do the same move to gain, more

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pressure is exerted on New York Gold making the price to rise, and more pressure on changing ¥ to USD, making the actual FX rate to rise until it matches the implied rate. However, by the advancement in internet and communications, arbitrage opportunities are less evident, and if they exist, they last for a very short time.

Speculation and Manipulation in Commodity Markets Speculation in its basic sense is a feature of a healthy market. It creates liquidity by making the market. Speculators assume the risk that hedgers want to get rid of (the counterparty). They do not introduce new risks to the market. Speculations help information spill-over, price discovery, and create more efficient markets. On the other hand, many confuse gambling with speculation; gamblers have a different risk profile from speculators. Gamblers introduce new risks to the market. However, aggressive speculation turns to be a market manipulation which is prohibited by law. Speculation leads to price distortions as commodity prices don’t reflect true fundamentals, either too low prices or bubbled prices. OTC offers an appropriate arena for manipulation since authorities can’t track and observe OTC trading activity. Here are some manipulation investigation cases that have been recorded worldwide: • Silver Thursday and the Hunt Brothers Scandal 1980: They bought silver futures that have 200 million ounces of underlying silver, almost half the world’s deliverable supply. They cornered the market and pressured price to jump from $10 to $50/ounce. They were investigated for market manipulation and they were convicted of fraud and were fined $1.5 billion. • The Enron Scandal: In 2001, a big US energy company was engaged in manipulative trading which caused physical congestion on California energy markets and provoked the “California energy crisis.” Enron filed bankruptcy in 2001 using off-balance-sheet accounts to hide huge derivative trading. Their auditor, Arthur Anderson also went out of the market. • The Copper King Scandal-Japan 1986: Mr. Copper was aggressively trading copper futures. He was also known as Mr. 5% because he alone controlled 5% of the global copper market for 10 years. He

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created very disrupted physical markets (production, sale, and shipment). Until 1995 when China increased sharply its mines supply. Mr. Copper was investigated for manipulation and faking the boss’s signature. He was condemned for eight years in jail and his firm paid billions of dollars as a fine. • Other cases: In 2006, investigation on energy futures manipulation in the US. In 2007, aggressive speculation on natural gas caused the price to jump. In 2009, speculations on wheat futures distorted prices. Crude Oil Scandals • For 10 years, Shell, BP, Statoil, and Platts, were controlling the benchmark price causing unreal oil prices in the EU. • 2006:14 companies were found involved in fixing the price of oil products. They paid $346 million. Shell received the biggest penalty in Europe. • 2007: BP paid a fine of $303 million for manipulating oil products in Europe. • 2012: $14 million fine on Optiver Holding BV, a Dutch highfrequency trading firm, for alleged oil market manipulation in the US market 2007. Some Manipulation Techniques Manipulators use different trading techniques to manipulate the market for profits, these techniques are considered market abusive behaviors, and they are prohibited by law, such behaviors are: 1. Wash trades: the manipulator sells and repurchases the same or substantially the same security to generate activity and increase the price. 2. Churning: when a trader places both buy and sell orders at about the same price. The increase in activity is intended to attract additional investors and increase the price. 3. Marking the close: manipulate the price of a security at the end of the trading day to ensure that it closes higher than it should.

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4. Cornering: buying a sufficiently large amount of a commodity so manipulators can control and make an artificial price. 5. Runs: create activity or rumors to drive the price of a security up or down. 6. Withholding physical commodity (controlling storage): to create a shortage in the market and cause artificial prices (physical traders only). 7. Physical-future manipulation: trading physical commodities for loss to make more profits in the future market positions (physical traders). When the commercial trader is selling a large amount of commodity futures, he/she intends to drive the price down by massive selling in the physical market to influence the price of the futures contracts.

Technical Analysis Technical analysis is another investment analysis approach widely used in financial markets besides fundamental analysis. It depends on statistical techniques such as trends and upper/lower bands to create signals for traders for buying, selling, or holding the asset. Technical analysis is considered an important tool for investors and can be distinguished from fundamental analysis. Technical analysis uses past prices or other trading measures to construct trends to predict future price movements. Whereas, fundamental analysis investigates the fundamental factors affecting the supply and demand of commodities such as the storage or reserves to predict future price moves. In practice, a brokerage account is needed to start trading in commodity derivatives. The trading platform offers a wide range of technical analysis tools through which the trader will be able to create his own technical indicators that fit his own trading needs and horizons. Technical analysis is not an exact science; it is more like an art. There is no definitive right or wrong, there is no strong science or theory behind it. Every trader builds his own indicators and charts and they are seen differently in different timeframes. One important thing to remember about technical analysis is that the same signals apply to all charts, whether they’re five-minute charts for day trading futures or daily, weekly, or monthly charts for longer-term trading. Once you understand the patterns, you can use them to trade

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Table 4.5 Technical signals and trading horizon Commodity

Type

Gold Copper Brent oil Natural gas

RSI RSI RSI RSI

signal signal signal signal

15 min

Daily

Monthly

Sell Sell Buy Neutral

Neutral Buy Buy Buy

Buy Buy Buy Sell

commodity futures over different time frames. However, the same technical indicator can indicate different signals according to the timeframe of the trading, for example, the Relative Strength Index (RSI) indicator tells you to sell if you are a daily trader, while it tells another longer-term trader to buy. Therefore, it is important to be aware of the investment and trading horizons and how to apply technical indicators for each horizon. To understand the trading horizon concept, Table 4.5 summarizes the trading recommendations based on some technical indicators (Relative Strength Index RSI) for different commodity futures. We can notice that for each trading horizon, the recommendation is different using the same technical indicator. Some technical indicators: Bollinger Bands: these bands use moving averages as a central line. Above and below the line are two tracing bands in standard deviation width. The lines act as an exponential moving average. Traders use the bands to detect the strength of a trend and time to market entries. RSI (Relative Strength Index): is a momentum indicator. It measures the asset’s relative strength against its price history. The RSI fluctuates between 0 and 100. If the indicator falls below 30, the asset is considered oversold (buy signal). If it climbs over 70, it is considered overbought (sell signal). EMA (Exponential Moving Average): EMAs are a basic type of moving average indicators. They measure trend direction over a period. EMA gives more weight, or importance, to recent data than to historical data. Classical Chart Patterns Head & Shoulders: Prices might fall below the support created by the left shoulder and head.

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Inverse Head & Shoulders: Prices might rise above the resistance created by the inverted left shoulder. Support & Resistance: Are points that reflect market saturation from buying and selling the asset. When the price touches the support level, means the asset is oversold and could rebound later. Flag: Flag shapes reflect a pattern continuation (upward or downward) or breakouts.

Chart Application in Technical Analysis To give more emphasis on how technical analysis works, the following graphs represent the Gold future contract with two trading horizons, daily and monthly, then we apply some technical indicators and chart patterns to extract trading signals (Fig. 4.5). 1289

N

Gold future price

1288

N

1287 1286 1285 1284 1283 1282

N

1281 0

5

10 Time

15

20

0

5

10

15

20

80 70 60 50 40 30 20 10 0

Fig. 4.5 Daily gold future chart

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Three technical indicators are used: Bollinger Bands (BB), the RSI, and the trend line. N refers to the news related to Gold on that day to show how does the price change according to the related information (fundamental factor), price spikes are usually associated with important news related to the commodity. Look at the point where the third N is located, we can extract a sell signal since the price overpassed the upper band supported by the RSI which is near the 70-level. The trend line demonstrates a positive trend (a buy signal in the lon-run). We can also refer to the chart pattern, we see at that point, the pattern resembles a head & shoulders pattern, which might indicate a price drop (selling signal). The monthly chart of the same day for the same commodity shows a different pattern. We notice that usually when the price hits the upper band, the RSI is near or above the 70-level, the security is overbought and 1292

N

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1290 1288 1286 1284 1282 1280

N

1278 1276 0

5

10 Time

15

20

10

15

20

RSI 80 70 60 50 40 30 20 10 0 0

5

Fig. 4.6 Monthly gold future chart

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it’s a sell signal, and when the price hits the lower band, the RSI is near or below the 30-level, the security is oversold and it’s a buy signal. This indicates the importance of using more than one technical indicator and more than one charting pattern besides the fundamental analysis (such as news). In our case, at the day and hour of taking the chart—and for both daily and monthly traders—the indicators don’t show any strong buy or sell signals, we can say it is a neutral recommendation.

References BIS. (2020). Statistical Release: OTC Derivatives Statistics at End-December 2019. https://www.bis.org/publ/otc_hy2005.pdf. World Federation of Exchanges. (2020). The WFE’s Derivatives Report 2019. https://www.world-exchanges.org/storage/app/media/IOMA2020/ FH1.2019IOMAreport_v13.pdf.

Further Readings Bouchentouf, A. (2007). Commodities for Dummies. Wiley Publishing, Inc. Christiano, L. (2017). Financialization in Commodity Markets. National Bureau of Economic Research. https://doi.org/10.3386/w23766. Consigli, G., Stefani, S., & Zambruno, G. (Eds.). (2018). Handbook of Recent Advances in Commodity and Financial Modeling—Quantitative Methods in Banking, Finance, Insurance, Energy and Commodity Markets (1st ed., Vol. 257). Springer International Publishing. https://doi.org/10.1007/978-3319-61320-8. Domanski, D., & Heath, A. (2007). Financial Investors and Commodity Markets. BIS Quarterly Review. https://papers.ssrn.com/sol3/papers.cfm? abstract_id=1600058&download=yes. James, T. (2016). Commodity Market Trading and Investment: A Practitioners Guide to the Markets (1st ed.). Palgrave Macmillan, UK. https://doi.org/10. 1057/978-1-137-43281-0. Mahajan, N., & Singh, K. (2015). A Beginner’s Guide to Indian Commodity Futures Markets. Madhyam. https://www.madhyam.org.in/wp-content/upl oads/2015/04/Commodity-Guide.pdf. Spurga, R. C. (2012). Commodity Fundamentals: How to Trade the Precious Metals, Energy, Grain, and Tropical Commodity Markets (1st ed., C. S. Ronald, ed.). Wiley. https://doi.org/10.1002/9781119202004. Zaremba, A., & Neumann, I. B. (2015). The Financialization of Commodity Markets—Investing During Times of Transition (1st ed.). Palgrave Macmillan, US. https://doi.org/10.1057/9781137476395.

CHAPTER 5

Financial Valuation Aspects

Abstract Commodity businesses have particular conditions that make them interesting from a financial valuation point of view; they usually operate globally, and their values are largely derived from underground reserves such as oil and gold. In this chapter, I discuss two financial valuation approaches adopted by practitioners and financial analysts applied to businesses operating in the commodity business and the natural resources. In particular, I cover the traditional Discounted Cash Flow (DCF) approach and the option models, offering practical examples. Keywords Financial valuation · Discounted cash flow model · Capital asset pricing model · Option approach · Black–Scholes model · Binomial model · Valuing natural resources

Financial Valuation First, this chapter will not be an exhaustive material on financial valuation methods, instead, it will provide a quick overview of the business valuation methods, then the chapter will be a direct application of the financial valuation models to commodity businesses. Therefore, a general background on financial valuation is essential at this point.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_5

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Before we start explaining the various financial valuation approached and methods, keep in mind that the classification of the models and their terminology can be different from one textbook to another, and there is a degree of subjectively in that. Financial Valuation is a common global language among practitioners and academics, it is a business and finance discipline that applies the quantitative tools to find the fair value of the asset, business, or project. Valuation utilizes accounting and financial data for various decisions such as investment, M&A, and corporate finance, thus, it can be regarded as a connection point between business accounting and finance and investment sciences, and a tool for value maximization. Financial valuation can be applied to: • Publicly traded companies – Equity valuation approach: when the valuation aims to find directly the equity value. – Enterprise valuation approach: is the value of all operating assets (equity + debt) and the value of equity is just the enterprise value minus debt. • Investment projects: projects that belong to publicly traded or privately owned companies. Projects can be the same, more, or less risky than the average firm’s portfolio of projects. • Privately owned companies: companies with limited financial and market data, the same financial methods are applied but with some corrections. • Synergies, brand values, and goodwill: valuation methods are also applied to help managers value synergies for M&A and corporate restructuring, the value of the brand, and the value of intangible assets. In a market with strong informational efficiency, the market price incorporates all relevant information and the price is the best indicator of the true value of the asset. However, in real life, perfect market efficiency does not exist and there exist degrees of market efficiency. Deviations of the market price from true value are random with different levels of efficiency:

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• Weak form: the current price reflects all information in past prices (past prices do not help to identify under or overvalued stocks). • Semi-strong form: the current price reflects all public information including the past one. • Strong form: current price reflects all relevant information, past, current, as well as privileged or insider information.

Approaches to Valuation Three main approaches to financial valuation are widely used among academics and practitioners, however, other classifications exist depending on the textbook and the context: • The Discounted Cash Flow (DCF) approach values an asset by its capacity to generate future cash flows discounted at the present time. • Relative valuation estimates the value of an asset by looking at the average price of ‘comparable’ firms with similar characteristics relative to a common variable like earnings, cash flows, book value, or sales. • The real options approach to valuation quantifies the value of managerial flexibility using option pricing models. In this chapter, we will focus on the first and the third valuation approaches, the DFC, and valuation with options. The two approaches presume the continuity of the firm, however, for a firm with serious problems and no hope of healing, the liquidation approach is applied. The liquidation approach finds the market value of a firm’s assets then subtracts the value of debt to find the residual value of equity holders, in such cases, the assets are sold at a price lower than their fair (discount) reflecting the liquidation needs.

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Discounted Cash Flow (DCF) The value of an asset is determined by its ability to generate future cash flows discounted at the appropriate discounted rate. The generic formula for the DCF valuation is: V alue =

t=n  t=1

C Ft (1 + i)n

where CFs are the future free cash flows1 from time 1 to n, i is the discount rate that reflects the cost of capital. Keep in mind that valuation is additive, which means that the value of the whole company is the summation of the values of all business units or projects within the company. DCF approach can have various valuation forms and models such as the dividends discount model (DDM); the adjusted present value (APV); and the economic value-added approach (EVA). In this chapter, we will focus on the standard free cash flow discounting. Free Cash Flow Valuation: can be either Free Cash Flow Firm (FCFF) when we use the asset side valuation, and Free Cash Flow Equity (FCFE) when we use the equity side valuation. Asset side valuation tends to value the whole operating assets financed by both debt and equity capitals, it is also called enterprise value (the value of operating assets without cash assets), and to find the value of equity, we just subtract the value of debt from the asset value, the generic asset side formula is: V alue Asset =

t=n  t=1

FC F Ot (1 + wacc)n

where FCFO 2 is the free cash flow operations (to firm) which represents the cash flow available for all capital providers (debt + equity) after deducting investment needs, wacc is the weighted average cost of capital 1 FCF is the after-tax cash flow remaining after fulfilling investment needs (capital investment and net working capital NWC). 2 FCFO = EBIT * (1 Tax Rate) + Non-Cash Expenses – Changes in NWC – Capex. Or FCFO = Cash Flow from Operations + Tax Adjusted Interest Expense – Capex. Other ways also exist.

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(the appropriate discounted rate that reflects the time value of money). The value of Equity using the asset side approach is: Equity value = Asset value − Value of Debt On the other side, the equity approach to valuation uses a modified formula to find directly the equity value: V alue Equit y =

t=n  FC F E t (1 + K e)n t=1

where FCFE 3 is the free cash flow available to equity holders after fulfilling investment needs and paying the debt obligations (interest rate and debt payment), Ke is the cost of equity capital. One way to calculate the cost of equity capital (Ke) is by applying the Capital Asset Pricing Model (CAPM)4 : K e = R f + B(Rm − R f ) Ke = Rf + ERP The idea behind the CAPM is that the expected equity return (cost of equity) is composed of the risk-free rate (Rf) + equity risk premium (ERP). ERP is a function of beta (B) which is the systematic (or market) risk of the asset, and the market risk premium (Rm − Rf) (the difference between the return on the market index and the risk-free rate). All are market-based information available for publicly traded firms. Now Ke is a component of wacc since wacc is the weighted average cost of capital (debt + equity), so wacc is calculated as follows: W ACC = K e

D E + K d(1 − tc) E+D E+D

3 FCFE = Cash Flow from Operations – Capex + Net Debt Issued (repaid). Or FCFE = Net Income + Non-Cash Charges – Changes in NWC – Capex + Net Debt Issued (repaid). Other ways also exist. 4 CAPM is an asset pricing model, it is used to calculate the remuneration for risky investments introduced and developed by Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently. However, exist other models for Ke calculation including the Fama-French three factor model, and the Arbitrage Pricing theory (APT).

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E D E+D and E+D

are the market wights of both debt and equity, and K d(1 − tc) is the after-tax cost of debt since interest paid on debt is tax-deductible. Now, let’s revise the components and procedures of the DCF valuation: 1. Determine the after-tax cash flows, investment needs, and debt structure. 2. Decide the valuation horizon and the growth rate after studying the business model. 3. Calculate all value components; CFs, discount rate, and the horizon. In applying the DCF model,5 there are many versions of the model according to the horizon, maturity, and growth stages of the company, here, we only reported the generic formula.

Real Option Valuation The option valuation approach applies option valuation methods to find the value of assets with option features. The idea is that the classical DCF models sometimes underestimate the asset value because they fail to consider the options embedded in the asset (managerial options). Sometimes, the value of real options can be significant to alter corporate decisions such as M&A. Strategic options examples: option to postpone an investment; project abandonment option; and project expansion option. An option has a derivative feature as it derives its value from another underlying asset such as the project’s value, or asset’s value. It provides the holder with the right to buy or sell a stated quantity of an underlying asset at a predetermined price (called a strike price or an exercise price) at or before the expiration date of the option. Options provide the flexibility to exercise the option which distinguishes them from other derivatives

5 For example, if the company is in one continuous growth stage, we apply this version C F0 (1+g) of the DCF: V = (wacc−g) And if it is in two-stage growth, we apply this version of the DCF: V = t=n  C F0 (1+g1 )t C Fn (1+g2 ) −n t + wacc−g (1 + wacc) t=1

(1+wacc)

2

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contracts such as forward and futures. Options traded for a premium to reflect the embedded flexibility. A call option is the option to buy the underlying asset at the strike price at or before the expiration date. The payoff on the call option is presented in the following diagram (Fig. 5.1). A put option gives the holder the right to sell the underlying asset at a fixed, at any time before the expiration date of the option. The payoff on the put option is presented in the following diagram (Fig. 5.2). According to the payoff diagrams, we can summarize the factors influencing the option value as; the value of the asset; the strike price; the time to maturity; the opportunity cost of capital; the variance in the underlying; and dividends (if there are). There are two classes of options, the American option that allows the exercise of the option at any time before maturity. And the European option that permits the exercise only at the maturity date. The early exercise feature of the American option makes it more valuable than the European style option but more difficult to value.

Fig. 5.1 Payoff from a call option

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Fig. 5.2 Payoff from a put option

Option Pricing Methods Three methods are used to value options, they range from easy to the most complex method: 1. Binomial model 2. Black–Scholes formula 3. Monte Carlo simulation. In this chapter, we will discuss the first two methods since the Monte Carlo method is usually used to value complex and exotic options.

The Binomial Model The binomial model is a discrete model considering the simple formulation for the asset price process during which the price, at any time, can move to one of two possible directions (up or down). The general formulation of a stock price process that follows the binomial is shown in the Fig. 5.3. S is the price of the underlying, p is the probability of price increase (up), 1 – p is the probability of price decrease (down). The value of the call option (C 0 , C u , C d ) resembles the same path, so we can express the

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Fig. 5.3 Tree sequence of the binomial model

option value for each path, X is the exercise price: Cu = max (Su − X, 0) Cd = max (Sd − X, 0) The risk-neutral probability q is given by S0 (1 + R f ) = q Su + (1 − q)Sd f )−Sd Thus q = S0 (1+R Su −Sd And the call option value is thus given by

C0 =

qCu + (1 − q)Cd 1 + Rf

In other words, the binomial method works by creating a replicating portfolio with the same payoff of the asset in question. It aims to use a combination of risk-free borrowing/lending and the underlying asset to create the same cash flows as the option being valued under the noarbitrage situation so that the value of the option must be equal to the value of the replicating portfolio, the value of the option is:

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Value of the call = Current value of underlying asset × Option Delta − Borrowing needed to replicate the option

The Black–Scholes Model While the binomial model is a discrete-time model considering jumps in asset prices including a time interval (t) between price jumps, the Black– Scholes model is a continuous pricing model assuming prices are normally distributed. The Black–Scholes can be considered a special case of the binomial model. The initial version of the model intended to value European-style options when it was first presented by Black and Scholes in 1973. Thus, the possibility of early exercise and the dividend payment is less relevant to the value of the option according to the initial version of this model. The value of the call option can be expressed according to the following expressions6 : V aluecall = S N (d1)−K e−r t N (d2) This shows that the value of the call is just the Net Present Value of its payoffs calculated as the current price menus the probability-adjusted present value of the strike price (continuous discounting). Where N (x) is cumulative standard normal distribution (z ≤ x).     ln KS + r + σ22 ∗ t d1 = √ σ t √ d2 = d1 − σ t According to the above formulas, the value of the call option is a function of the following factors:

6 If the company pays regular dividends, the following modified formula is applied     ln KS + r −y+ σ22 ∗t −yt −r t √ V aluecall = Se N (d1)−K e N (d2) and d1 = , where y is the σ t dividend yield (D 0 /P 0 ).

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S = Current value of the underlying asset K = Strike price of the option t = Life to the expiration of the option r = Risk-free rate represents the cost of borrowing σ2 = Annualized volatility of the underlying asset.

Valuation Applications In this section we will cover three applications for financial valuation related to the commodity business: 1. Valuation of natural resources with option pricing method 2. Valuation of commodity companies with option pricing method 3. Valuation of commodity companies using Discounted Cash Flow (DCF) with normalized commodity prices.

Natural Resource Valuation Investing in natural resources is risky and costly. When valuing natural resources with options, the underlying asset is the natural resource and the value of the investment depends on two variables: the estimated quantity, and the market price of the commodity. Therefore, in an oil field, the underlying asset is the value of the estimated oil reserves underground, based upon the current price of oil. In such investments, the cost of developing the natural resource is an essential part of the investment; and the profit of the owner is the difference between the value of the asset extracted and the cost of the development. If we describe the development cost as X and the resource value as V , the payoff from the natural resource option can be written as follows:  V − X, if V > X Payo f f s = 0, if V ≤ X These payoffs resemble the call option payoffs which can be presented in the following diagram (Fig. 5.4). In this context, we notice that the determinants of the option value are not facts but estimations based on assumptions, assumptions regarding the amount of the natural resource, the commodity price, the commodity volatility, the lifetime, and the delay in the project development.

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Fig. 5.4 Payoffs from developing natural resource

Application: Valuing an Oil Reserve Imagine an oil company with an offshore facility. The estimated oil reserve of 75 million barrels of oil; the cost of developing the reserve is estimated to be $1200 million, and the development lag is two years. The firm has the right to exploit this reserve for the next 20 years, and the current price per barrel is $407 . With the completion of the field development, the net revenues from production will be 5% of the value of the reserves each year. The riskless rate is 4%, and the variance in the logarithm of oil prices is 0.04. Thus, the inputs for the Black–Scholes models are: • The discounted value of the developed reserve = S as an underlying = 40 × 75 (1 + 5%)−2 = 2,721 because the production will not be available immediately but in 2 years, so we discount the value for 2 years at the dividend yield. • The exercise price = the development cost = $1200 million. • Time to expiration = 20 years. • The standard deviation = 20% assuming oil price variance is the only contributing variance. • Risk-free rate = 4%.

7 We assume that the price is fixed for the whole duration with bilateral contracts, or the oil price has been normalized.

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• Dividend yield = Net production revenue/value of reserve = 5% (can be calculated as 1/t = 1/20 = 5%, it’s also considered as the annual cost of delaying the project). Inserting the above data into the Black–Scholes model we get the following results8 : 

d1 =

ln

2721 1200

   + 4%−5%+ .04 2 ∗20 √ .2 20

d2 = 0.244

= 1.139 N (d1) = 0.873 N (d2) = 0.596

V aluecall = 2721e−.05∗20 × 0.873−1200e−.04∗20 × 0.596 = 551.83 According to the given estimations and the oil price fixation, the project (oil reserve) is worth $551.83 million which adds a positive value to the aggregate corporate value. Furthermore, simulations can also be performed to see how the reserve value changes as one or more inputs change. For example, a drop in oil price from $40 to $25 replicating what happened during the first months of the COVID-19 pandemic (keeping other factors unchanged), would results in an oil reserve value = $247 million. A drop of 37.5% in oil price results in a 55% loss of value, this generates a 1.47 sensitivity factor (for each 1% drop in oil price, resource value decreases by 1.47%). However, when oil price increases by the same rate of 37.5%, the value of the oil reserve increases by 61.67%, making a 1.64 sensitivity factor. Therefore, the value of the oil reserve is more sensitive to the oil price increase than to the price decrease. Sensitivity analysis can be performed on the rest of the model inputs, and sometimes, the effect of one variable is offset by another resulting in a slight change in the value of the oil reserve.

Valuing a Commodity Company with Options We have seen in the previous section how to value a reserve of a natural resource such as a gold mine or oil field using option pricing. In this section, we apply the option pricing models to value the company that utilizes those natural reserves since the company is considered a portfolio 8 You can also verify your manually calculated results using online Black–Scholes calculators or excel.

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of natural reserves that are valued separately then summed up. Information used in this approach of valuation is mostly assumed and estimated based on an expert’s analysis. Application: Valuing an Oil Company—ConocoPhillips ConocoPhillips is an American multinational energy corporation with its headquarters located in the Energy Corridor district of Houston, Texas in the United States. It is the world’s largest independent pure-play exploration and production company and the company ranked No. 95 in the 2018 Fortune 500 list of the largest United States corporations by total revenue. ConocoPhillips was created through the merger of American oil companies Conoco and Phillips Petroleum Company on August 30, 2002. Conoco Inc. was an American oil company founded in 1875, as the Continental Oil and Transportation Co. Currently, the multinational has different oil fields, some are developed reserves and others are not yet developed. The already developed reserves have an estimated time until the expiration of 10 years, while the undeveloped reserves have 20 years until expiration. We will proceed as follows: 1. Value the undeveloped reserve using option pricing models. 2. Value the already developed reserve with the DCF model. 3. Find the value of all assets by adding up both components. 4. Deduct the net debt to find the equity value. The following two tables summarize the valuation process (Table 5.1). Inserting the model inputs, we get around $15 billion call value, then we add the present value of cash flow from the already developed reserves discounted for 10 years at 8%, then we reduce the value of net debt, we get an equity value of $30.4 billion, and a value per share of $28.33. This value is lower than the pre-pandemic price because it reflects the effects of the COVID-19 pandemic (we used $33/barrel of 6-month pandemic average), so, the drop in the oil price during the pandemic is discounted in the value and the share value is close to the price during the oil drop (March–April 2020). However, the oil price during the pandemic might not be a good representation of the oil value since companies sell their physical oil at

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Table 5.1 The value of Conocophillips at low oil price Estimated reserve (barrels) Production cost per barrel Oil price-pandemic average Time to expiration

5,262,000,000

Current value of asset

173,646,000,000

10

Strike price

52,620,000,000

33

Value of call

15,194,964,754

20

Value of developed reserve Total value of the activity Menus value of debt Equity value Value per share

29,980,643,690

% of revenues/value

7%

Rf Oil volatility wacc CF from developed reserve Value of developed reserve N . of shares

2.39% 14% 8% 4,468,000,000

45,175,608,444 14,790,000,000 30,385,608,444 28.33

29,980,643,690 1,072,425,162

a fixed price in bilateral contracts, therefore, we made a simulation where we apply a higher oil price of $53/barrel calculated as the last 5 years’ average. The following table demonstrates a summary of the valuation process (Table 5.2). Following the same process of option valuation, and after adjusting for pandemic price shock, we obtain a final share value of $49.4 while the stock is traded at $43 during July–August 2020. Therefore, the normalized oil price could be a fair proxy for the oil price in valuing oil companies such as ConocoPhillips and such companies seem to be undervalued due to the COVID-19 shock and markets are ready to adjust the valuation once positive information is released such as pandemic control or an effective vaccine.

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Table 5.2 The value of Conocophillips at a normalized oil price Estimated reserve (barrels) Production cost/barrel Oil price-5 years average Time to expiration

5,262,000,000

Current value of asset

278,886,000,000

10 53

Strike price Value of call

52,620,000,000 37,786,714,186

20

Value of developed reserve Total value of the activity Menus value of debt Equity value Value per share

29,980,643,690

% of revenues/value

7%

Rf Oil volatility wacc CF from delevloped reserve Value of developed reserve N . of shares

2.39% 14% 8% 4,468,000,000

67,767,357,876 14,790,000,000 52,977,357,876 49.40

29,980,643,690 1,072,425,162

Valuation with Discounted Cash Flow and Normalized Commodity Price Uncertainty is a core attribute to financial valuation derived from macro or market factors and firm-specific factors, the performance of commodity companies is highly related to macro and external factors through the economic cycles that drive commodity prices ups and downs. The oil price is a core component of the business model of commodity firms, it represents the main revenue component for oil companies and the main cost component for airlines or power generation companies. In this sense, commodity companies share common features with cyclical companies: 1. The cyclicality of commodity prices and shocks: in this respect, commodity prices are determined by global markets according to fundamental factors influenced by the economic cycle, and commodity companies are price takers. Shocks are also a determinant of commodity prices that could bring opposite effects on different companies, for example, during the first months of the COVID-19 pandemic, global oil companies registered huge losses due to price drop, whereas gold price has been increasing since then favoring companies in the gold business.

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2. Finite resources: commodity companies survive on commodity reserves but there is a finite quantity of natural resources on the planet. This fact plays an important role in the valuation process through the horizon forecast and the normalization process of commodity prices, this means there is no perpetuity assumption in valuing the reserves of natural resources as we have seen in the previous examples. To overcome the volatility issue in earnings for cyclical companies and commodity prices, normalization using past averages is practically used to smooth valuation inputs such as cash flows and commodity prices. One of the following normalization techniques can be used: 1. Absolute time-averaging is a simple method for averaging using past data, however, a long time series is necessary to overcome the cyclicality by capturing opposite cycles in the calculation. The period usually depends on the commodity sector and usually 5 to 10 years are enough to smooth values. However, normalized values for growing companies can be underestimated. 2. Relative time-averaging: to overcome the absolute value issue, some practitioners normalize the profitability ratios rather than profits. 3. Weighted time-averaging: another way to avoid absolute average limitations, a common practice applies different time weights; more weight for recent or good years. 4. Sector average: is usually used for companies with a lack of performance record, thus the average of similar companies in the sectors is used as a proxy for the profitability margin of the company in question. Regarding commodity companies and knowing that they derive their revenues from commodity prices, it would be appropriate to use normalized commodity prices then build up revenues and cash flows accordingly. In this regard, there are two ways for commodity price normalization: • Looking at the average price of the commodity over time, adjusted for inflation. • Or determine a fair value for the commodity, given the fundamental factors affecting the commodity price.

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Once we obtain the normalized prices, we can use the classical bottomup approach to build revenues, profits, and cash flows forecasts as in the DCF valuation model. The estimated quantity of the commodity is important for revenue forecast, then we use the proforma income statement approach to calculate the bottom line (profits). Then to figure out the free cash flow, it is necessary to estimate the investment needs (both in Capex and Net working capital). At this point, we are ready to apply the DCF model by discounting the forecasted free cash flows at the appropriate cost of capital (wacc if we use asset side valuation, and the cost of equity Ke if we use the equity side valuation) for the estimated time of the commodity reserve. V alue =

t=n  t=1

C Ft (1 + i)n

Then, sensitivity analysis can be performed to show how the firm’s value change according to different levels of normalized commodity prices. Sometimes, analysts are criticized for the subjectivity in the input estimations (oil price and quantity). In this regard, practitioners use market-based prices for the commodity in their forecasts to minimize subjectivity and the commodity futures curves offer a market-based tool for future price estimations. The advantage of this approach is that it comes with a built-in mechanism for hedging against commodity price risk. Valuation Application: ConocoPhillips We have seen how to value ConocoPhillips using option pricing using the Black–Scholes model. In this application, we apply the discounted cash flow approach with the normalized oil price. Building on the data and quantities given in the options application, we estimated the revenues, operating profit, cash flows, and the value per share according to different normalized oil prices: 1. The quantity of the undeveloped reserve is estimated to be 5,262 million barrels. 2. Normalized oil prices range from $20 to $70 per barrel. 3. The cost of capital (wacc) = 8% for 20 years.

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4. Depreciation offset new investment (steady-state for simplicity). 5. The marginal tax rate is 25%. 6. Cash flows from the developed reserves = $29,980 million. The simulation results are presented in the following graph (Fig. 5.5). We can notice a linear relationship between oil price and the stock price of oil companies (ConocoPhillips in this case), the equation provided makes it easier for predicting the stock price given a certain oil price. It’s also worth noting that the sensitivity factor is less than 1 (0.48), for each 10% change in oil price, there is a 4.8% change in the stock price. This is because a significant portion of cash flows are derived from already existing reserves at predetermined prices. However, another simulation can be run exposing all types of cash flows to market price swings obtaining a higher sensitivity coefficient. Currently (as of August 2020), the Brent oil is traded at $44/barrel and the stock of ConocoPhillips is traded at $40, and during March–April 2020 when the Brent price dropped to around $20, and the stock of ConocoPhillips was traded at $22. These actual market data support our previous valuation simulations and the sensitivity analysis in the previous graph.

70 y = 0.48x + 27.4 R² = 0.998

Stock price

60 50 40 30 20 10 0 0

20

40 Normalized oil price

Fig. 5.5 Sensitivity of stock price to oil price

60

80

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Further Readings Berk, J., & DeMarzo, P. (2017). Corporate Finance (4th ed.). Pearson Education Limited. Pearson Italy: Milan. Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637–654. https://www.jstor.org/ stable/1831029. Brealey, R., Myers, S., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). New York: McGraw-Hill Education. Damodaran, A. (2003). Corporate Finance: Theory and Practice (2nd ed.). Chichester: Wiley. Damodaran, A. (2005). The Promise and Peril of Real Options (NYU Working Paper). https://ssrn.com/abstract=1295849. Damodaran, A. (2011). The Little Book of Valuation (Vol. 9, Issue 2). Hoboken: Wiley. Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47 (1), 13. https://doi.org/10.2307/1924119. Mossin, J. (1966). Equilibrium in a Capital Asset Market. Econometrica, 34(4), 768–783. http://efinance.org.cn/cn/fm/EquilibriuminaCapitalAssetMarket. pdf. Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance, 19(3), 425–442. https:// doi.org/10.1111/j.1540-6261.1964.tb02865.x. Treynor, J. L. (1961). Market Value, Time, and Risk. SSRN Electronic Journal, 1–46. https://doi.org/10.2139/ssrn.2600356. Treynor, J. L. (1962). Jack Treynor’s Toward a Theory of Market Value of Risky Assets. SSRN Electronic Journal, https://doi.org/10.2139/ssrn.628187.

CHAPTER 6

Commodities and the Sustainability Transition

Abstract For the last three decades, global warming and climate change and their implications have been a focal point for researchers, regulators, and politicians. The earth temperature and the GHG emissions have reached alarming levels fearing the irreversibility point, that’s why the sustainability transition has become on global agendas. Increasing earth population, economic growth, and industrialization are said to contribute to climate change. In this regard, commodities are in the heart of these factors; commodities feed economic growth, and they satisfy individuals’ needs. Therefore, in this chapter, I present the climate-related issues in commodity production, mobility, and consumption, and the global efforts and policies to minimize the negative externalities from commodities. Keywords Climate change · Sustainability transitions · Sustainable commodities · Emission trading · ESG reporting · ESG rating

Why We Need a Change The twentieth century has demonstrated radical technological changes; innovations, and a revolution in ICT (Internet, Communication, and Telecommunications). At the same time, our world has been showing more vulnerablility to global issues; financial crisis, climate change, natural © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2_6

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disasters, cyber-attacks, commercial wars, and lately the global pandemic of COVID-19. These global trends have proven how global and regional coordinations are still weak and much more is needed to be done to mitigate these global risks. Globalization and interconnectivity imply that financial capital, human capital, and knowledge are more closely linked at the global level, and the global financial crisis of 2008/2009 has proved this such link. Global governance is an important implication of the crisis in which regulators called to promote financial stability in global markets, transparency, and addressing sustainable development by better linking investment decisions with the true corporate behavior, thus adequate reporting has become an essential need for decision making. Today, we face fundamental sustainability challenges in several domains. Energy supply, for example, is confronted with a rapid depletion of natural resources, air pollution, and greenhouse gas emissions (GHG), nuclear risks, uncertainties related to short and long-term security of supply, and energy poverty. Water supply and sanitation are not exclusion. The transportation sector is getting highly congested with increasing negative environmental impacts. Other sectors such as agriculture and the food system deal with the same issues. While most of these challenges are related to environmental and social problems, economic problems are persistent, therefore, we face environmental, social, and economic challenges at the global level, and these are the three sustainability pillars that we need to coordinate at the global level. Therefore, the governance and promotion of sustainability transitions—achieving structural changes in consumption and production behaviors toward more sustainable patterns—is getting more important at the academic and policy levels, politicians are recently including sustainability issues in their election campaigns. Sustainability transitions are long-term, multidimensional, and fundamental transformation processes through which social, economic, and technical dimensions of the economy are pushed toward adopting more sustainable consumption and production patterns. According to the European Environmental Agency (EEA), the environmental challenges ahead of us are global and systemic, and global sustainability challenges increasingly raise concerns about the stability of the earth system that supports all life on our planet. Therefore, to achieve long-term sustainability goals, the core systems of our societies will have to change dramatically. That is especially true for the systems related to

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food, energy, mobility, and construction. This is not only true for the EU context but extends globally. Our highly globalized world is characterized by a variety of largescale, high impact, and often interdependent changes, known as global megatrends. In the last 150 years, especially after the industrial revolution, there has been substantial growth in economic indicators and in the population which imposes an excessive burden on the ecosystem. This growth is always associated with higher demand pressure of earth’s resources through which negative externalities on ecosystems are said to escalate further in the coming decades. Global macrotrends are many, in the following figure we show aggregated macrotrends. These global trends are the main drivers for the “planetary boundaries” approach, and they trigger the change for sustainability transitions (Fig. 6.1). The global macrotrends raise questions about the limits of tolerable environmental pressure on the Earth’s systems, sometimes referred to as planetary boundaries. An interesting approach and frameworks (can also be considered a way of thinking) adopted the EEA is the “Planetary boundaries.1 ” Human and economic development patterns have been creating serious sustainability issues and urgencies that have never been more evident; challenges related to climate change and global biodiversity loss. The alarming sustainability issues question whether human-induced pressures approach or exceed the planet’s environmental limits. Are current pressures on the Earth’s system put the earth at risk? and finally, have we reached the point of irreversibility in terms of ecosystem damage? The nine processes identified by the boundaries framework work to regulate the stability and resilience of the earth system. The framework is built on calculated boundaries that set the limits within which humans can continue to live on earth referred to as a “safe operating space.” It suggests that crossing these boundaries increases the risk of generating large-scale irreversible environmental changes that could turn the Earth system into a state that is detrimental to human development. The most recent estimate suggests that four Earth system processes: climate change, biosphere integrity, land system change, and biogeochemical cycles, are in a zone of risk alert for triggering fundamental and undesirable Earth system changes. 1 For more details on this issues, you can refer to the EEA joint report: “Is Europe living within the limits of our planet?” available at https://www.eea.europa.eu/publicati ons/is-europe-living-within-the-planets-limits.

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Fig. 6.1 Aggregated global macrotrends (Source Author’s elaboration based on [EEA 2015])

Figures 6.2 and 6.3 are related to the earth’s temperature and CO2 concentration. Both figures represent some of the environmental global megatrends that are related to the framework of planetary boundaries. Human-induced CO2 and other GHG gases are considered one of the most serious climate issues and they are highly related to the increasing earth’s temperature which is very evident when depicting the long history of earth’s temperature and the concentration of CO2 and other GHG gases. Figure 6.2 demonstrates the long history of temperature anomalies relative to the 1961–1990 level. We see that human activities in the last decades were responsible for raising the global temperature by approximately 0.7 °C. When we consider 150 years back, it seems that the

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Temperature change in celsius

Temperature anomaly 0.8 0.6 0.4 0.2 0 1800 -0.2

1850

1900

1950

2000

2050

-0.4 -0.6

Time

ppm

Fig. 6.2 Global temperatures anomaly (Data source [Our World in Data 2020]—CC-BY-4.0) 450 400 350 300 250 200 150 100 50 0 0

2

4

6

8

10

12

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Time

Fig. 6.3 Atmospheric CO2 concentration (Data source [Our World in Data 2020]—CC-BY-4.0. Note Global average long-term atmospheric concentration of carbon dioxide [CO2 ], measured in parts per million [ppm]. Time ranges from 400,000 BCE to 2018)

global temperature was lower (colder) by 0.4 °C with respect to the reference year. Adding 0.4 and 0.7 results in a 1.1 °C global temperature increase in the last 150 years. With a simulation without adopting stringent environmental policies, the average temperature would reach 1 °C by 2040. Figure 6.3 shows the very long-term atmospheric CO2 concentration.

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The control of the atmospheric concentration of GHG is a key element for stabilizing the anomalies in global temperatures. As we have shown earlier, there is a long history of association between the GHG concentrations and the rising earth temperature. However, the effect of GHG concentration is not simultaneously transmitted in rising temperatures and a time lag between the two events is also proven, this means that the environmental policies manage to contain and control GHG concentration, earth temperature will continue to rise for decades incorporating past concentrations. Over this long period, atmospheric concentrations of CO2 did not exceed 300 parts per million (ppm). However, the industrial revolution and the human-made emissions have changed the shape of the CO2 concentration creating an exponentially growing trend which is considered an alarming sign. Again, with a simple simulation performed with no stringent policies, by 2030, the CO2 concentration will exceed 450 ppm. In this regard, important drivers for the sustainability transitions are presented here: 1. The demand side: consumers and investors (the real and financial sides of the economy) are becoming more aware of the negative and disastrous consequences related to the global macrotrends. Consumers are buying sustainable products through the whole supply chain (low GHG emissions, no child work, no land abuse, no corruption, etc.). And investors are actively searching for sustainable investments that meet the ESG standards. 2. Policies and regulations: regulators are also aware of and actively regulating climate and sustainability-related issues. Politicians are now including ESG issues on their agendas. 3. Fast-changing environment: this factor could be a driver for the previous factors. Humans and corporate entities have been exercising unsustainable practices since always with the limited or long-term appearance of the negative effects. However, in the last 50 years, with the intense use of fossil fuel sources, massive deforestation, urbanization, and the increasing world population, the damage to the environment and to the ecosystems have been becoming more evident and visible with the shorter time needed to prove it. Additionally, with internet advancement and social media, images of damages are easily accessed everywhere on the globe which promotes social awareness.

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4. Supply-side: this factor can be influenced by the previous three drivers. Supply-side states also the suppliers of the commodity, product, or service are now concerned about sustainability issues. Corporations are becoming more aware that physical markets (consumers) and financial markets (investors), and regulators are requiring more sustainable products and processes. Furthermore, corporations were aware of sustainability issues 50 years ago, however, due to limited demand and regulatory pressures, corporations did not alter their ways of doing business, and because a huge amount of investments had been done at that time using conventional (polluting) technologies, and the last 20 years experienced the obsolescence of the old investments, therefore, businesses are investing in new and cleaner technologies. Businesses also promote sustainability as an image improving tool which enhances reputation and business results.

Global Efforts to Combat Climate Change2 Efforts and activities have been coordinated at the global level lead by the United Nations to stabilize policies and guidelines to mitigate environmental risks induced by human activities. Perhaps one of the earliest successful global coordination is the Kyoto Protocol of 1997, followed by the Paris Agreement of 2015. The Kyoto Protocol was adopted in December 1997. Owing to a complex ratification process, it entered into force in February 2005. Currently, there are 192 Parties to the Kyoto Protocol. In short, the Kyoto Protocol operationalizes the United Nations Framework Convention on Climate Change by committing industrialized countries and economies in transition to limit and reduce GHG emissions according to agreed individual targets. The protocol binds developed and industrialized countries to adopt more stringent measures to combat climate change on differentiated bases according to their share of emissions and capabilities to mitigate it. Those countries are responsible for most of the global emissions, but all countries in the protocol must report their emissions and policies periodically. Consequently, global emission trading has been 2 For more information on Kyoto protocol and the Paris agreement, and other climate actions, you can refer to the United Nation’s Climate Change Committee, www.Unfccc.Int.

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allowed. Emission trading, as set out in Article 17 of the Kyoto Protocol, allows countries to exchange emissions units, which means that countries with excess units can trade them for gain with another country. This market mechanism creates incentives to reduce emissions by rewarding under-emitters and penalize over-emitters, it is also known as the “carbon market” since CO2 is the prevalent GHG emitted in the atmosphere. Emissions trading schemes are established as climate policy instruments at the national and regional levels. Under such schemes, governments set emissions obligations to be reached by the participating entities. The European Union emissions trading scheme (EU-ETS) is the largest in operation, it was introduced in 2005 as a prudent response to Kyoto protocol, setting emission reduction targets at the EU level. It targets more than 12,000 installations and more gases and sectors are being covered. The energy sector and other energy-intensive industries are the main targets, special attention is also given to carbon leakage when including certain industries under the scheme. The second global peace of coordination is the Paris agreement (CPO21). It is a continuation rather than a replacement of the Kyoto Protocol. The Paris Agreement builds upon the Convention and for the first time brings all nations into a common basis to undertake ambitious efforts to combat climate change, with enhanced support to assist developing countries to do so. As such, it establishes a new path in the global climate effort. It sets out a global framework to avoid dangerous climate change consequences by setting a target of global warming to be below 2 °C and pursuing a very optimistic target at 1.5 °C. COP21 targets also the vulnerable countries suffering the consequences of climate change by strengthening their resilience by formulating climate-enhanced policies. It also establishes what is called the nationally determined contributions (NDCs) showing the role of each nation in mitigating climate-related hazards. Against this background, we can agree that commodities are at the heart of sustainability transitions especially the environmental dimension. The production, transportation, and consumption of commodities are at the core of climate change, environmental risk, and GHG emissions. If we draw a broad environmental accounting, we conclude that almost all environmental damages come from the supply chain of commodities. For instance, imagine the supply chain of the natural gas, it is associated with GHG emissions during the extraction, during the transportation by ships, the leakage of methane gas (CH4) from the pipeline in the land transportation, and finally, the release of CO2 and other gases during the

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Transporation Consumption Ship (GHG from ship)

Pipline (CH4 leakage)

(GHG from heat & power)

Fig. 6.4 Natural gas supply chain and the environment

burning for heat and power generation. The following figure represents a simplified natural gas supply chain and the associated environmental issues. In this quick example, we focus only on the GHG emissions and the leakage related to the natural gas supply chain, however, other environmental and sustainability issues are also linked to the natural gas supply chain (Fig. 6.4). The supply chains of all other commodities, energy, metallic, and agricultural commodities are also associated with environmental risks as we will see in the next sections.

Sustainability Issues in Commodities In this section, we present the global trends related to commodities and their sustainability impacts. Many sustainability issues are related to commodities but almost all commodity groups (agricultural, energy, and metals) share the following issues: GHG emissions, deforestation , child

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labor, wildlife, and water quality. The issues mentioned here are not only related to the production of the commodity but also transportation and consumption. Such issues make commodities very relevant and at the core of the sustainability transitions. Global GHG Emissions The energy sector alone is responsible for more than 70% of CO2 emissions and about 50% of all GHG emissions. Emissions are related to production, transportation, and the consumption of energy sources. Figure 6.5 shows the the various energy sources contribute to the CO2 emission. They responsible for about 36 billion tons of CO2 annually— mainly oil, coal, and gas. The contribution of each of these sources has changed significantly over time, and large differences are still seen among regions. In the chart, we see the absolute and relative contribution of CO2 emissions by source, differentiated between coal, gas, oil, flaring, and cement production. As of today, solid and liquid fuels dominate, although contributions from gas production have also been notable due

Fig. 6.5 Global annual CO2 emissions by fuel type (Source [Our World in Data 2020]—CC-BY-4.0)

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to gas reliance especially in Europe. Cement and flaring at the global level remain comparably small (Figs. 6.5 and 6.6). Across regions, there has been switching from coal to other sources due to cost and energy efficiency. Throughout the nineteenth and twentieth centuries, coal production was dominant across countries in Europe (predominantly the UK) and the United States. However, energy transitions in these countries have resulted in significant declines in recent decades. And emissions from coal have been shifting to newly industrializing nations such as BRICS countries and the Middle East. Nowadays China dominates global emissions from coal due to the intensive use and production. As shown in Fig. 6.7, the two most powerful nations, the United States and China, are on the top of global emitters of CO2 from oil followed by Saudi Arabia and Brazil. The difference between China and the US emissions is that China emissions are production-induced (emissions from production exceed emissions from consumption) whereas US emissions are consumptioninduced (emissions from consumption exceed emissions from production) (Figs. 6.7 and 6.8).

Fig. 6.6 Annual CO2 emission from coal by country (Source [Our World in Data 2020]—CC-BY-4.0)

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Fig. 6.7 Annual CO2 emission from oil by country (Source [Our World in Data 2020]—CC-BY-4.0)

Fig. 6.8 Annual CO2 emission from gas by country (Source [Our World in Data 2020]—CC-BY-4.0)

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Regarding emissions from gas, Russia is the second important after the United States due to the large share of Russia in the production of natural gas, almost 50% of Europe’s gas needs come from Russia. Figure 6.9 shows the breakdown of total greenhouse gases (the sum of all greenhouse gases, measured in tons of carbon dioxide equivalents) by sector. So, in 2016, about 50 billion tons of CO2 equivalent GHG emissions released into the atmosphere. Electricity and heat production is seen to be the largest contributor to global emissions. This is followed by transport, manufacturing and construction (largely cement and similar materials), and agriculture. The share of each sector is different by country. This explains why the energy sector is the earliest to be targeted by the EU-ETS in 2013 (the start of the second phase of the EUETS) by not receiving free allocations and a reduction rate in emissions is set to be achieved each year. This graph is interesting because many think agricultural activities are clean and are completely healthy for the environment. However, we can notice that total GHG emissions from agriculture are 5.8 billion tons which makes agriculture responsible for almost 12% of global

Fig. 6.9 Global annual GHG emissions by sector (Source [Our World in Data 2020]—CC-BY-4.0)

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Fig. 6.10 Annual global methane emission by sector (Source [Our World in Data 2020]—CC-BY-4.0)

emissions. The global breakdown for CO2 is like that of total greenhouse gases in which the top emission producer is the electricity and heat production sectors, followed by transport, and manufacturing, and construction (unreported figure). Agriculture is not a pure or pollution-free activity. Globally, agriculture is the first responsible for methane emissions mostly from livestock (they produce methane through their digestive processes, in a process known as “enteric fermentation”). Besides agriculture, fugitive emissions produce a significant amount of methane. “Fugitive emissions” represent the gas leakage from oil and gas processes and the poorly maintained transportation pipelines. The issue of fugitive methane from gas transportation pipelines is now a hot issue on the table of European regulators. The EU-ETS covers most of the GHG emissions from most of the activities within the EU jurisdiction, however, a significant share of methane leakage is registered yearly from the gas transportation from Russia to Europe3 without being counted by the EU

3 EU imports 80% of its gas needs, and almost 75% of imports comes from Russia (almost 60% of the EU needs).

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trading scheme. The Institutional Investors Group on Climate Change wrote to the Commission in May 2020 asking it to propose rules to ban gas with a methane leakage rate in upstream supply chains of more than 0.25 percent by 2025. Methane is more powerfull to global warming than CO2 , but it degrades faster while CO2 remains longer in the atmosphere (Figs. 6.10 and 6.11). Nitrous oxide (N2O) is produced by microbes in nearly all soils and absorbed by the crops. However, the use of nitrogen fertilizers contributes to the excess nitrogen to be converted into N2O. Emissions from N2O have been increasing in the last 50 years due to the intensive use of chemical fertilizers. But nitrous oxide is not only produced when synthetic nitrogen fertilizer is applied; the animal manure, as an organic fertilizer, generates the same process. It is worth noting that agriculture has a bidirectional relationship (dual causality) with global warming and climate change: 1. As we have just seen in the previous graphs, agriculture is responsible for at least 12% of total annual GHG emissions, mostly from CH4

Fig. 6.11 Annual global N2O by sector (Source [Our World in Data 2020]— CC-BY-4.0)

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and N2O that negatively affect the atmosphere and contribute to global warming. 2. However, climate change and global warming have their negative effects on the production of agricultural commodities in most parts of the world causing droughts and floods. Yet, some parts of the world have been “positively at least in the short-run” affected by global warming, for example, the northern part of the Canadian land is becoming more fertile due to rising temperature. Other emission facts related to food and agricultural activities • Food production is responsible for one-quarter of the world’s GHG emissions. • Livestock & fisheries account for 31% of food emissions. • Crop production accounts for 27% of food emissions. • Land use accounts for 24% of food emissions. • Supply chains account for 18% of food emissions. How do we make progress in reducing emissions from commodities (production, consumption, and transportation)? To reduce greenhouse gas emissions, we should track the sources of emissions and try to make efficient use of the resources or effectively reduce our dependence on polluting sources. In this regard, energy is a primary source of emissions that should be dealt with, this includes energy production, transportation, and consumption. Agriculture is not less important since agriculture dominates global land use. Below is a list of some of the key actions to be made in each group of commodities. The listed factors mainly deal with two core concepts: improving efficiency (same output with less energy use; and using less land, fertilizer, and other inputs for food production, and reducing food waste); and decarbonization of economic activities or shifting to low-carbon sources (using cleaner energy such as renewables; shifting to low carbon-intensive products in food production).

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In Energy 1. More use of low-carbon and renewable sources. 2. Foster clean innovations. 3. The development of the smart and large storage battery to store electricity generated from intermittent sources (renewables). 4. Improve energy efficiency. For example, at the EU level, the mentioned points are the core of the EU energy policies; the 2020 policy, the 2030 policy, and the EU green deal of 2050. In Food Production Agriculture 1. Reduce consumption in rich countries. 2. Promote sustainable food production. 3. Linking sustainable solutions to farm productivity. 4. Tackling food waste issue. Regarding metal commodities, the production of various metals and the mining activity lead to emissions of carbon dioxide (CO2 ), methane (CH4), and nitrous oxide (N2O). Figure 6.12 shows the GHG emissions Emissions in million tons of CO2 equivalent Steel

3749

Coal

1243

Aluminium

818

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Copper

91

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Lead

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Fig. 6.12 Global GHG emission of mine production—2016 (Data source [Our World in Data 2020]—CC-BY-4.0)

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of the mine production of metals worldwide as of 2016. The GHG emissions of steel and coal production are the highest worldwide, 3.75, and 1.24 billion metric tons of CO2 equivalent, respectively. Against the previous background and the statistics provided, we conclude that commodities and their supply chains (production, transportation, and consumption) are responsible for the major part of environmental damages and therefore, they rest in the core of climate policies at the global level. In the next sections, we will discuss those global policies and initiatives tackling environmental issues in commodities.

Global Actions to Enforce Sustainability in Physical and Financial Commodities Commodities are crucial for the life of everyone regardless of whether they are green or not. But they contribute significantly to global GHG emission and to climate change. International and national institutions have been drawing maps for sustainability transitions in the global commodities and their supply chains. The global actions cover the physical commodities including the supply side (production and transportation segments of the supply chain) and the demand side (the consumption side of the chain). Such actions are mainly focused on energy efficiency in production, transportation, and consumption to reduce the GHG emissions and to foster the use of new and clean technologies, besides other social issues. On the financial side, investors (including equity and debt) are the providers of funds for investment projects in commodities. The global actions try to reinforce sustainable (or responsible) finance and investment by encouraging banks and equity investors to use their money in commodities with high sustainability ratings. Besides the demand and the supply-side factors in physical and financial commodities, regulations play an important role in shifting consumers’ and investors’ preferences toward more sustainable commodities to achieve certain national or regional policies. Moreover, the role of social media should be underestimated in driving peoples’ preferences. An increasing number of sustainability-linked initiatives, driven primarily by ESG policies and undertaken by a wide range of stakeholders, will have an impact on the commodities sector. The effects of these initiatives are likely to manifest through increases in

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• demand from consumers, investors, and businesses for supply chain transparency, and • the development of sustainable commodity products and processes. Commodity market participants should be aware of these initiatives and adopt a position commensurate to the opportunities that these changes will bring. Many sector-specific or company-specific factors are affecting the adoption of ESG principles across the different commodities. However, at the international level, the push toward the adoption of greater ESG practices is likely to be driven by four main initiatives: • the Paris Agreement, which obliges its 195 participants to reduce the risk and impacts of climate change and to bring back the earth temperature below 2 degrees Celsius; • the United Nations Principles for Responsible Investment (UN PRI), which has led to an increase in asset owners and professional investors adopting ESG objectives and policy commitments; • the United Nations Sustainable Development Goals (SDGs), a set of ambitious sustainable objectives to be achieved by 2030 by all member; and • The Sustainable Commodity Initiative (SCI), is a joint initiative launched by the International Institute for Sustainable Development (IISD) and the United Nations Conference on Trade and Development (UNCTAD) in 2003. Time and scale are two dimensions of the application of the initiatives. Time concerns the accelerating global actions to achieve ESG goals by 2030, however, the COVID-19 pandemic might be seen as a factor for changing priorities from ESG goals to global health coordination. Scale concerns the expanding interested parties involved in achieving the ESG goals; many developing and emerging countries, businesses, investors, and consumers are boarding on the ship of ESG and sustainability transition. To fit the definition of a sustainable commodity, the following attributes have to be met in the supply chain of any commodity: low or no damage to the environment and the ecosystem and maintain production ethics.

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The Sustainable Commodity Initiative (SCI) SCI is a global initiative guiding sustainability issues in global commodities and the supply chains covering environmental, social, and labor issues. It was launched jointly by the International Institute for Sustainable Development (IISD) and the United Nations Conference on Trade and Development (UNCTAD) in 2003. The aim is to create a global network of partners collaborating and coordinating efforts to enhance ESG issues in global commodities to achieve sustainable commodities in the long-run. Various active programs under the SCI including finance and sustainability programs promoted among the partners to achieve the following objectives. 1. Improve informational efficiency to enhance decision making. 2. Improve production efficiency to achieve higher rates of return. 3. Strengthen rural development initiatives to combat rural poverty. 4. More private sector engagement in the public policy. Sustainability in Commodity Derivatives Besides the SCI to foster sustainability in the physical commodities, other parallel initiatives to enhance sustainability issues in financial commodities. In August 2019, The World Federation of Exchanges (WFE) and the global industry group for exchanges and CCPs (Central Counterparties), have published a white paper on sustainability and commodity derivatives. The aim of the paper is to respond to the increasing demand for more sustainable commodity derivatives from individual investors and investment funds. This demand is also linked to a parallel movement in the physical commodities supply chain. Many interested parties in global commodities are increasingly and actively engaged in overseeing the sustainability issues along the entire supply chain. Thus, the paper is a prudent response to the demand side of the picture (investors and consumers). Given the lack of a single standard or framework for how to integrate sustainability in global commodities, the paper tries to address the following issues: • Creating new asset classes as risk mitigation tools for sustainability issues. Some exchanges have created such titles reconsidering

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ESG issues. For example, renewable energy certificates; emissions allowances; and low Sulphur oil contracts. • Incorporating ESG dimensions into existing contracts and to distinguish sustainable from unstainable contracts by introducing certain premium or create parallel contracts. The way ahead is long and many challenges are being encountered to integrate ESG into financial commodities; the lack of one standard framework for sustainability disclosure, the difficulty to observe the physical commodity all over the entire supply chain, and the functional and technical issues to guarantee the issuance the trading of ESG certificates.

Environmental, Social, and Governance (ESG) Reporting Business reporting has always gone through changes and evolutions. A jump in reporting requirements usually comes after financial crises. After the 2000 hi-tch buddle and the Enron scandal, the Sarbanes Oxley Act (SOX 2002) required more emphasis on governance in business reporting. The 2008/2009 financial crisis has shown the weak reporting on risk management issues. The last decade has witnessed a different upgrade in business reporting that can be seen as a real evolution in corporate disclosure. Businesses nowadays incorporate the global macrotrends in their reports by showing how their operations, processes, and management styles are performed according to the ESG reporting frameworks. Therefore, besides governance, social and environmental aspects have been clearly introduced to business reporting and should be clearly addressed. In the past, businesses were viewed as pure economics and financial activities, however, the perception of business and its definition have been changing by integrating their social and environmental aspects along with their economic role—this is referred to as the sustainable business. In this regard, some global frameworks have been developed to tackle the other dimensions of business reporting. Integrated reporting4 is considered a holistic approach enhancing the sense

4 Integrated reporting was developed by the International Integrated Reporting Council (‘the IIRC’) to promote integrated thinking, you see more details on https://integrate dreporting.org/.

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of responsibility and accountability besides enforcing the informational efficiency by guaranteeing adequate flow of information for investors and other stakeholders and maximizing the long-run return on investment. Recently, the Non-Financial Disclosure (NFD) has received a fresh boost thanks to the development of a new model of business reporting introduced by the International Integrated Reporting Council (IIRC), 2013, and 2017. The new model combines financial and Non-Financial Information (NFI) about the companies’ ability to create sustainable value and their opportunities and risks. Although a standardized framework and detailed guidelines for disclosure are still being defined, Integrated Reporting has already been adopted by an increasing number of companies. Perhaps one of the earliest countries to introduce NFD voluntarily was South Africa in 2009 in which listed companies draw up Integrated Reports following the guidelines issued by King Code of Governance Principles for South Africa 2009 (King III). On the other hand, the European Union has introduced a mandatory NFD directive. The directive EU 2014/95 establishing new minimum reporting standards in environmental and social matters, concerning the management of staff, respect for human rights, and the fight against active and passive corruption. This Directive aims to introduce and strengthen virtuous behaviors and aims to increase transparency in the communication of NFI and to increase the confidence of investors and stakeholders in general. It applies to companies or large enterprise groups (total of net sales revenues exceed 40.000.000 euros or total assets of balance sheet exceeding EUR 20,000,000) which constitute bodies in the public interest and had, on average, during the financial year, over 500 employees. The directive encourages the use of internationally recognized frameworks and standards. These include the GRI (Global Reporting Initiative). The GRI Standards offer companies a universal tool for disclosing economic, environmental, and social information. It aims at providing a logical and modular structure of the GRI indicators, and it contains, and provides a set of KPIs (Key Performance Indicators) and KRIs (Key Risk Indicators) related to sustainability issues. These standards are intended to build complete and reliable environmental performance control systems capable of producing a high-quality non-financial statement. Besides, the increasing interest of policymakers in ensuring the financial system resilience to every form of risk led, in April 2015, the G20 asked the Financial Stability Board (FSB) to also consider climate risk. Eight

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months later the FSB launched the Task Force on Climate-related Financial Disclosures (TCFD). Its functions are to review how the financial sector and business corporations can take account and effectively disclose climate-related issues and to develop according to recommendations.

ESG Rating Analogous to the credit ratings measuring the firm’s ability to service its debt obligations, recently, firms try to capitalize on their ESG performance by obtaining an ESG rating5 from specialized rating agencies. Companies try to differentiate themselves in terms of ESG issues from their competitors to acquire higher value. But where does the value come from? We have previously discussed the role of the demand side and the regulations in driving the ESG performance. Consumers are demanding more sustainable products and investors are investing in sustainable firms; therefore, the physical market and the financial market are rewarding companies with higher ESG performance through higher profitability and long-term future cash flows. Companies are improving their reputation using ESG disclosure to attract consumers and investors. Another channel through which the value is enhanced is the reduced risk, more sustainable firms can be viewed as less risky, thus, a lower cost of capital. Regulations play an important role in deciding the allocation of rights by deciding whether ESG issues and reporting should be voluntary or mandatory. In this regard, ESG performance is related to the long-term value creation, not only shareholders’ value matters but also the holistic value created to all stakeholders without creating conflicts with the firm or among stakeholders. Furthermore, academic research still provides inconclusive evidence on the linkage between ESG performance and value measured by accounting or market performance. Another line of research tries to build an association between ESG performance and corporate risk measures such as market beta, analysts’ forecasting errors on the stock value, and other market-related risk measures. However, if the ESG performance is a firmspecific factor, it should not influence market factors but reduces firms’ specific risk (idiosyncratic risk) and a well-diversified portfolio mitigates the individual risk of the single firm. On the investment side, in the last 5 Various terms are being used among academics and practitioners, but they somehow mean the same thing, ESG rating, sustainability rating, ethical rating.

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years, there has been an increase in investment funds and stock market indices that focus on ESG stocks6 and that those funds and indices sometimes overperform other non ESG funds. Companies nowadays are capitalizing on their ESG performance and ratings in their marketing campaigns and they can be branded accordingly. It is important to keep in mind that many of the ESG ratings are mainly based on the quality of the reports and not on the real or actual ESG performance of the company, which means that management can have more influence on their ESG rating by producing better-decorated reports, but they have less influence on their financial performance reports that can be influenced by many factors outside the company. Rating firms provide insights into potentially significant ESG Risks so companies can make better investment decisions and communicate with the clients. The ratings are used for various internal and external corporate purposes. As awareness of the materiality of ESG factors has grown, so too has the demand for new uses of ESG data and information to be disclosed beyond just the investor community. Various accessible ESG ratings are available by financial data providers for publicly traded companies. Many other private rating companies exist worldwide, and the number is growing due to the need for corporations to get their “purity certificate.” It is worth noting that there is no standard ESG rating, different rating firms use different ESG indicators in which the same company might get two different ESG valuations from two different rating firms. Furthermore, there is still a debate on the national authority and the type of external auditor responsible for verifying the compliance and the truthfulness of ESG business information. I would conclude the ESG rating by introducing two fundamental concepts. Companies trying to get their sustainability rating—a brand that they sustainable—however, fundamentally, we know more about unsustainable practices than about sustainable ones. Many people talk about sustainability, but we still don’t really know what a sustainable practice is. That’s why it is easier to judge an unsustainable practice than judging sustainable ones and rejecting the unsustainability hypothesis does not guarantee that the business is sustainable. This is like testing the null hypothesis, rejecting the null does not mean accepting the alternative

6 It’s an investment funds or a market index composed of companies with high ESG rating.

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hypothesis. Many are discussing sustainability and granting sustainability certificates without realizing this issue. The other issue is that big companies sometimes escape the necessity to do the luxury, which means that they commit tax evasions, but they promote themselves as the sustainability leaders. This brings us to the important question about the role of a firm in the economy and the society, what do really mean business sustainability practices with Tax evasion? Remember how Milton Friedman described the socially responsible business “There is one and only one social responsibility of business to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud” (Friedman 1970).

References EEA. (2015). The European Environment State and Outlook 2015: Assessment of Global Megatrends. In European Environment Agency. Publications Office of the European Union. https://doi.org/10.2800/126936. Friedman, M. (1970, September 13). A Friedman Doctrine—The Social Responsibility of Business Is to Increase Its Profits. The New York Times. https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-thesocial-responsibility-of-business-is-to.html. Our World in Data. (2020). Our World in Data. https://ourworldindata.org/.

Further Readings Gardner, T. A., Benzie, M., Börner, J., Dawkins, E., Fick, S., Garrett, R., et al. (2019). Transparency and Sustainability in Global Commodity Supply Chains. World Development, 121, 163–177. https://doi.org/10.1016/j.wor lddev.2018.05.025. Steffen, W., Richardson, K., Rockstrom, J., Cornell, S. E., Fetzer, I., Bennett, E. M., et al. (2015). Planetary Boundaries: Guiding Human Development on a Changing Planet. Science, 347 (6223), 1259855. https://doi.org/10.1126/ science.1259855. The Institute of Directors in Southern Africa. (2009). King Report on Governance for South Africa 2009. https://cdn.ymaws.com/www.iodsa.co.za/res ource/resmgr/king_iii/King_Report_on_Governance_fo.pdf. The UN Global Compact. (n.d.). Sustainable Commodity Initiative (SCI). Retrieved September 15, 2020, from http://supply-chain.unglobalcompact. org/site/article/46.

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World Federation of Exchanges. (2019). Sustainability & Commodity Derivatives. https://www.world-exchanges.org/storage/app/media/research/Stu dies_Reports/wfe-commodity-derivatives-sustainability-final-wpaper-200819. pdf. Zaman, P., & Yeo, M. R. (2020). Sustainable Commodities—A New Reality? (Issue June).

Conclusions

In this book, I present global commodities from multidisciplinary perspectives offering a view on the most common business and financial issues related to commodities. In particular, I discuss the physical, financial, and sustainability aspects of global commodities. I start with the physical aspect by introducing the common traded physical commodities and the commodities move globally by the appropriate supply chain management. The next part was dedicated to risk management in global commodities, I covered various risk management tools commodity businesses utilize for mitigating and managing global risk in the commodity supply chain. Then I move to the financial aspects of global commodities, one part is related to the concept of “financialization” of global commodities and how financial commodities are traded. The other part is related to the financial valuation of commodity businesses and businesses owning natural resources, I mainly apply the option pricing models using the Black–Scholes approach and the DCF. The last part of the book discusses the sustainability issues in global commodities. We live in an era of sustainability transitions and I show how commodities are contributing to climate and environmental issues. I show different global initiatives to involve physical and financial commodities in sustainability transitions.

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2

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CONCLUSIONS

Finally, this book offers an introduction to commodities in the modern era from different perspectives which represents a useful guide for those who are seeking professional or academic careers in the field. However, not all commodities are the same and to be specialized in a class of commodities (agricultural, energies, metals), you need to seek more specialized books in that specific commodity such as financial trading, risk management, price forecasting models, and sustainability issues. Other legal and political aspects have not been discussed at this level. Contracts related to electricity supply have not been covered in details for two reasons; most of those contracts are considered national or regional, so they lack the global aspect, additionally, there is still an ongoing debate on the legal definition and consideration of such contracts under the financial or physical definition which might have different implications.

Index

A Agricultural commodities, 2, 6, 10, 12, 13, 21, 62, 77–80, 90, 91, 137, 144 Arbitrage, 34, 36–38, 64, 66, 67, 94, 100 Arbitrage opportunities, 33, 35–37, 100, 101 Arbitrageurs, 94, 100

B Bilateral contracts, 32, 37, 60–62, 120, 123 Binomial model, 116, 118 Black–Scholes model, 118, 120, 121, 126 Brokers, 92, 94, 95, 97, 99

C Call option, 73, 74, 115–119 Capital Asset Pricing Model (CAPM), 58, 113

Climate change, 129, 131, 135, 136, 143, 144, 146, 147 Commodity, 1–5, 12, 13, 17, 21, 23, 25–42, 44, 48, 50, 53–57, 59–69, 71, 72, 77–81, 83, 84, 86–98, 100, 101, 103, 104, 106, 109, 119, 121, 124–126, 135, 137, 138, 147–149, 155, 156 Commodity traders, 3, 27, 29, 33, 35–39, 41, 42, 56, 59, 61, 68, 69 Commodity trading, 28–30, 32, 33, 39, 42, 43, 64, 74, 78–81, 83, 86, 91, 94, 97, 98 Commodity transformation, 33, 36 Contango, 66, 67 Cost, Insurance, and Freight (CIF), 31 COVID-19, 8–10, 13, 17, 21, 59, 121–124, 130, 147 D Dealers, 79, 92, 94 Digitalization, 26, 28, 45

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. Harasheh, Global Commodities, https://doi.org/10.1007/978-3-030-64026-2

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INDEX

Direct players, 26 Discounted Cash Flow (DCF), 111, 112, 114, 119, 122, 124, 126, 155 Diversification, 39, 54–56, 59, 84, 96 Dodd–Frank Act, 80, 82

E Emission trading, 135, 136 Energy commodities, 5, 6, 14–17, 19, 21, 91 Energy derivatives, 90 Environmental, Social, and Governance (ESG), 134, 146–149, 151, 152 ESG rating, 151, 152 ESG reporting, 149, 151 European Market Infrastructure Regulation (EMIR), 23, 80, 84, 92

F Financial aspects, 77, 155 Financial crisis, 17, 21, 41, 56, 80, 83, 129, 130, 149 Financial derivatives, 64 Financialization, 23, 64, 79, 81, 83, 84, 96, 155 Financial valuation, 109–111, 119, 124, 155 Financing commodity trades, 38 Financing the hedge, 39, 41, 42 Financing the trade, 39, 42 Foreign exchange market (FOREX), 71–73, 83 Free cash flow valuation, 112 Free On Board (FOB), 31, 32 Fundamental factors, 13, 22, 83, 84, 97, 103, 106, 124, 125 Future contacts, 63

G Global actions, 146, 147 Global commodities, 2–4, 12, 13, 22, 24, 25, 28, 35, 38, 39, 41, 43, 45, 48, 50, 52, 53, 55, 57, 59, 63, 71, 73, 86, 89, 90, 146, 148, 155 Global supply chain, 25, 26, 28, 29, 39 Global warming, 136, 143, 144 Greenhouse gases (GHG), 3, 130, 132, 134–138, 141–146 H Hedgers, 42, 72, 83, 84, 92–94, 96, 100, 101 Hedging, 24, 29, 33, 36, 39, 41, 42, 54–56, 59–63, 68, 69, 71, 73, 74, 78, 82, 100, 126 I Initial margin, 39, 42, 68, 69, 93, 96–98 Insurance, 3, 28, 31–34, 36, 54–59, 69, 83 Integration, 20, 55, 56, 59 L Leverage, 3, 28, 29, 79, 92, 95, 96, 98 Liquidity risk, 74 Logistics, 12, 26, 29, 36, 39, 48, 53, 55 M Manipulation practices, 17 Manipulation techniques, 102 Margin call, 42, 68, 74, 96–98 Markets in Financial Instruments Directive (MiFID), 80

INDEX

Metal commodities, 6–8, 10, 17, 21, 22

N Natural resource valuation, 119 Normal backwardation, 66, 67

O Oil industry, 20 Oil reserve, 119–121 Option approach, 111 Option pricing, 111, 116, 119, 121, 122, 126, 155 Option valuation, 114, 123 Organized exchanges, 12, 33, 42, 68, 81, 84, 86, 88, 92–95, 97 Over-The-Counter (OTC), 23, 32, 33, 41, 80, 81, 84–88, 92–94, 97, 101

P Price discovery, 33, 34, 37, 38, 93, 101 Price risk, 24, 55, 59, 61–63, 71, 83, 93, 94, 126 Primary commodity, 5, 6 Production, 1, 3–5, 7, 8, 10, 13, 16, 17, 20–22, 25–29, 35, 91, 97, 102, 120, 122, 130, 136, 138, 139, 141, 142, 144–148 Put option, 115, 116

R Regulated market, 92, 95 Regulatory bodies, 80 Risk categories, 52, 53

159

Risk management, 24, 28, 30, 36, 41, 42, 47, 48, 50, 53–55, 81, 149, 155, 156 Risk-sharing, 43, 56 Risk tolerance, 50 S Secondary commodity, 6, 8 Special Purpose Vehicle (SPV), 39, 43, 44 Speculation, 13, 17, 23, 37, 64, 80, 83, 84, 93, 101, 102 Speculators, 66, 82–84, 93–95, 100, 101 Storage, 3–5, 12, 13, 19, 21, 26–30, 33–35, 48, 55–57, 60, 65–67, 103, 145 Sustainability, 3, 4, 48, 130, 131, 134–138, 146–150, 152, 153, 155, 156 Sustainable Commodity Initiative (SCI), 147, 148 T Technical analysis, 97, 99, 103, 105 Trade orders, 94, 99 Transformation in form, 34 Transformation in space, 33 Transformation in time, 33 Transportation, 3, 5, 7, 26–33, 35, 38, 74, 130, 136, 138, 142, 144, 146 V Valuation application, 119, 126 Valuation models, 126 Volatility, 7, 22–24, 26, 119, 125