Commodity Swap: Definition, How It Works, Example

What Is a Commodity Swap?

A commodity swap is a type of derivative contract where two parties agree to exchange cash flows dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against price swings in the market for a commodity, such as oil and livestock. Commodity swaps allow for the producers of a commodity and consumers to lock in a set price for a given commodity.

Commodity swaps are not traded on exchanges. Rather, they are customized deals that are executed outside of formal exchanges and without the oversight of an exchange regulator. Most often, the deals are created by financial services companies.

How a Commodity Swap Works

A commodity swap consists of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or agreed-upon commodity index, while the fixed-leg component is specified in the contract. Most commodity swaps are based on oil, though any type of commodity may be underlying the swap, such as precious metals, industrial metals, natural gas, livestock, or grains. Because of the nature and sizes of the contracts, typically only large financial institutions engage in commodity swaps, not individual investors.

Generally, the floating-leg component of the swap is held by the consumer of the commodity in question, or the institution willing to pay a fixed price for the commodity. The fixed-leg component is generally held by the producer of the commodity who agrees to pay a floating rate, which is determined by the spot market price of the underlying commodity.

The end result is that the consumer of the commodity gets a guaranteed price over a specified period of time, and the producer is in a hedged position, protecting them from a decline in the commodity's price over the same period of time. Typically, commodity swaps are cash-settled, though physical delivery can be stipulated in the contract.

In addition to fixed-floating swaps, there is another type of commodity swap, called a commodity-for-interest swap. In this type of swap, one party agrees to pay a return based on the commodity price while the other party is tied to a floating interest rate or an agreed-upon fixed interest rate. This type of swap includes a notional principal–a predetermined dollar amount on which the exchanged interest payments are based–a specified duration, and pre-specified payment periods. This type of swap helps protect the commodity producer from the downside risk of a poor return in the event of a downturn in the commodity's market price.

In general, the purpose of commodity swaps is to limit the amount of risk for a given party within the swap. A party that wants to hedge their risk against the volatility of a particular commodity price will enter into a commodity swap and agree, based on the contract set forth, to accept a particular price, one that they will either pay or receive throughout the course of the agreement. Airline companies are heavily dependent on fuel for their operations. Swings in the price of oil can be particularly challenging for their businesses, so an airline company may enter into a commodity swap agreement to reduce their exposure to any volatility in the oil markets.

Example of a Commodity Swap

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two scenarios can happen: paying the entire cost upfront or paying each year upon delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil per year for two years. However, there is a counterparty risk, and the oil may not be delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels are being delivered. Here, the following equation must be solved to equate the total cost to the above example:

Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56.

Given this, it can be calculated that the consumer must pay $50.49 per barrel each year.