The financial implications of volatile commodity markets

Box extracted from special feature "Commodity markets: shocks and spillovers"

BIS Quarterly Review  |  September 2022  | 
19 September 2022

The financialised commodities market – comprising mainly derivatives such as futures and options – is fairly concentrated, dominated by a few large commodity traders.icon These traders' main role is to intermediate between producers and consumers of commodities, taking advantage of arbitrage opportunities when they arise. This box discusses how recent developments in physical markets affected financial markets and the attendant vulnerabilities.

The Ukraine-Russia war led to large and frequent margin calls in financialised commodities markets. The exceptionally large price movements, in some cases equivalent to roughly a 15-sigma event (Graph A1 first panel), resulted in sizeable daily or even intraday variation margin (VM) calls as derivatives contracts were marked to market. The elevated volatility also prompted central counterparties (CCPs) to increase initial margin (IM) substantially. For instance, the IM requirement for European natural gas futures at Intercontinental Exchange (ICE) more than doubled right after the start of the war and then hovered at around 50% above pre-war levels (Graph A1, second panel).

Leveraged commodity traders faced large margin calls and high funding costs

Higher IM requirements are costly for commodity traders. In order to maintain derivatives positions, they need to pledge more liquid assets as collateral. Furthermore, sizeable IM and VM calls can potentially drain the liquidity assets of commercial traders – possibly impairing their creditworthiness – as traders tend to be highly leveraged and reliant on short-term funding. For instance, one major trader in energy commodities has an asset-to-equity ratio of eight, while more than 75% of its liabilities are financed with short-term instruments of less than one year's maturity (Graph A1 third panel). Accordingly, bond prices for major commodity traders dropped by around 20% in the first half of 2022 (Graph A1, fourth panel). This has raised traders' funding costs, making it even more expensive to participate in commodities markets.

As the cost of trading on commodities derivatives markets increased in H1 2022, these markets became substantially thinner. After the war started, open interest in exchange-traded natural gas futures fell by more than 50%; and that in oil futures by almost 30% (Graph A2, left-hand panel). Trading volumes in both exchange markets and OTC markets also saw large declines and have remained at low levels ever since (Graph A2, centre panel).

Commodity derivatives markets become thinner as activity dropped

Setting aside their contribution to commodity price volatility, thinner derivatives markets are of particular concern if the reduction in open interest and trading volumes reflects declines in hedging rather than speculation activities. Indeed, US data on oil futures indicates that end users of commodities – such as producers, merchants and processors – were affected the most by the high trading costs.icon  The number of end users with long (short) positions in WTI oil futures dropped from 46 (36) in February 2022 to 33 (31) in May 2022, while the number of other types of user who are more likely to engage in speculation – eg money managers – remained relatively stable (Graph A2, right-hand panel). This suggests that some commodity end users tried to opt out of their usual hedging activities and to absorb price risks on their balance sheets. If they fail, there could be adverse consequences for commodity supply security.

icon US data from the CFTC commitment of traders report on WTI futures contracts.