By Gerald Nana KUSI
In the dynamic global commodity markets, producers and consumers of energy, base metals, precious metals, and soft commodities encounter a multitude of challenges.
Volatile prices, geopolitical disruptions, and unpredictable demand patterns can disrupt even the most robust operations. However, these uncertainties also present opportunities for those equipped with the appropriate tools.
Over-the-counter (OTC) commodity derivatives offer tailored solutions to assist in managing risk and optimising value, enabling businesses to flourish even amidst market turbulence.
This article examines four key OTC instruments: commodity forwards, swaps, options, and collars (option strategies).
It demonstrates how these instruments can address specific financial needs and encourage both producers and consumers to take initiative-taking measures to safeguard their commercial interests in relation to volatility in the commodities markets.
Commodity Forwards: The Art of Certainty
Let us take a closer look at commodity forwards – contracts that allow parties to lock in a pre-agreed price for a specified quantity of a commodity, for settlement at a known future date.
This mechanism is beneficial for mitigating the risk associated with price volatility while providing a level of flexibility not typically available with standard exchange-traded contracts. It is important to note that forwards referencing commodities as the underlying asset do not typically require physical delivery but are instead settled in cash.
Consider a cocoa farmer anticipating a harvest of 10,000 metric tonnes in six months but concerned about potential price declines.
To mitigate this risk, the farmer enters into a forward contract with a purchaser to sell the cocoa at $9,500 per metric tonne, thereby securing revenue of $95 million regardless of market fluctuations. Typically, such an agreement can be established with a bank that guarantees the agreed forward price for the specified quantity.
If the market price falls below the agreed level, the bank compensates the farmer with a cash payment equal to the shortfall. This application holds significant importance for producers. By locking in future selling prices, producers can safeguard their revenue against unfavourable price movements.
Similarly, consumers – such as manufacturers relying on base metals like copper or aluminium – can hedge against input costs, ensuring stable production expenses irrespective of market changes.
The advantages of a commodity forward are evident from the foregoing. The terms of the hedge are fully customisable, allowing the hedger to specify the precise quantity needed. The delivery or settlement date can be any day convenient to the hedger.
Additionally, there is no need to make any upfront premium payment, which is particularly advantageous for counterparties that are constrained by cash or operating on a tight budget.
The significance of the OTC nature of this structure cannot be overstated. Direct negotiation with counterparties for tailored solutions eliminates the basis risk associated with standardised contracts.
Whether you are managing the operations of a gold mine or sourcing energy inputs for an industrial plant, forward contracts provide you with control over price risk – a crucial step towards achieving financial stability.
Commodity Swaps: Achieving Predictable Cash Flows
Commodity swaps are financial instruments that enable two parties to exchange cash flows based on a fixed price and a floating market price for a specified commodity.
These agreements are advantageous for maintaining liquidity and aligning expenses or revenues with market fluctuations.
To differentiate between forwards and swaps, forwards are typically utilised to hedge a single cash flow, whereas swaps are employed for multiple cash flows over a series of transactions. Mechanically, both instruments operate in similar ways.
Consider again a Bulk Distribution Company (BDC) in Ghana that imports refined petroleum products and faces fluctuating oil prices, which create challenges in budgeting and pricing strategies.
To mitigate this volatility, the BDC enters into a swap agreement with a bank, committing to pay a fixed price of $70 per barrel while simultaneously receiving the market price. If market prices rise to $90, the BDC remains obligated to pay only $70, effectively shielding itself from cost increases and ensuring pricing stability.
From the foregoing, it is evident that BDCs and other fuel importers can use oil price swaps to lock in predictable costs for petroleum products such as gasoline and diesel.
This approach is equally beneficial for airlines, transportation companies, and other fuel-intensive industries, allowing them to swap floating market prices for fixed ones – ensuring cash flow predictability and reducing exposure to price fluctuations.
The advantages here are clear: the hedging party can achieve long-term stability in highly volatile markets.
There is also a high degree of flexibility to structure contracts around operational needs, while reducing exposure to unfavourable market conditions.
It is therefore imperative to manage uncertainty in your commodity-linked revenues, and provided that cost is a priority, commodity swaps offer a straightforward and effective solution.
Engage with your bank immediately to explore bespoke structures aligned with your business goals.
Commodity Options: Maximising Upside While Limiting Downside
Commodity options provide the right (but not the obligation) to buy or sell a commodity at a predetermined price on or before a specific date. If you have been following keenly any of the articles in this series, options should not be at all strange!
They are ideal for participants who want to protect against adverse price movements while retaining the potential to benefit from favourable price movements.
Consider a gold mining company expecting to produce 5,000 ounces of gold in the next quarter. It buys a put option from a bank with a strike price of $2,900 per ounce. If gold prices fall below $2,900, the company can sell at the strike price, protecting its revenue.
If prices rise above $2,900, the company benefits from the higher market price by simply walking away from the put option contract.
Of course, the right to simply walk away requires a fee or premium to be paid at the onset of the contract – or deferred until maturity, depending on the creditworthiness of the hedger.
Precious metals miners (such as gold producers) or soft commodity producers (such as cocoa farmers) can use put options to set a floor price for their output while benefiting from upward price movements.
Likewise, precious metal or soft commodity buyers – such as jewellers and cocoa processors – can utilise call options to cap purchase prices without committing to higher costs if prices decline.
The advantages here are very evident. The upfront cost is limited and clearly defined – it cannot exceed the premium amount paid.
Additionally, the hedging party retains the upside: the potential for price movements to favour either buyer or seller, depending on whether a call or put option is used. Again, the fact that options can be customised into collars or spreads for more cost-effective strategies is a plus for those seeking flexibility through the use of options.
In uncertain times, options provide unparalleled flexibility and security. Whether hedging input costs or revenue streams, options strategies can be tailored to match your risk tolerance and market outlook.
- Commodity Collars: Balancing Cost and Protection
As highlighted above, options can be combined to construct various structured products depending on the outcome required. The last structure we will look at closely is the commodity collar.
This is simply a strategy that combines the purchase of a put option and the sale of a call option – or vice versa (depending on whether a producer or consumer outcome is desired) – to create a cost-effective hedging solution.
Collars limit downside risk while capping the potential upside, often with no net premium cost. It also tends to be the preferred structure for clients (and even for banks) a concept we will explore in subsequent articles in this series.
Consider closely an aluminium processor that anticipates purchasing 1,000 metric tonnes of aluminium in two months and wants to limit exposure to rising prices.
The processor sets a collar with a floor price of $1,900 per metric tonne and a cap of $2,200 per metric tonne. If market prices rise above $2,200, the processor pays no more than $2,200. If prices fall below $1,900, the floor protects the downside.
Once again, the advantages of a structured option such as a collar are evident. Given that there is no upfront premium for this structure, it is the more cost-effective approach while still guaranteeing participation.
The hedging party can also go further to customise price bands (the cap and the floor) to match their specific risk tolerance, which ultimately allows for the balancing of protection with clearly defined limits.
If cost management is as important as risk mitigation, collars offer a practical approach to achieve both objectives. As a client, you can explore this strategy to maintain financial predictability within your commodity operations.
Strategic Considerations for Success
To maximise the benefits of over-the-counter (OTC) commodity derivatives, businesses must begin with a clear understanding of their exposures.
This means identifying the specific risks they face in commodity markets – whether it is price volatility, input cost fluctuations, or supply chain disruptions. A well-defined view of risk is the starting point for any effective hedging strategy.
Equally important is the choice of partner. Businesses should engage financial institutions, such as Absa Bank, that bring on board the transactional capability to execute trades, and also the structuring expertise and market insight needed to develop solutions tailored to the business’s unique context.
Collaborating with an experienced partner can often be the difference between a hedge that simply exists and one that performs.
Ongoing market awareness is also critical. Commodity prices are influenced by a wide range of factors – geopolitics to macroeconomic shifts – and hedging strategies must be reviewed and adjusted accordingly. A static strategy in a dynamic market is unlikely to serve its purpose over time.
Lastly, businesses should make full use of the customisation that OTC derivatives allow. Unlike exchange-traded instruments, OTC contracts can be structured to reflect operational realities, financial goals, and even internal cash flow cycles.
There is no reason to accept off-the-shelf hedging approaches when the risks themselves are anything but standard.
Over-the-counter (OTC) commodity derivatives – whether forwards, swaps, options, or collars – are powerful instruments that can transform uncertainty into opportunity.
When applied thoughtfully, they enable businesses to achieve price stability, predictable cash flows, and financial resilience in today’s dynamic and often unforgiving commodity markets.
By adopting these tools, businesses can take proactive control of their exposures rather than allowing market volatility to dictate outcomes.
Whether businesses are managing input costs, stabilising revenues, or simply seeking greater financial predictability, bespoke OTC solutions provide a level of precision and flexibility that standard contracts cannot match.
The writer is the Head Institutional Sales &Structuring ,Absa Bank
