Mohammed Khiara, Consultant

 Appreciating the physicality of raw materials is fundamental to understanding and anticipating the behavior of forward and spot prices. It accounts for certain essential specificities in commodities markets relative to stock markets; backwardation, contago, averaging characteristics, decline in forward price volatility with contract maturity In a forthcoming article, we will come back to the futures structure of raw material prices.

Driven by our knowledge of the importance of futures contracts for raw material markets, in this article we will examine forward products for energy commodities. On the one hand, the forward curves on raw materials provide a great deal of information, in particular concerning agents’ expectations and supply markets. On the other hand, most derivative products (European options, exotic options, swaps, etc.) used in commodity markets have forward prices as their underlying.

This is due to the fact that futures contracts, unlike spot purchases and sales, are paper contracts with which it is much easier to create hedging strategies. Consequently, forward price modeling makes pricing as well as financial instrument hedging possible. Forecasting the shape of forward curves can be used by speculators interested in carrying out arbitrage transactions.

Forward contracts are furthermore widely used as hedging and management instruments by raw material consumers, producers, and traders. In this case, forward curve modeling enables strategy simulations, pricing, and long-term liability hedging.

The modeling isn’t easy given the variety of explanatory factors affecting forward curves: seasonality, spot prices, stock levels, storage costs, opportunity yield.

Two main approaches have been described in the relevant literature to account for the behavior.
 

> Certain approaches involve expressing in economic terms the cost of carry relationship linking the price of a forward contract to the spot price and the storage cost of raw materials.
> Other approaches adapt the futures-structured models of interest rates to raw materials: these are the approaches of Schwartz (1997), Clewlow and Strickland (1989).

In the present article, we will examine the economic approach. It shows that a commodity behaves like an option, allowing its holder either to immediately use the commodity or to store it for later use or sale. The holder of a forward contract doesn’t enjoy the same advantage. This characteristic, specific to commodities, explains backwardation, which is particularly prevalent on the oil markets. Indeed, higher volatility, which increases the likelihood of a sharp price rise and thus the likelihood of higher future profit, encourages producers to hold on to their supplies with a view to selling later.

This approach enables an economic understanding of forward contract behavior and includes supply level and volatility as explanatory or even predictive variables of the behavior.

We will touch on the principle of price valorization of a forward contract by way of arbitrage opportunity for a non-physical, completely liquid asset. We will then extend this opportunity for the forward price valorization of a storable commodity (which allows us to introduce the concept of convenience yield) and then show the difficulty of expressing the forward price of a commodity starting from observable magnitudes.

Definition of a forward contract
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A forward (or futures) contract is a contract that permits one to buy an asset (shares, commodities, etc.) at a future date, called the maturity of the contract, at an agreed-upon price on the signing date, called the forward price.
 

Forward contracts are essentially used in order to protect against fluctuations in prices of an asset.
 

Two different types:

> Forward contracts, individualized contracts by mutual agreement and for which there is counterparty risk.
> Futures contracts, anonymous and standardized, and for which a clearing house protects against counterparty risk.

The essential difference between the two types of contract is that the holder of a futures contract will see his account being debited or credited each day according to the daily forward price (we say the future is “marked to market”), whereas the holder of a forward contract only makes a profit or loss at the maturity of the contract, the daily variations indicating only latent gains or losses.
 

All forward contracts considered here will henceforth be futures contracts, which will always be “marked to market.”