Trading CBOT Fertilizer Derivatives

source: CME Group

source: CME Group

How to Hedge Fertilizer

Futures and swaps are an efficient way to manage commodity price risk and can help companies navigate challenging market environments. Proper price risk management practises can aid in price certainty, reducing the impact of volatile commodity cash prices on earnings and cash flows. The principle of hedging relies on the correlation between a futures market and a physical cash market – that the two prices will move up and down together. A hedger will take the opposite position in the futures market than the position they take in the cash market.

The two ways to engage with fertilizer derivatives are by buying or selling. Buying, or “going long,” means a participant needs protection against a rise in underlying cash prices, and selling, or “going short,” means a participant needs protection against a drop in underlying cash prices. The long hedger (futures buyer) will gain in the futures market with an increase in futures prices, and a short hedger (futures seller) will gain in the futures market with a decrease in futures prices.

In fertilizer derivatives, the futures price is determined by two assessments known as the “floating price.” In a futures transaction, the customer exchanges the floating price for a fixed price – the price which is agreed when a derivative trade is executed. The long customer will benefit when the floating price increases and the short customer will benefit from a decrease in the floating price.

In general, a producer of fertilizer will be short (sell futures) to protect against falling cash prices. Because the cash market is highly correlated with the futures market, if prices fall in the cash market, they will also fall in the futures market. The short hedger will lose money in the cash market due to the falling price but be able to make up a portion of that loss in the futures market by “buying back” a position also at a lower price.

The same logic can also be applied to a consumer purchasing physical fertilizer. The consumer needs protection against increasing prices when it is time to buy fertilizer. If prices increase, the long participant (buyer) would pay more for the cash fertilizer but would realize a gain in the futures market, buying a futures position at a lower price and offloading that position at a higher price.

It is important to note that, while correlated, the physical cash market and the futures market do not always move identically. A participant may end up losing more in the cash market than they gain in the futures market or may end up losing less in the cash market than they gain in the futures market. The concept of hedging is to lock in a future price and not be subject to price swings when buying or selling the physical commodity.

Trading in fertilizer derivatives also allows participants to engage in more speculative activities. Having cash exposure to fertilizer is not a prerequisite to trading CME Group fertilizer products. In general, a participant may examine the underlying supply and demand fundamentals and form a view on which way the market is going. That participant can engage in a trade even if they are not directly involved in the production, storage, or consumption of fertilizer. Ultimately, the presence of speculators in a market benefits the hedgers, as they assist in providing both price discovery and liquidity in the market.

Benefits of CME Group Fertilizer Products

There are several benefits to using the fertilizer futures and cleared swaps listed by CME Group. First, all CME Group fertilizer products are financially settled (also called cash settled). This allows the market to lock in prices or speculate on prices without fear of physical delivery. There are no decisions about whether to stand for or make delivery in the futures market versus transacting in the physical market. Second, the final settlement number is derived from assessments from two price reporting agencies. Each Thursday, both agencies release assessments that go into the final settlement price. On the last Thursday of the month, each weekly price is listed, and the highest and lowest numbers from each week – regardless of source – are excluded. The remainder of the numbers are averaged to create the final settlement price. By having two price reporting agencies and throwing out the weekly high and low, any cash transaction considered in a price assessment that is outside of the normal range will be mitigated in determining final settlement. Lastly, trading exchange-listed and exchange-cleared products provides the safety and security of central counterparty clearing and of anonymous execution on a central limit order book. CME Group operates a well-capitalized and regulated Clearing House, CME Inc., that guarantees financial performance between the buyer and seller. Positions are risk-assessed in real time, performance bond is collected at a minimum of twice a day, and the Clearing House will collect and pay out settlement variation though the intra-day and end of day clearing cycles. The collection of performance bond is a valuable and necessary tool to manage market and counterparty risk.

Current Fertilizer Product Suite

CME Group currently offers 7 different products, both nitrogen and phosphate fertilizer, which cover a variety of origin and destination locations. The contracts are monthly structures and are listed for 12 consecutive months. A contract unit is tradable in multiples of 100 tons (metric tons for the contracts that reference non-US locations, and short tons for the contracts that reference US locations), with a minimum block transaction size of 2 lots per transaction.

Accessibility of Fertilizer Futures

The conversion of cleared swaps to futures contracts allows greater market access to CME Group’s fertilizer products. Many traditional agricultural futures clearing merchants (FCMs) are not set up to clear swaps, though they are active in futures markets. Futurization of the fertilizer derivatives market will mean greater participation across the industry, improved liquidity, and an increased universe of market counterparties with which to execute business.

All futures products are available for block trading on ClearPort (accessible through CME Direct) and for trading on the screen via the central limit order book (Globex).

Futures and swaps can be an efficient instrument for hedging physical exposure to fertilizer or speculative on the fertilizer market. CME Group offers a comprehensive suite of products that covers the most widely referred fertilizer price assessments. The fertilizer suite has been experiencing continued growth since its inception, showing that CME Group futures and swaps are an appealing tool for engaging in the fertilizer derivatives space.