On the buyers’ side, buying at a price fixed at the time of the transaction enables them to anticipate possible increases. In order to fully understand how this market works, we present here in detail its functioning and the management of the prices of the different raw materials.
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How does the raw materials market work?
Before being used by industrialists, raw materials are at the heart of many stock market transactions. All types of materials are thus subject to sales and purchases on a constantly evolving market. Specific contracts are thus signed between the different parties to certify the transaction. Many investors today speculate on this market in order to diversify their stock portfolio. Trading the price of a raw material can only be done if it is interchangeable with another product of equivalent quality. In order to determine the quality of each raw material, they can be divided into two categories:
- Hard” raw materials: precious metals and fossil fuels
- Soft” raw materials: agricultural products
Among these categories of raw materials, several products are the subject of particularly intense transactions: gas, oil, gold, silver, wheat, rapeseed, rice… These numerous transactions have a direct impact on the scarcity and value of the various products on this market.
How the market works
Depending on the specific contracts signed between buyers and sellers, the terms and conditions of the transactions may vary. For example, on the spot market, transactions on raw materials imply immediate settlement as soon as the transaction is validated. Conversely, on a futures market, the payment of the transaction as well as the delivery take place at a later date. In a futures market, this type of operation has advantages for both parties involved in the transaction.
Indeed, by selling his production forward, i.e. before it is harvested, the producer knows in advance the selling price of his crop. Whatever the evolution of market prices, the transaction will take place at the price fixed at the time of the agreement between the two parties. If the price of its production falls between now and delivery, this type of sale allows the company to be protected. On the other hand, if the product it harvests increases in value in the meantime, it will not be able to benefit from this increase. At the time of the agreement with the buyer, it is therefore necessary that the purchase price is appropriate for the producer.
On the buyer’s side, the futures market allows him to negotiate the purchase price of a raw material upstream. In order to anticipate a possible increase in the price of the product he wishes to acquire (example: oil), the futures transaction allows him to buy a product that will be delivered to him at a later date without being impacted by market developments. As for the seller, this criterion can be to his advantage or disadvantage depending on the developments.
How is the commodities market organized?
All transactions are carried out on organized markets or on the OTC (Over The Counter) market. The main difference between these two types of market is that an intermediary validates the transactions on the organized markets: the clearing house. On the OTC market, transactions are more flexible since they are concluded directly between sellers and buyers. The commodities market is a totally dematerialized market that has different financial places among which we find in particular :
- CBOT (Chicago Board Of Trade): wheat, corn, rice, oats, soybeans, oil, flour, milk, wood…
- NYME (New-York Mercantile Exchange): cocoa, arabica coffee, sugar, orange juice, cotton…
- COMEX (New-York Commodity Exchange): precious metals, gold and silver
- LME (London Metal Exchange): aluminium, copper, tin, nickel, lead, zinc, steel, strategic and precious metals…
- LBMA (London Bullion Market Association): gold, silver, oil…
- ICE (Intercontinental Exchange): energy, gas, cocoa, coffee, sugar, cotton, orange juice, cereals…
Note: the Chicago Mercantile Exchange is today the world’s leading market for agricultural commodities.
How to manage raw material prices?
The cost of raw materials can fluctuate strongly from one day to another according to many criteria: political, economic, climatic… The evolution of the price of raw materials is therefore not linear and can be different from one day to another. In order to achieve the best possible risk management, it is therefore essential to closely monitor and analyze these changes. This market thus requires companies to have a certain knowledge of how it works and to anticipate the different evolutions as well as possible.
A specific sector
In this market where speculators have a particularly important weight on the evolution of raw material prices, it is therefore advisable to have a good hedging strategy. To be able to invest in this highly volatile market, it is important to know that several supports exist to carry out your management strategy: Trackers (Exchange Traded Commodities) or derivatives. Trackers make it possible to replicate the price of raw materials, while derivatives offer the possibility of investing in the underlying in order to limit the risks to the premium invested. Some of the derivatives available for your company include :
- Forwards (over-the-counter contract)
- Futures (forward contracts)
- Options (Call / Put)
- Commodity swaps
- What are the profiles of players in this market?
As raw material prices are particularly volatile in this market, the risks for buyers are very high. For this reason, not everyone can invest in the commodity market. Some of the main investor profiles include :
Producers: anticipation of the sale of their production in order to avoid a possible drop in value.
- “Hedgers”: purchases and sales of raw materials to offset their risks.
- Speculators: objective of the leverage effect of derivatives to obtain the best return on investment.
- What are the main risks of raw materials?
The market for raw materials is particularly broad since it encompasses many products intended for the production of a finished product. Among the various operations that are carried out, there are several raw materials that are favoured by the participants:
In order to choose the products to which it is most interesting to turn, it is advisable to use the adapted financial tools. For this reason, we have developed our SaaS software DeftHedge to support your company in the management of raw materials.
A market regulated by the clearing house
On organized markets, transactions are guaranteed by a commodity clearing house. This institution guarantees the proper settlement as well as the delivery of the purchased securities. The presence of this clearing house ensures the smooth running of the transaction and avoids any counterparty risk. The missions of commodity clearing are multiple for this organization:
- Single counterparty: intermediary between buyers and sellers
- Security deposit: a security deposit is required for each transaction.
- Transaction management: ensures the execution of orders with stock exchange operators.
- Product management: monitoring of treatable products on the market
- Account balance: obligation to settle the balance of the operators at the close of each trading day.