Commodity Swaps

As the name suggests, a commodity swap is an agreement to exchange a fixed quantity of a commodity at fixed times in the future. Commodity swaps are the newest type of swap, and the market for them is small relative to that for other types. The potential for growth is enormous, however.

Swap contracts for oil have been engineered. For example, say that an oil user has a need for 20,000 barrels every quarter. The oil user could enter into a swap contract with an oil producer to supply the needed oil. What price would they agree on? As we mentioned previously, they can't fix a price forever. Instead, they could agree that the price would be equal to the average daily oil price from the previous 90 days. As a result of their using an average price, the impact of the relatively large daily price fluctuations in the oil market would be reduced, and both firms would benefit from a reduction in transactions exposure.

Unlike futures contracts, swap contracts are not traded on organized exchanges. The main reason is that they are not sufficiently standardized. Instead, the swap dealer plays a key role in the swaps market. In the absence of a swap dealer, a firm that wished to enter into a swap would have to track down another firm that wanted the opposite end of the deal. This search would probably be expensive and time-consuming.

Instead, a firm wishing to enter into a swap agreement contacts a swap dealer, and the swap dealer takes the other side of the agreement. The swap dealer will then try to find an offsetting transaction with some other party or parties (perhaps another firm or another dealer). Failing this, a swap dealer will hedge its exposure using futures contracts.

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