Introduction to Commodity Derivatives

What is a (i) deficit and (ii) a surplus market and how should commodity prices move in each market scenario?

(i) A deficit market is when there is insufficient supply of a commodity to satisfy demand.  This generally leads to increasing prices, particularly when there are insufficient stocks to meet the shortfall.

(ii) A surplus, or over-supplied, market is when supply exceeds demand.  This generally leads to falling prices and a build-up of stockpiles.

Why are commodity prices volatile?

The demand-side and the supply-side for a commodity often react differently in response to price signals.  Frequently the demand-side comprises of many parties each making relatively small decisions on the amount of commodity they will purchase at each price level.  By contrast, the supply side often comprises of few parties. When a supplier decides to increase or reduce production it is often in a larger amount relative to the overall market.  Thus, commodity price processes typically exhibit sharp movements over short time frames.

What is a commodity derivative?

A commodity derivative is a contract between two willing counterparties whose value is linked to the value of one or more commodities.