Pricing methods in commodity trading: about pricing & valuation

Prices of a commodity are based on the supply and demand of the commodity. This is similar to other non-commodity products. Commodities however are bought and sold at prices while exchange of these products usually takes place on a later date somewhere in the future. Therefore there is a lot of uncertainty whether the market or spot price will be in line with the pre-determined price of a contract. Parties agree on a pre-determined price to cover themselves against adverse price movements. They however also risk missing out on positive price movements in the future, due to the obligation to a contract. Therefore a number of different pricing methods have evolved for determining a price upon which both parties can agree.

Pricing methods

When two parties are negotiating a contract for the delivery of a commodity, the price can present an obstacle. Prices can be determined by different pricing methods such as a fixed price, a floating price or a combination of both.

Fixed price

A fixed price is the most basic form for settling a price for a commodity or futures contract. A fixed price is determined at the start of a contract and is in many cases based on the price futures, that have a comparable size and delivery date. This agreed upon price is the price for which the contract will be settled at the delivery date. This fixed price is an insurance for both parties against negative price movements on their position. There is the possibility both parties agree on the option to periodically revise the price of their contract. This way the contract will remain in accordance with the exchange prices.

Floor and ceiling price

Parties can also agree on minimum and maximum price, called floor and ceiling prices. In this situation, when a price would move outside of these boundaries, both parties would share the profit from this price evolution. This way both parties benefit from large price movements. When the price remains within the boundaries, the contract will be settled according the market price upon the time of delivery.

Floating price

Another pricing method for determining a price for a commodity contract, is using a floating price. A floating price can be calculated as an average of a reference price over a set period of time. This methods reduces the risks of an temporarily extreme price at the date of delivery. While calculating averages, a sudden increase will only have a small effect on the overall price of the commodity. This type of pricing is especially effective for long-term contracts, because the chance for price fluctuation increases with the increased duration of a contract. The reference price for such a contract is determined at the start of a contract and is in many cases the spot price of a commodity on a leading exchange.
Another way of using a floating price is by agreeing to pay the spot price at the time of delivery or the spot price at a date near the delivery date. Hereby it is again important the parties agree on the exchange which will be used as reference price. This pricing method is very risky due to the uncertainty of the price in the future, it can move either way. Usually participants will hedge their price risks on an exchange to cover themselves against adverse price movement.

Price based on the basis

The price can also be established upon the basis of a commodity. A basis is the difference between the local cash price and futures price. This contracts gives the holder the ability to lock in on a basis, which he thinks will be profitable in the future. The final price for the commodity however will be decided when the holder exercises the contract. When he decides to exercise the contract the price will be determined by taking the current futures price and reducing this with the agreed upon basis. This result in the final price the buyer will pay for the commodity. Using a basis contract offers certain advantages. In combination with a hedge on a futures market, a basis contract offers a certain level of security about the final price of a commodity. Furthermore the basis are quite predictable due to seasonal patterns or historical references. Therefore the risk of high basis fluctuations can be minimized.

A basis contract however must always be covered via hedging to reduce the price risk. While the basis is predicted and settled upon in the contract, the actual selling or buying price can fluctuate greatly. Therefore a basis contract is only effective in combination with a proper hedge.

Speculative trading

The numerous traders working the market, can have major impact on the price volatility of the commodity markets. These traders only trade with the prospect of making a profit, without ever owning a physical commodity. Therefore they will attempt to move prices in their favor. This can result in unforeseen price fluctuations and thus create risks for companies, who depend heavily on commodities and their prices.
Traders are however not merely a risk factor for commodity and futures prices, but are simultaneously vital to the effectiveness of the market. They serve as an intermediary between producers and end-users. They will match producers and end-users whereby both parties receive a price which they find acceptable. This way they perform the role of generating a price upon which the trade will be executed, and are therefore vital to the market effectiveness. Furthermore they generate liquidity for the market, which will help market participants find an acceptable price.

Agiblocks CTRM solution

Commodity traders – as well as most other traders – tend to be risk averse. That is to say, they prefer situations with low uncertainty over situations with high uncertainty. Or better yet, no uncertainty at all. However, in economics and finance, as well as in life, things are never one hundred percent certain, nor do the most certain outcomes yield the best results.

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