The use of futures and options for physical trading purposes: directly linking physical trade and futures markets Futures market delivery Alternative delivery

The use of futures and options for physical trading purposes: directly linking physical trade

and futures markets

• Futures market delivery

• Alternative delivery procedures (ADPs)

• Exchange of futures for physicals (EFPs)

• Price-to-be-fixed contracts (PTBFs)

Delivery on futures markets

Although it is an exception rather than a rule, sometimes physical products are delivered under futures contracts. All contracts which are not closed out before the expiry date or settled in cash, result in delivery.

Most, but not all, futures contracts specify three possible ways to settle the contract through delivery:- physical delivery or cash settlement under the specifications of the contract- alternative delivery- exchange of futures for physicals.

Cash settlement: those holding positions at contract expiry receive (or have to make) a payment based on the cash prices (physical market prices) prevailing at the time of expiry, according to some pre-established formula.

Physical delivery: those who are short (who had previously sold contracts and did not consequently close out their position) have to make delivery according to one of several predetermined mechanisms, while those who are long receive the corresponding amount of commodities.

An example: physical delivery against the NYMEX Sweet Crude Oil futures contract

The day after the contract's last trading day, when all EFP's conducted have been assessed, NYMEX matches market participants having open positions in the relevant contract. Buyers nor sellers have any say in whom will be their counterparty. Once matched by the exchange, they are obliged to take or make delivery with the indicated trader. Moreover, these appointed notices can not be transferred to third parties.

Three business days before the 25th day of the month prior to the delivery month, trading of the Sweet Crude Oil contract ceases. If a seller of the contract has not closed out his position before closing time of the last trading day, he will have to deliver to the buyer of the futures contract 1,000 barrels of sweet crude oil, conform the quality standards as defined by NYMEX.


Both contract sellers and buyers do have a say in the physical delivery of against the Sweet Crude Oil contract:

1. They make their own storage and transport arrangements.

2. Sellers determine the site of delivery. The only condition is that it should be possible to lift the cargo by truck and by barge.

3. Buyers can choose the period in which the crude oil will be made available.

Deviations from NYMEX standards are allowed, under the Alternative Delivery Procedures rules.


The par crude for the NYMEX Sweet Crude Oil futures contract is West Texas Intermediate (WTI), having a sulphur degree of 0.4% and 40% API gravity. A range of other US domestic crudes and foreign crudes like Brent and Bonny Light are also deliverable. Delivery is FOB Cushing Oklahoma, at any pipeline or storage facility with pipeline access to ARCO or TEXACO, by in-tank or in-line transfer or by pumpover.

All physical deliveries of sweet crude oil must be initiated after the first calendar day and completed before the last calendar day of the delivery month. For example, an oil trader has sold 28 Sweet Crude Oil futures for July delivery. He still holds the contracts on Wednesday 22 June, the final trading day. The next week, on Friday 1 July, the trader can start delivery operations, but he may as well deliver the 28,000 barrels at a later date in July.

Alternative Delivery ProceduresAlternative Delivery Procedures

Instead of delivery conforming to the Instead of delivery conforming to the standard contract procedures, it might standard contract procedures, it might be more interesting to futures market be more interesting to futures market participants to make alternative participants to make alternative delivery arrangements. Once delivery arrangements. Once matched by the Exchange, sellers and matched by the Exchange, sellers and buyers of the (expired) contracts may buyers of the (expired) contracts may agree delivery in another location agree delivery in another location than specified in the contract, a than specified in the contract, a different product or under different different product or under different conditions etc. Such a deviation from conditions etc. Such a deviation from the original futures contract the original futures contract regulations under supervision of the regulations under supervision of the Exchange is called an Alternative Exchange is called an Alternative Delivery Procedure (ADP).Delivery Procedure (ADP).

Once a seller and a buyer of a Once a seller and a buyer of a futures contract agree an ADP, futures contract agree an ADP, the clearing house should be the clearing house should be given notice. The Exchange given notice. The Exchange formulates standard rules on the formulates standard rules on the form and details of these notices. form and details of these notices. When the clearing house has When the clearing house has been informed of the ADP by been informed of the ADP by receipt of such notices, the receipt of such notices, the contracts are liquidated against contracts are liquidated against the settlement price agreed upon the settlement price agreed upon by the ADP- participants. by the ADP- participants.


From this point on, the clearing From this point on, the clearing house no longer has any house no longer has any obligations towards the buyer and obligations towards the buyer and seller with regard to the futures seller with regard to the futures contracts, the ADP or otherwise. contracts, the ADP or otherwise. The only involvement of the The only involvement of the clearing house in the ADP is clearing house in the ADP is channelling the payments under channelling the payments under the arrangement between the the arrangement between the buyer and the seller.buyer and the seller.

To give an impression of the volume of fuel futures delivered under an To give an impression of the volume of fuel futures delivered under an ADP (1994 figures):ADP (1994 figures):

Product ADP's number of ADP'srelative to standarddeliveries (%)

IPE Gas Oil 10,349 61

NYMEX Sweet Crude Oil 9,776 55

NYMEX Heating Oil 6,981 85

NYMEX UnleadedGasoline

4,814 40


Exchange of Futures for PhysicalsExchange of Futures for Physicals

Yet another possible delivery is via an Exchange of Futures for Yet another possible delivery is via an Exchange of Futures for Physicals (EFP). For example, with an oil EFP, participants negotiate Physicals (EFP). For example, with an oil EFP, participants negotiate the delivery of crude oil and oil products bilaterally. It is a way to use the delivery of crude oil and oil products bilaterally. It is a way to use the futures market to reduce price risk on physical sales and the futures market to reduce price risk on physical sales and purchases rather than a means to arrange more convenient delivery purchases rather than a means to arrange more convenient delivery conditions once a contract has just expired, as is the case with an conditions once a contract has just expired, as is the case with an ADP.ADP.

NYMEX offers a standardized NYMEX offers a standardized form to EFP participants, form to EFP participants, containing:containing:

Exchange of Futures for Physicals on Oil Exchange of Futures for Physicals on Oil

A statement of changing ownership of a A statement of changing ownership of a certain oil productcertain oil product

The date of transactionThe date of transaction

The type and quantity of the cash energy The type and quantity of the cash energy commodity involvedcommodity involved

The price at which the futures transaction The price at which the futures transaction is to be clearedis to be cleared

The names of the clearing members The names of the clearing members involvedinvolved

The delivery placeThe delivery place

A statement that an EFP is transactedA statement that an EFP is transacted


The oil EFP can be used for The oil EFP can be used for a number of purposesa number of purposes

To exchange an oil To exchange an oil futures position futures position and an oil spot and an oil spot

cargocargo

To exchange an oil To exchange an oil futures position futures position

and an oil forward and an oil forward cargocargo

To exchange an oil To exchange an oil futures position futures position and an oil swap and an oil swap

dealdeal


Exchange of Futures Exchange of Futures for a Spot Cargofor a Spot Cargo

Exchange of Futures Exchange of Futures for a Forward Cargofor a Forward Cargo

Exchange of Futures Exchange of Futures for a Swap Dealfor a Swap Deal

ExampleExample

ExampleExample

ExampleExample

Exchange of Futures for a Spot CargoExchange of Futures for a Spot Cargo

7 April7 April: An oil trader, believing that the : An oil trader, believing that the price of physical crude oil will rise in the price of physical crude oil will rise in the future, agrees an EFP with a shipping future, agrees an EFP with a shipping company having an opposite opinion. company having an opposite opinion. They notify the exchange and the trader They notify the exchange and the trader will be assigned a long position while the will be assigned a long position while the refining company the offsetting short refining company the offsetting short position. The trader is to deliver to the position. The trader is to deliver to the shipping company a similar amount of shipping company a similar amount of physical products. Nominally priced at physical products. Nominally priced at the settlement price of the IPE at this the settlement price of the IPE at this time - but this is not important as the time - but this is not important as the real price for these two parties will real price for these two parties will depend on the price prevailing when depend on the price prevailing when they close out their futures positions. they close out their futures positions.

21 April21 April: The shipping : The shipping company liquidates its company liquidates its short futures position by short futures position by buying 400 June fuel oil buying 400 June fuel oil contracts at the actual contracts at the actual futures price.futures price.

13 May13 May: The trader : The trader liquidates his long futures liquidates his long futures position, herewith fixing position, herewith fixing his profit margin.his profit margin.


Or, in figures:

Trader Shipping company

7 April Is assigned a long position; is todeliver a physical cargo

Is assigned a short position; is toreceive delivery of a physicalcargo

21 April - Buys futures at US$ 14/bbl.

14 May Sells futures at US$ 15.50/bbl -

Effective pricepaid/ received

US$ 15.50/bbl. US$ 14/bbl.

400 June fue l oil future sTrade r Shipping company

400,000 ba rre ls of fue l oil

400 June fue l Future s marke t oil futures Shipping company

400 June fue lTrade r oil future s Future s marke t


2 January2 January: A refiner is long 500 February Brent crude oil contracts. It : A refiner is long 500 February Brent crude oil contracts. It is willing to sell its position in exchange for a 15-day forward Brent is willing to sell its position in exchange for a 15-day forward Brent crude oil cargo (equalling 500,000 barrels). Hereto it agrees an EFP crude oil cargo (equalling 500,000 barrels). Hereto it agrees an EFP with an oil exporter. The refiner has now off-set its previous futures with an oil exporter. The refiner has now off-set its previous futures position. The exporter is long in futures and has an extra short position. The exporter is long in futures and has an extra short position of one 15-day forward cargo.position of one 15-day forward cargo.19 January19 January: The refiner takes delivery of the Brent crude oil bought : The refiner takes delivery of the Brent crude oil bought under the forward contract.under the forward contract.25 January25 January: The exporter closes out its futures position.: The exporter closes out its futures position.

500 Febr.R efine r futures Futures marke t

500 Febr. B rent futuresR efine r Exporte r

15-day forw ard B rent ca rgo500 Febr.

Futures marke t futures Exporte r

Exchange of Futures for a Forward CargoExchange of Futures for a Forward Cargo

Refiner Oil exporter

10 December Buys 500 February Brent contracts atUS$ 15/bbl.

-

2 January Transfers contracts to exporter;obtains 15-day Brent forward at US$15/bbl.

Is now long 500 February Brent contracts

16 January - Sells 500 February Brent contracts atUS$ 15.50/bbl.

19 January Takes delivery Delivers 500,000 barrels

Effective price paid/received

US$ 15/bbl. US$ 15.50/bbl.

Or,in figuresOr,in figures

Note that the same types of trade could have taken place by the two Note that the same types of trade could have taken place by the two parties in the foregoing examples taking independent futures market parties in the foregoing examples taking independent futures market positions, but at higher costs and risk.positions, but at higher costs and risk.


The advantage of conducting an EFP with a counterparty instead of The advantage of conducting an EFP with a counterparty instead of operating solely via the exchange is that the costs of an EFP are much operating solely via the exchange is that the costs of an EFP are much lower than the transaction costs involved in buying and selling futures lower than the transaction costs involved in buying and selling futures contracts. contracts.


Moreover, the risk of slippage Moreover, the risk of slippage (realized prices being worse (realized prices being worse than expected prices because of than expected prices because of fast market movements) is fast market movements) is smaller; and until the moment smaller; and until the moment that their futures positions are that their futures positions are closed out, the EFP-participants closed out, the EFP-participants benefit from the "counterpart benefit from the "counterpart guarantees" provided by the guarantees" provided by the clearing house. Furthermore, clearing house. Furthermore, EFP's can also be used as a EFP's can also be used as a marketing tool to identify new marketing tool to identify new clients.clients.

Exchange of Futures for a Swap DealExchange of Futures for a Swap Deal

An exporter has a swap with a An exporter has a swap with a remaining life of 2 years. He remaining life of 2 years. He receives a fixed payment of US$ receives a fixed payment of US$ 16/ barrel and pays the average 16/ barrel and pays the average price of the Brent futures contract price of the Brent futures contract directly following each quarter directly following each quarter (e.g. in the first quarter of the (e.g. in the first quarter of the year, his payment is based on the year, his payment is based on the average price from January to average price from January to March of the April Brent contract). March of the April Brent contract). The quantity swapped is 1 million The quantity swapped is 1 million barrels a quarter. barrels a quarter.

The exporter wants to offset his The exporter wants to offset his swap and finds a trader willing to swap and finds a trader willing to be his counterparty. The trader be his counterparty. The trader buys 100 futures contracts on the buys 100 futures contracts on the April delivery, 1000 on the July April delivery, 1000 on the July delivery, and so on; in total, he delivery, and so on; in total, he buys 8,000 futures contracts. buys 8,000 futures contracts. After notification of the exchange, After notification of the exchange, the contracts are transferred to the contracts are transferred to the exporter, who will in return the exporter, who will in return pay to the trade house a fixed pay to the trade house a fixed sum based on the expected sum based on the expected forward prices for 8 million forward prices for 8 million barrels.barrels.

Price-to-be-fixed contracts

In many cases in commodity trade, parties conclude a contract for sale without settling the price. In such a case there are normally two scenarios:

(b) the price is left to be set by one of the parties according to a pre-determined formula. Such contracts are called price-to-be-fixed contracts, (in sugar trade) executable orders, (in cotton trade) on-call contracts or (in grain trade) fixed basis contracts;

(c) the price is to be fixed in terms of some agreed market or other standard as set or recorded by a third person or agency

– e.g., The average price of the 2nd position of the LME copper contract in the 20 trading days before delivery; or the average Mediterranean heating

oil spot price over the past five days as reported by Platt’s.


The PTBF contract is a contract that specifies a particular delivery period and locks in the basis for that delivery period.

It leaves the futures component of the net producer price open to be priced at a later date. It allows producers to lock in or capture an attractive basis for a specified delivery period and yet not be locked into that particular day's futures price.

The price formula of the contract looks, for example:

Price = price of the September 2002 New York Board of Trade arabica contract, at dates to be determined by the buyer (or seller), minus 3 cts/lb.

The buyer or seller, as determined in the contract, does not have to fix the prices of all the product at the same time.

E.g., for a contract for 50 tons of robusta coffee (equal to 10 futures contracts) he could fix 10 tons on 5 July, 5 tons on 15 July, 10 tons on 30 August and 25 tons on 3 September.


The PTBF contract is particularly useful because it allows the signature of contracts for future delivery even if price prospects are uncertain, or buyer and seller disagree on the direction of prices.

It also reduces the counterparty risk in commodity contracts.

The PTBF contract effectively allows the seller or the buyer to separate his requirements with respect to his physical product (to find a buyer or to procure sufficient supply for processing) from his pricing decisions.

It provides great flexibility to the buyers and sellers. Trading companies will generally lay off the price risks that they take in PTBF contracts either through other physical contracts or in the futures market. Therefore, the pricing decisions that their buyers and sellers make have no impact on their own profits or losses. In turn, this implies that the trader has no incentive to keep his clients poorly informed.

Price-to-be-fixed contracts – a simple example

On October 1, a trader offers you as a producer a premium for wheat deliveries during the month of January of US$35.00 under the March futures. This is higher than normal and better than what the competition offers. You feel however, that the futures price is low and will move higher during the winter. The problem is that as the futures move higher the basis has a good chance of widening. Therefore:

On October 1 you enter into a PTBF contract with the trader. You take on the obligation to deliver and before delivery takes place you will have to fix the price. The trader will pay you the March futures contract price(s) on the date(s) that you use for fixing, minus $35.00 a ton.

On January 10, the March futures have gone to U$140.00 a ton but the basis has widened out to $40.00 under the futures for a spot price of U$100.00 a ton. The producer now fixes the price at US$140.00 a ton giving him a net price of US$105.00.

Price-to-be-fixed contracts – another example

July 30: producer sells 68 tons of arabica coffee (four lots) for October shipment, PTBF at 2 cents over New York December.

September 10: trade house sells the physicals to a roaster, PTBF at 3.5 cents over New York.

October 15: producer decides to fix. The trade house sells four lots of the New York contract at 91 cts/lb.

November 10: roaster decides to fix. The trade house buys four lots of the New York contract.

End result: The producer receives 93 cts/lb.

The roaster pays 96.5 cts/lb.

The trader has a profit of 1.5 cts/lb.(profit of 3.5 cts/lb on physicals,loss of 2 cts/lb on futures)

New York futures prices (cts/lb)

30/7 90

10/9 88

15/10 91

10/11 93

Price-to-be-fixed contracts – another example (2)

THE TRADER’S PROFIT WILL BE THE SAME IRRESPECTIVE OF ABSOLUTE PRICE MOVEMENTS

July 30: producer sells four lots, PTBF at 2 cents over New York December.

September 10: trade house sells the physicals to a roaster, PTBF at 3.5 cents over New York.

October 15: producer decides to fix.

November 10: roaster decides to fix.

End result: The producer receives 97 cts/lb.

The roaster pays 90.5 cts/lb.

The trader has a profit of 1.5 cts/lb.(loss of 6.5 cts/lb on physicals,profit of 8 cts/lb on futures)

New York futures prices (cts/lb)

30/7 90

10/9 88

15/10 95

10/11 87

Major risks of price-to-be-fixed contracts

For producers:

There is a risk that a producer will “run after the market” – more specifically, that if prices fall, he is slow in adjusting his expectations and therefore, only able to fix his price once the market hits a bottom. This is particularly a problem if the producer is a state-run enterprise where the decisions on price fixing are de facto in the hands of a committee. Inclusion of put options may be advisable.

For traders:

If there is non-delivery under a PTBF-contract there may be losses under other physical or futures contracts. With high-risk clients, traders therefore often prefer to lay off their price risks through options.

Traders have at times been tempted to allow price fixing after delivery of the products by a producer, paying them on delivery on the basis of the prices at that moment. If prices continue falling, the producer will owe the trader money…. which is unlikely to be paid.

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The use of futures and options for physical trading purposes: directly linking physical trade and futures markets Futures market delivery Alternative delivery