Managing Palm Oil Risks with futures
Palm Oil is a versatile product being used in multiple industries ranging from food manufacturing to biofuel production, which created a unique market dynamic. The Palm Oil market is influenced by many pricing factors, including energy prices, economic growth, weather, policy adjustments in both exporting and importing countries, etc. In fact, price fluctuations are common in the market. Given the volatilities, it poses challenges to firms as profits are impacted by price changes, which are hard to foresee. One way to manage the price uncertainty is through hedging using futures markets.
Hedging with futures
Hedging is essentially taking a position in the futures market that is opposite to one’s position in the cash market. The cash and the futures prices tend to be highly correlated, i.e., the two markets should move up and down together in similar amount. Therefore, gains or losses in one market will be offset by gains or losses in the other market. In addition to protection from uncertain price movements, hedging with futures also provides following potential benefits.
Stabilized cash flow - Through hedging future sales/purchase activities, companies can stabilize its revenue/cost cash flow for better financial planning.
Market transparency – Futures settlement prices and other market information, such as trading volume and open interest are published daily, which contribute to market transparency.
Central counterparty clearing – For futures traded on CME Group, CME’s clearing house acts as the counterparty to all buyers and sellers. This guarantees the performance of the futures contracts and greatly mitigates counterparty risk.
CME Group has a long history running world class Agricultural futures and options markets and has developed a number of global benchmark products such as CBOT Wheat, Soybean, and Corn. CME Group has also launched futures and options for the Palm Oil market. However, these contracts are different than the flagship CBOT contracts mainly in two ways.
Firstly, the Palm Oil futures and options are financially settled, unlike CBOT Grain and Oilseeds markets that are physically delivered. Physical delivery for a futures contract typically requires logistical arrangement, more paperwork, and is often operationally complex. Cash-settled futures contracts provide an effective way to manage price risks without these additional requirements.
Secondly, Palm Oil futures are typically transacted in larger trade sizes. Therefore, Palm Oil futures trading tends to be executed via the inter-dealer brokers who match bids and offers and submit the trades to the exchange as a block transaction.
Since the launch of the CME Crude Palm Oil products in 2013, the Exchange has seen growing participation in the markets with more firms adopting the products, especially in the recent years. In 2021, monthly volume in the CME Crude Palm Oil contracts hit record high and averaged close to 18,000 lots per month, which equate to 450,000 mt.
Among the different CME Palm products, the most liquid contract is the Malaysian Crude Palm Oil Calendar futures (CPO). The final settlement price of CPO contract is the monthly average of the daily settlement prices for the third nearby Bursa Malaysia Derivatives (BMD) Crude Palm Oil futures contract converted to U.S. dollars. Underlined by a well-known benchmark market, CME Crude Palm Oil products represent Crude Palm Oil priced in U.S. dollars and serve as a more precise tool for entities engaged in international trades. Firms involved in other parts of the supply chain may also find the contracts useful as a proxy hedge.
In a separate example we will look at a hypothetical scenario to see how a palm oil exporter could potentially use the Malaysian Crude Palm Oil Calendar futures to price its cargoes and hedge its sales.
Key Contract Characteristics of CME Malaysian Crude Palm Oil Calendar futures1
|Malaysian crude palm oil cAleNdAr FUTURES|
|Contract Size||25 MT|
|Settlement Type||Financial – Final settlement is based on the average of the settlement prices for the third forward month BMD FCPO contract for each trading day in the contract month converted to USD using the Kuala Lumpur USD/MYR Reference Rate.|
|Price Quotation||U.S. dollars per metric ton|
|Minimum Price Fluctuation||$0.25 per metric ton|
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.