Commodities · 9 lessons

Revision sheet

Every Commodities lesson’s essentials, formula and takeaway on one page. Each heading opens the full lesson.

M1The commodity complex

Commodity: A raw material traded in bulk, where one unit of a grade is as good as another, so it trades on price alone. The four families are energy, metals, farm products and permits to emit carbon.
Storage and transport: Gold keeps in a vault for years, gas needs pipelines or tankers, power can barely be stored and wheat arrives once a year. These physical facts drive prices, which is why desks specialise in one commodity.
Benchmarks: Each market prices one grade at one place. is US crude delivered at , Oklahoma; is waterborne North Sea crude and prices most oil traded worldwide. Brent usually trades a few dollars above WTI.
Contract size: Each covers a fixed amount: 1,000 barrels for Brent or WTI, 100 ounces for COMEX gold. So $1 a barrel is $1,000 on one oil contract, and oil’s one-cent tick is worth $10.
Producers and consumers: A producer, such as an oil company, loses when prices fall, so it hedges by selling futures. A consumer, such as an airline, loses when prices rise, so it hedges by buying them.

Profit or loss on futures

P&L = N × Q × ΔP

N: number of contracts (negative if you sold)
Q: contract size: 1,000 barrels for Brent or WTI
ΔP: change in the price, per barrel

Remember: Brent or WTI: $1 a barrel = $1,000 a contract. Contract value is price × size: learn the size, and every price move becomes a P&L you can say out loud.

M2The futures curve: contango and backwardation

Spot and futures prices: Spot is the price for delivery now; a futures price is agreed today for delivery later. Lined up by delivery month, futures prices form the futures curve.
Cost of carry: Interest on the money tied up in the commodity, plus storage and insurance. With spot at $100, interest at 5% and $3 of storage, oil for delivery in a year should cost about $108.
Convenience yield: The benefit of having the commodity on hand, such as keeping a refinery running. It is highest when stocks are scarce, and it comes off the futures price.
Contango and backwardation: In later months cost more than nearer ones, a sign of ample stocks. In the costs most, because stocks are scarce and buyers pay up to have the commodity now.
Storage limits: Buying spot, storing it and selling forward (cash and carry) caps contango only while there is space. When storage at Cushing ran short in April 2020, the expiring May contract settled at −$37.63 a barrel.

Cost of carry

F ≈ S × (1 + (r + u − y) × t)

F: futures price for delivery in t years
S: spot price
r: interest rate, % a year
u: storage cost, % of spot a year
y: convenience yield, % a year
t: time to delivery, in years

Remember: F ≈ S × (1 + (r + u − y) × t). Contango says stocks are ample and storage is being paid for; backwardation says the market will pay to have the commodity now.

M3Roll yield and commodity investing

Rolling: Futures expire, so a fund that wants lasting exposure sells the expiring contract before delivery and buys the next one. That switch is a , repeated every month.
Roll yield: The gain or loss from rolling, as each new contract drifts towards spot. Rolling from $70.00 into $71.40 costs about 1.96%; repeated monthly with the curve unchanged, about 23.5% a year.
Curve shape and roll yield: In the next contract costs more, so the roll yield is negative. In it costs less, so the roll yield is positive and a long fund can beat spot.
Three parts of the return: A futures investor earns the spot return (the change in the price), the roll yield, and interest on the cash not needed as a deposit. Spot plus roll is the excess return.
Why an oil fund lags oil: Headlines quote spot, but a futures fund earns spot plus roll plus interest. If oil rises 10%, the roll costs 20% and cash earns 4%, the fund returns about −6%. Funds holding gold in a vault don’t roll.

Roll yield per roll

Roll yield ≈ (F₁ − F₂) ÷ F₂

F₁: price of the expiring (front) contract
F₂: price of the next contract

Remember: Roll ≈ (F₁ − F₂) ÷ F₂ per roll. A futures investor earns spot plus roll plus collateral; in contango the roll is negative and can outrun the spot move.

M4Spreads: cracks, sparks and locations

Spread: One price minus another. A refinery, a power plant or a trader shipping cargoes earns a spread, so it cares about the gap between two prices more than about either price alone.
Crack spread: A refinery’s margin: the fuels it makes minus the crude it buys. The 3-2-1 assumes 3 barrels of crude make 2 of gasoline and 1 of diesel, with fuel prices converted at 42 gallons a barrel.
Spark spread: A gas-fired plant’s margin: power minus the gas it burns. Gas burned per MWh of power is the , 2 for a 50% efficient plant, so power at £90 and gas at £35 give a of £20.
Calendar spread: Buying one delivery month of a commodity and selling another. Buying the nearer month gains if prompt supply tightens; selling it gains if a glut builds.
Location spread: The price gap for one commodity at two places, such as over . When it is wider than the cost of moving the oil, traders ship it, and their buying narrows the gap.

The 3-2-1 crack spread

Crack = (2G + D − 3C) ÷ 3

G: gasoline, $ a barrel ($ a gallon × 42)
D: diesel, $ a barrel
C: crude, $ a barrel

Remember: 3-2-1 crack = (2G + D − 3C) ÷ 3. Desks trade the gap between two prices; the spread tells you whether a refinery, a power plant or a cargo makes money.

M5Supply, demand and the data

Builds and draws: Stocks rise in a build, when more is produced than used, and fall in a draw. A draw means the market is tightening, which tends to lift prices.
The weekly report: The US on oil stocks is normally out on Wednesdays at 10:30am New York time. Prices trade the surprise: a 2m-barrel draw against a forecast 1m build is −3m, which is bullish.
Days of cover: How long stocks would last at current use: 400m barrels at 20m a day is 20 days. Fewer days of cover make a market fragile and tend to push the curve into .
OPEC+ and shale: , a group of big oil exporters, sets production targets; a cut removes barrels now, so the nearest futures rise most. US shale can add wells within months, which limits how far later months rise.
Seasons, weather and China: US petrol demand peaks in the summer driving season and heating demand in winter. Cold snaps in Asia pull cargoes away from Europe, and news from China, the largest crude importer and a big copper buyer, moves both.

Days of cover

Days of cover = stocks ÷ daily demand

stocks: inventories, such as million barrels
daily demand: use per day, in the same units

Remember: Days of cover = stocks ÷ daily demand. Markets trade the surprise against forecasts: a bigger draw than expected is bullish, and the front of the curve moves most.

M6Hedging for producers and consumers

Hedge: A position that gains when the business loses. Consumers buy futures (a long hedge) and producers sell them (a short hedge). Futures bought at $80 lock in about $80 whether oil ends at $95 or $70.
Hedge ratio: The share of expected volume that is hedged, usually less than all of it because volumes are uncertain. Hedging 70% of 2.4m barrels with 1,000-barrel contracts takes 1,680 contracts.
Basis risk: is the local cash price minus the futures price. A hedger ends up with the locked-in futures price plus the basis at the end, so changes in basis are , usually far smaller than price risk.
Options as hedges: A caps a buyer’s price but keeps the saving if prices fall; a gives a producer a floor but keeps the gain if they rise. Both cost a fee up front.
Margin and cash: Futures losses are paid in cash every day as , while the matching gain on physical output arrives only when it is sold. In 2022 that left hedged European energy firms short of cash.

Contracts for a hedge

N = E ÷ Q × h

N: contracts to trade
E: the amount to hedge, such as barrels
Q: contract size
h: hedge ratio: the share hedged (0.7 for 70%)

Remember: Effective price = futures at the start + basis at the end. A hedge swaps price risk for basis risk, and an exchange hedge needs cash for margin before the physical gain arrives.

M7Gold and precious metals

Gold as a store of value: Almost all the gold ever mined still exists, so its price depends on how much people want to hold rather than on a year’s mining. Investors keep it as a store of value and a .
Real yields: Gold pays no interest, so holding it means giving up the real return on safe bonds. Higher tend to push gold down; lower ones tend to lift it.
The dollar: Gold is dollars, so a weaker dollar makes it cheaper for other buyers and tends to lift the price. In pounds, the price is the dollar price ÷ GBPUSD: $3,000 at 1.25 is £2,400 an ounce.
Central-bank buying: Central banks hold gold as a reserve with no issuer that could default. They bought more than 1,000 tonnes a year in 2022, 2023 and 2024, on World Gold Council figures. Buying on that scale can outweigh the pull of real yields.
Silver and the gold/silver ratio: Silver is used in electronics and solar panels as well as held, so it moves with gold but swings more. The is ounces of silver per ounce of gold: 80 with gold at $3,000 and silver at $37.50.

Return in pounds

£ return = (1 + r$) ÷ (1 + rFX) − 1

r$: the return in dollars
rFX: % change in GBPUSD (positive when the pound rises)

Remember: £ return ≈ $ return − change in GBPUSD. Gold moves on real yields, the dollar and central-bank and investor demand; lower real yields and a weaker dollar usually lift it.

M8Power, gas and the energy transition

Power and storage: Very little electricity can be stored, so supply must match demand at every moment. Power is priced for each half-hour or hour, and prices swing between a windy night and a still, cold evening.
Merit order: Plants run from cheapest to dearest: wind, solar and nuclear, then gas, then old oil-fired plants. The last plant needed sets the price every running plant receives; in Britain it is usually gas, so power follows gas.
Gas benchmarks: British gas trades at the in pence per therm, continental gas at the Dutch in euros per MWh, US gas at . One MWh is 34.12 therms, so 100p a therm is £34.12 per MWh.
Clean spark spread: A gas plant’s margin after fuel and carbon. A 50% efficient plant burns 2 MWh of gas per MWh of power and emits about 0.4 tonnes of CO₂; at £50 a tonne, carbon costs it £20 per MWh.
Carbon pricing: Under the UK and EU , plants hand in an allowance per tonne of CO₂. Coal emits roughly twice as much per MWh as gas, so dearer carbon pushes coal behind gas in the merit order.
Europe in 2022: As Russian gas deliveries fell, Europe bid against Asia for and TTF set all-time highs in August 2022. Gas plants were still the last ones needed, so power prices soared with gas.

Clean spark spread

CSS = P − HR × G − CI × C

P: power price, per MWh
HR: heat rate: MWh of gas per MWh of power (1 ÷ efficiency)
G: gas price, per MWh of gas
CI: carbon intensity: tonnes of CO₂ per MWh of power
C: carbon price, per tonne

Remember: Clean spark = power − HR × gas − CI × carbon. The last plant needed sets the power price; in Britain that is usually gas, so power follows gas and carbon.

M9Market structure and crises

Clearing house: The body that stands between the two sides of every exchange trade, as buyer to every seller and seller to every buyer, so if one side fails the other is still paid. It is also called a .
Initial and variation margin: Both sides post initial margin when a trade opens, and more when markets get wilder. Gains and losses are then settled in cash daily as : a $6.50 rise costs a seller of 200 contracts $1.3m.
Liquidity risk: A hedged producer pays its futures losses in cash now, while the gain on its output arrives only when it sells. A big enough spike drains its cash, and an unmet gets the position closed out.
Squeezes and position limits: In a , sellers who can’t deliver or meet margin must buy back at once, pushing prices higher. Exchanges cap the contracts anyone can hold near delivery, a , to stop anyone cornering supply.
Three kinds of crisis: Negative in April 2020 was a storage crisis, Europe’s energy margin calls in 2022 a liquidity crisis, and nickel in March 2022 a squeeze, when the exchange cancelled about $12bn of trades.

Variation margin

VM = N × Q × ΔP

N: contracts (negative if you sold)
Q: contract size
ΔP: change in the closing price

Remember: VM = contracts × size × price change. Margin protects the exchange but turns a price spike into a cash call today: a hedge can be right and still drain your cash.