Commodity derivatives are useful tools for hedging against risk in emerging economies whose revenues mainly come from exports of mono products. Commodity markets are generally held to comprise oil and gas, gold, silver, platinum and palladium, copper nickel, aluminum, zinc and tin, as well as agricultural products which include grain, sugar, coffee, cocoa.
Each of these products can potentially use derivative instruments for risk management purposes, but it is the energy and metals markets that are at present the most well developed with parallels with most financial derivatives products.
Derivatives markets in emerging countries are required to assist such economies insure themselves against volatile capital flows and help manage financial risk associated with uncertainties and high volatility of assets commodity prices. Commodity derivatives will mainly be vanilla products, i.e., simple products such as futures, options and swaps which will usually be traded through an exchange for standardisation in quantity, price and settlement or delivery methods.
Nigeria does have a commodities exchange set up in Abuja, but the modalities for it to be fully effective are yet to be worked out. Derivative market operations in other sub-Saharan African countries are at best rudimentary or non-existent. South Africa, which has the most developed derivatives exchange south of the Sahara, whilst having made modest progress, has tight regulations on asset allocations by insurance and pension funds to prevent excessive risk taking. For instance, the South African Futures Exchange (SAFEX), agricultural division, was established only in 1995 with a start-up capital of 4.2 million rand.
Derivatives markets started with agricultural commodities. For instance, the Chicago Board of Trade (CBOT), which was acquired by the Chicago Mercantile Exchange (CME) in 2007, began with farmers trying to hedge against uncertainties in agricultural produce. In Europe, agricultural commodities markets are well developed and agricultural commodities such as cocoa, coffee, sugar and wheat are traded on EURONEXT (commodities exchange) in London, which was acquired by the New York Stock Exchange (NYSE) in 2006.
Considering that our main commodity resource is oil, large price volatility of oil products, sometimes more than 40 percent, and general market uncertainty can greatly distort the perceived value of crude oil. For instance, when oil prices collapse markedly, a lot of losses ensue from hedgers who had entered into the market to stabilise their commodity prices. An oil producing country may wish to utilise oil futures or options, depending on the perception that prices may go up or down, to stabilise its price risk for budgetary purposes.
An energy futures contract is a legally binding agreement to make or take delivery of a standard quantity of a specific crude or product cargo at a future date and at a price agreed between the parties on the floor of an organised exchange. The Brent crude (the oil marker that is applicable to Nigeria) oil futures contract began operating in its present form in 1988, and now trades at over 60 million barrels a day, about 75 percent of total global consumption, for up to 36 months forward. It is a standardised contract and is negotiable in terms of the delivery month and the price. Earlier on, Brent blend was only traded on spot or forward basis; today, the Brent market includes dated cargoes, forward transactions and deliverable futures and options contracts on the International Petroleum Exchange (IPE). Other possible trades include futures and options with cash settlement as well as OTC swaps and options which can also be tailored to Brent trades.
However, options contracts are recommended for emerging nations rather than futures and speculative contracts. This is because of the risks of huge losses when markets move against the investor in a restrictive covenanted contract such as a futures or forwards contract, or where there has been much speculation.
Usually, the options holder has the right but not the obligation to buy or sell an agreed amount of energy futures at a specified price on or before a specified date. With this kind of contract, the payment of a premium is often required. Usually, the option is settled in cash against the corresponding energy futures. With energy options, when the option is exercised, it results in the holder taking long (buy) or short (sell) positions in the transaction, which is then settled. The holder of one call (buy) option on the energy futures will be long on energy futures contract when he exercises his option.
Options usually exhibit ‘asymmetry of risk’, meaning that risks can be greatly limited for the holder of the option, although losses cannot be totally eliminated. This presupposes that when the premium is paid on the purchase of an option contract, the most that the option holder can lose is the original premium that he has paid, whereas the most he can profit is unlimited, meaning that the amount of profit will be determined by how much the market has moved in his favour. On the other hand, a seller of options can only hope to keep the premium paid to him, but the amount of losses can be unlimited if the market moves against him.
There is a choice of exchange traded derivatives or over-the-counter derivatives in the markets. Exchange traded derivatives are available for West Texas Intermediate (WTI), Brent blend, Dubai. As price projections are difficult, if not impossible, the risk management of long and short positions is crucial to the long-term performance of the industry as a whole. The major exchanges where energy derivatives are traded are the New York Mercantile Exchange (NYMEX), International Petroleum Exchange (IPE), London, and the Singapore International Monetary Exchange (SIMEX).
The value of a particular crude oil is compared to the ‘benchmark’ or market crude for pricing in the final destination of importation. The oil will then be sold at a premium or discount, to the value on the marker used at maturity. Generally, the values of most brands of crude will depend on their quality and availability, the location of the refinery and geographical or seasonal differences between the markets to be supplied, while the level of premium or discount will relate to the quality of the crude oil itself. Usually, light crudes yield more PMS and other high value products than heavier crudes.
The Brent crude is important to Nigeria as it is a marker for other crudes in the North Sea, the Mediterranean, African, Far East and South America. Therefore, there is need to set up proper modalities for the working of our already established Abuja securities and commodities exchange so that we can expand trade in these areas and give participants in the commodities market the opportunity to hedge their business against price uncertainties and volatilities in the market. Also, it is envisaged that this exchange can easily become a regional hub for commodities trade, thereby improving cross-border trade. Careful regulation and monitoring of the market to prevent largely uncovered positions would help to mitigate the taking of risky speculative positions and attendant possibility of high losses. In all, this is considered to be a good area of focus for the commodities markets.