Market Structure

Commodity markets operate through multiple interconnected structures. Understanding how these markets work and interact is essential for effective participation.

Market Types

OTC vs Exchange

Aspect	OTC (Over-the-Counter)	Exchange-Traded
Trading venue	Bilateral, private	Central exchange
Standardization	Customizable	Standardized
Counterparty	Direct exposure	Clearinghouse
Transparency	Limited	Full price visibility
Liquidity	Varies	Generally high
Regulation	Less	More

The Physical-Financial Continuum

MARKET STRUCTURE CONTINUUM
──────────────────────────

PHYSICAL                                      FINANCIAL
◄─────────────────────────────────────────────────────────►

Spot         Physical    OTC        Exchange    Financial
Physical     Forwards    Swaps      Futures     Options
│            │           │          │           │
│            │           │          │           │
Actual       Contract    Custom     Standard    Right,
delivery     for future  hedging    hedging     not
today        delivery    tool       tool        obligation

Spot Markets

Physical Spot

SPOT MARKET CHARACTERISTICS
───────────────────────────

DEFINITION:
Immediate (or near-immediate) delivery
Typically 1-30 days forward

PRICING:
Negotiated between buyer and seller
Referenced to benchmark + premium

PARTICIPANTS:
- Producers selling output
- Consumers buying needs
- Traders intermediating

EXAMPLES:
"Spot Rotterdam Gasoline"
"Prompt copper cathode"
"Cash grain at elevator"

Spot Market Dynamics

Factor	Impact
Immediate need	Premium for availability
Surplus	Discounts to move product
Quality variations	Premiums/discounts vs standard
Location	Freight differentials

Forward Markets

Physical Forwards

PHYSICAL FORWARD CONTRACT
─────────────────────────

STRUCTURE:
Buyer and seller agree:
- Quantity
- Quality specifications
- Delivery location
- Delivery date/period
- Price (fixed or formula)

EXAMPLE:
"100,000 MT copper concentrate
 Grade: 25% Cu
 Delivery: Santos, July 2024
 Price: LME Cash average July
        minus $100/MT TC/RC"

KEY FEATURES:
- Bilateral agreement
- Customized terms
- Physical delivery intended
- Counterparty credit risk

OTC Derivatives

OTC SWAP EXAMPLE
────────────────

STRUCTURE:
Fixed-for-floating swap

EXAMPLE:
Notional: 100,000 bbl/month
Period: Jan-Dec 2024
Fixed price: $75.00/bbl
Floating: Platts Dated Brent monthly average

MONTHLY SETTLEMENT:
If average = $78.00:
Floating payer pays fixed payer: $3.00 × 100,000 = $300,000

If average = $72.00:
Fixed payer pays floating payer: $3.00 × 100,000 = $300,000

USE CASE:
Producer locks in selling price
Consumer locks in buying price

Exchange Markets

How Futures Work

FUTURES CONTRACT MECHANICS
──────────────────────────

STANDARDIZATION:
- Contract size (e.g., 1,000 bbl)
- Quality specification
- Delivery location
- Delivery month
- Tick size and limits

DAILY SETTLEMENT:
Price-to-market every day
Gains/losses settled via margin

EXAMPLE:
Buy 10 WTI contracts @ $75.00
Price moves to $76.00
Daily gain: 10 × 1,000 × $1.00 = $10,000
Credited to margin account

EXPIRATION:
Physical delivery or cash settlement
Most traders roll before expiration

Open Interest and Volume

OPEN INTEREST ANALYSIS
──────────────────────

OPEN INTEREST:
Number of contracts outstanding
(one long + one short = 1 OI)

VOLUME:
Number of contracts traded per day

INTERPRETATION:

Rising price + Rising OI = New longs entering (bullish)
Rising price + Falling OI = Short covering (less bullish)
Falling price + Rising OI = New shorts entering (bearish)
Falling price + Falling OI = Long liquidation (less bearish)

EXAMPLE:
WTI Jul contract
Open Interest: 450,000 contracts
Daily Volume: 1,200,000 contracts

Turnover: 2.7x OI daily
(Highly liquid)

Market Participants

By Role

MARKET PARTICIPANT ECOSYSTEM
────────────────────────────

COMMERCIALS (Hedgers):
├── Producers
│   - Sell futures to lock in prices
│   - Natural sellers
│
├── Consumers
│   - Buy futures to lock in costs
│   - Natural buyers
│
└── Merchants (Traders)
    - Both sides depending on position
    - Arbitrage between markets

NON-COMMERCIALS (Speculators):
├── Managed money
│   - Hedge funds, CTAs
│   - Directional positions
│
├── Index investors
│   - Passive, long-only
│   - Roll positions monthly
│
└── Proprietary traders
    - Bank desks, prop shops
    - Various strategies

Market Share

Category	Typical Futures Share	Impact
Commercials	40-60%	Price discovery
Managed money	20-35%	Trend amplification
Index funds	10-20%	Roll pressure
Other	10-20%	Various

Price Relationships

Spot-Forward Relationship

SPOT-FORWARD PRICING
────────────────────

THEORETICAL FORWARD PRICE:
F = S × e^(r + c - y)t

Where:
F = Forward price
S = Spot price
r = Interest rate
c = Storage cost
y = Convenience yield
t = Time

IN PRACTICE:
F = S + Carry Cost - Convenience Yield

Contango: F > S (carry > convenience)
Backwardation: F < S (convenience > carry)

Cross-Commodity Relationships

CROSS-COMMODITY SPREADS
───────────────────────

CRACK SPREAD (Refining margin):
3-2-1 Crack = (2×Gasoline + 1×Diesel)/3 - Crude

CRUSH SPREAD (Soybean processing):
Crush = Soybean Oil + Soybean Meal - Soybeans

SPARK SPREAD (Power generation):
Spark = Power Price - Gas Price × Heat Rate

CALENDAR SPREAD:
M1 - M6 (front month vs 6 months out)

GEOGRAPHIC SPREAD:
Brent - WTI (Atlantic Basin spread)

Market Microstructure

Order Book

EXCHANGE ORDER BOOK
───────────────────

         BIDS (Buy)              ASKS (Sell)
Price    Quantity        Price    Quantity
──────────────────────────────────────────────
                         75.05    100
                         75.04    250
                         75.03    500
                         75.02    1,000
                         75.01    2,500
75.00    3,000
74.99    2,000
74.98    1,500
74.97    800
74.96    400

SPREAD: $0.01 (75.00 bid, 75.01 ask)
DEPTH: Sum of quantities at each level

Execution Strategies

Strategy	Description	Use Case
Market order	Execute immediately at best price	Urgent
Limit order	Execute at specified price or better	Patient
TWAP	Time-weighted average price	Large orders
VWAP	Volume-weighted average price	Large orders
Iceberg	Hide full size	Avoid market impact

Regulatory Framework

Key Regulations

Regulation	Jurisdiction	Key Requirements
Dodd-Frank	US	Clearing, reporting, position limits
EMIR	EU	OTC clearing, trade reporting
MiFID II	EU	Transparency, position limits
CFTC Rules	US	Exchange regulation, speculation limits

Position Limits

POSITION LIMIT EXAMPLE
──────────────────────

COMMODITY: WTI Crude (NYMEX)

SPOT MONTH LIMIT:
6,000 contracts (6 million bbl)

SINGLE MONTH LIMIT:
80,000 contracts

ALL MONTHS COMBINED:
120,000 contracts

EXEMPTIONS:
- Bona fide hedgers can apply
- Must demonstrate physical exposure
- Subject to approval

REPORTING THRESHOLD:
25 contracts → Must report position

Key Takeaways

1. Multiple market types coexist — OTC, exchange, physical
2. Each serves different needs — Customization vs liquidity
3. Participants have different motives — Hedgers vs speculators
4. Price relationships matter — Spot-forward, cross-commodity
5. Microstructure affects execution — Order types, market impact
6. Regulation shapes behavior — Position limits, reporting

References

• CME Group Market Structure
• ICE Futures Documentation
• LME Market Structure
• CFTC Position Limit Rules