FocusFertilizer swap futures, a good sign for the market

08 August 2011 14:48  [Source: ICIS news]

LONDON (ICIS)--US-based risk management firm and exchange owner the CME Group recently began clearing cash-settled swap futures for urea, urea ammonium nitrate (UAN) and diammonium phosphate (DAP) fertilizers.

The news sparked interest in the fertilizer industry, but is being eyed with some caution despite bringing some transparency to this fairly opaque over-the-counter (OTC) market.

“Fertilizer has had consistent interest and we’ve been looking at what’s trading in the market place, and we think there’s value there,” said Tim Andriesen, managing director for agricultural commodities and alternative investments at CME Group.

Since CME’s ClearPort services were expanded on 11 July to include fertilizer swaps, agricultural commodities specialists expect this type of trading to increase significantly, now that a major company is clearing the transactions.

"When you don’t have to be focused on the risk, it opens up the ability to trade with a greater number of people… and when you’re dealing with smaller firms or [agricultural] co-ops, sometimes accessing the swaps market can be laborious,” Andriesen said.

The clearing service provides risk mitigation for OTC market participants. Developed in response to the Enron debacle, it provides a centralised system whereby CME registers market participants, analyses their credit, and then allows counterparties to engage in a swap, or a forward price agreement in which the seller and buyer agree on a future price of a specific fertilizer for a specific timeframe.

Then CME provides a neutral settlement of the swap price assessments provided by ICIS and Profercy. The settlement is the difference between the agreed price and the actual price.

But no product changes hands – it is a cash-settled swap agreed between financial advisers acting on behalf of companies and co-ops. In the case of fertilizers, this provides a way for farmers to hedge their inputs and for producers to obtain a clearer idea of future profits and costs.

“The swap is meant to help manage prices for volatile commodities,” said Andriesen.

The price for urea provides a good example of such volatility, trading around $500/short ton FOB (free on board) US Gulf on 23 June, falling as low as $465/short ton FOB on 14 July, and then rising and settling in the $490s/short ton FOB by 4 August.

When trading fertilizers on the paper market, counterparties will also typically have a physical position. OTC swap futures are agreed in tandem with actual product trades in an effort to mitigate the volatility of the real market. So whether the party gains or loses in the swap, the amount of the swap settlement only offsets the change in the price of the physically traded fertilizer.

“Ultimately [the benefit] trickles down to producers – it’s not for the people in the middle of the value chain – it provides greater security for producers,” said Andriesen.

In this post-crisis economy, however, many people become anxious when traders and market participants start mentioning “hedging” and speculating on future prices. Even some fertilizer producers expressed some scepticism and concern that too much derivatives trading could lead to an over-inflated market.

Several producers acknowledged that their companies already dealt in the OTC market, but at least one southeast Asian producer said OTC swap futures could have undue influence on the real market and contribute to further volatility.

Andriesen said that the number of fertilizer swaps transactions represents a very small portion of the market, probably below 5%. Ultimately, Andriesen said, it would be impossible for swaps to artificially inflate or deflate prices.

"That would be like the tail wagging the dog,” Andriesen added. “The supply and demand for the physical is what drives those swaps. The swaps markets are very much secondary and get their value from physical market participants.”

Previously, the OTC swaps fertilizer market in the US had been what Andriesen labelled a “call-around market”, making it difficult to measure and quantify OTC trades. But CME’s monitoring of OTC fertilizer swaps will help bring some transparency to an otherwise fairly opaque market.

“We expect to go beyond fertilizer as well, into a large range of agricultural products and inputs, food products like meats and dairy products,” Andriesen said. “[We’re interested in] places where there are already OTC markets and where market participants might be looking for CME to provide clearing services."

Click here for more information on CME’s fertilizer swap futures

By: Lauren Williamson
+44 (0) 20 8652 3214

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