Pellet Trading

APX-ENDEX and Port of Rotterdam are proposing to introduce a wood pellet exchange, which should be operational by the fourth quarter of 2011. Sipke Veer is the APX-ENDEX product manager in charge of this initiative, and I had an opportunity to meet him recently at his office in Amsterdam.

“APX-ENDEX is well known for its gas and power exchanges,” says Veer. “A pellet exchange will extend the range of trading opportunities that we offer. The Port of Rotterdam knows all the parties who do the physical handling of pellets and will set up the infrastructure to receive, store, and tranship pellets.”

Power-generating companies are familiar with trading through exchanges. “They do it all the time with coal, gas, and power,” says Veer. “In fact, the power utilities were the original shareholders of the futures side of APX-ENDEX until it was sold it to our current owners. And they like our idea for a pellet exchange. However, we realize it will be something new for some of the pellet producers, and they may initially be hesitant. But once they learn the benefits of participating in an open, liquid, and transparent market, we think they will be enthusiastic participants.”

So what exactly is a commodity futures exchange? It is an organized marketplace in which members can freely buy and sell commodities. The exchange provides the facilities and ground rules for its members to trade in commodity futures, and for non-members to trade by dealing through a member broker and paying a brokerage commission. The primary distinction between a futures market and a market in which actual commodities are bought and sold for immediate or later delivery is that in the futures market, one deals in standardized contractual agreements only. These agreements, known as futures contracts, provide for delivery of a specified amount of a particular commodity during a specified future month, but involve no immediate transfer of ownership of the commodity itself.

Trading on a commodities futures exchange provides:

• Liquidity—the ability to buy or sell a commodity at a posted price;
• Price discovery—the ability to observe instantaneous market price; and
• Price transparency—the ability to know that the instantaneous price is fair, in contrast with a bilaterally negotiated price.

The more liquid a market is, the truer the instantaneous price and the less the price distortion. The price is what it is; if you disagree, you don’t trade.

Modern futures trading started in the grain markets with the establishment of the Chicago Board of Trade in 1848. In the 1870s and 1880s, the New York Coffee, Cotton, and Produce Exchanges were introduced. Today there are major commodities futures exchanges in more than 20 countries.

Each futures market has producers and consumers who need to hedge their risk from future price changes. Speculators, who do not actually deal in the physical commodities, play an important role. They provide liquidity and assume the risks that are hedged. Rather than taking delivery or making delivery, speculators offset their position at some time before the date set for future delivery. If the price moves in the right direction, they profit; if not, they lose. This maintains an orderly market in which price changes are small from one trade to the next.

One can buy and sell commodities in a futures market regardless of whether one owns the particular commodity involved. When dealing in futures, it is unnecessary to make or receive delivery of the actual commodity providing that the future isn’t bought or sold during its delivery month. A previous purchase or sale can be cancelled out at any time by an equal offsetting sale or purchase, respectively. Done prior to the delivery month, the trades cancel out, with no delivery of the commodity. Less than about 2% of all futures contracts are ever settled through deliveries. Prices are determined solely by supply and demand; if there are more buyers than sellers, prices will go up, and vice versa.

Each futures exchange has its own clearinghouse through which members must clear their trades. This simplifies futures trading by allowing parties to settle their transactions with the clearinghouse, rather than with each individual party with whom they’ve traded.

The justification for futures trading is that it provides the means for those who produce or deal in cash commodities to hedge, or insure, against unpredictable price changes. Following is an example of how a pellet producer might use futures to hedge against price uncertainty.

Pellet Futures Short Hedge
A wood pellet producer has just entered into a contract to sell 50,000 tonnes of pellets, to be delivered in three months. The sale price will be based on the market price of pellets on the day of delivery. At the time of signing the agreement, the spot price for pellets is €135/tonne, and the price of pellet futures for delivery in three months €132/tonne.

To lock in the selling price at €132/tonne, the producer enters a short position in an appropriate number of pellet futures contracts. If each standard pellet futures contract is for 1,000 tonnes, the producer must short 50 futures contracts.

By entering the hedge, the producer will be able to sell the 50,000 tonnes of pellets at €132/tonne for a total amount of €6,600,000. Let’s see how this is achieved by looking at scenarios in which the price of pellets makes a significant move upwards or downwards by the delivery date.

Scenario #1
Pellet spot price falls by 10% to €118/tonne by the delivery date

As per the sales contract, the producer sells the pellets at €118/tonne, resulting in net sales proceeds of €5,900,000.

At the delivery date, the pellet futures price has converged with the pellet spot price and is now €118/tonne. The short futures position was entered into at €132/tonne, for a gain of €14/tonne (€132/tonne – €118/tonne). With 50 contracts covering 50,000 tonnes, the total gain from the short futures position is €700,000.

Together, the gain in the pellet futures market and the amount realised from the sales contract totals €6,600,000, equivalent to selling 50,000 tonnes of pellets at €132/tonne.

Scenario #2
Pellet spot price rises by 10% to €146/tonne by the delivery date

With the increase in pellet price to €146/tonne, the producer sells the 50,000 tonnes of pellets for net sales proceeds of €7,300,000.

However, as the short futures position was entered at €132/tonne, it has lost €14/tonne (€146/tonne – €132/tonne). With 50 contracts covering 50,000 tonnes, the total loss from the short futures position is €700,000.

In the end, the higher sales proceeds are offset by the loss in pellet futures, resulting in net proceeds of €6,600,000, equivalent to selling 50,000 tonnes of pellets at €132/tonne.

The short hedge protects the producer in a falling market, but restricts profits in a rising market. However, it allows the producer to reduce risk and make a modest profit, regardless of market fluctuations.

Pellet Exchange
The idea for APX-ENDEX’s pellet exchange arose three years ago. Veer says, “In 2008, we established a pricing panel and began publishing wood spot pellet prices to increase price transparency. Our pricing panel currently has 145 members consisting of utilities, pellet producers, and traders, who all report to us on a weekly basis. We track prices of future contracts on a three month, three quarter, and three year basis and publish the prices on our website.”

In 2010, APX-ENDEX and the Port of Rotterdam conducted a feasibility study that indicated a need for exchange-traded biomass products. They prepared a business plan, with some details to be worked out as of July 2011:

• Finalize standard pellet quality specifications, in consultation industry buyers and pellet producers;
• Define sustainability criteria;
• Adopt a standard contract;
• Choose a standard contract lot size (e.g., a standard coal futures contract on the New York Mercantile Exchange is 1,550 tons);
• Present trading rules to the regulator for approval; and
• Define exchange member accession procedures.

APX-ENDEX has decided upon a two-phase approach to launch the exchange. Initially, trading will occur in two five-hour sessions per week. Contract terms will be for three months, three quarters, or three years. After each session, trading parties will be made known to each other and trades will be settled between them. Once the concept has proven successful, APX-ENDEX will begin providing clearinghouse services and act as the counterparty to each futures contract.

A pellet exchange should provide an excellent opportunity for participants to reduce risk by hedging, to improve liquidity, and to increase confidence that transaction prices reflect real market values.

Gordon Murray is executive director of the Wood Pellet Association of Canada (www.pellet.org) and can be reached at 250-837-8821 or gord@pellet.org.