What exactly is a commodity index anyways?
A commodity index represents a basket of commodities, or measure of a single commodity, that can be designed to provide its users with a broad-based view of the global economy, a more narrow view of a specific sector (i.e. agriculture or energy), or designed to deliver a fair market value for a specific commodity like corn.
Note that the level of granularity that an index represents can vary dramatically, and even a commodity-specific index can be designed to deliver price transparency at lower levels of specificity. For example, a commodity index could focus on deliveries into a particular port, a particular delivery window, or even a unique variety / quality of the commodity. The sky's the limit, and the efficacy of any index really depends on what a user is looking to get out of it.
How are commodity indexes weighted?
Weighting for an index can be accomplished in many different ways depending on who structures the product, the desired methodology, and the commercial use-case of the index. Since commodities don’t have market capitalizations like equities, creating the equivalent of the S&P 500 index isn’t really possible. This means that, for a broad-based index, certain constraints need to be implemented in order to ensure that short or long-term dislocations in nominal price performance across constituent commodities don’t result in disproportionate weightings - such that the index product’s price doesn’t align with the goal of the index.
There are a number of different methodologies available (Bloomberg or the S&P GSCI indexes for example) to prevent goal drift, and some draw on information produced either by the underlying constituent markets, or commodity fundamental data such as the value of production for the commodity itself. In this example an index creator seeking to design an agricultural index might consider the production of corn, and soybean production among other factors to determine the relative weight among index constituents.
Tell me more about broad-based indexes
As mentioned previously, broad indexes are typically used as a barometer of the general economy. When commodity prices are high, this generally indicates that there is strong demand for raw materials, which would suggest that the underlying market or economy is doing well. Intuitively you could also consider the scenario where persistently high commodity prices actually have an adverse effect on the economy, as they indeed are a component in the basket of inflation measures such as CPI. Either way, commodity prices are very important considerations in the global economy and the commodity trading ecosystem.
Popular broad commodity indexes include the S&P GSCI, Bloomberg Commodity Indexes, and the cmdty BLS Indexes. As we’ll discuss, these products, and other broad-based index products are typically used to achieve exposure to the commodity asset class or to specific sub-asset classes within commodities - such as energy. Exposure to these indexes is typically expressed themselves through listed derivatives both in futures and exchange traded products such as ETPs or ETFs. A list of commodity related ETFs can be found here. Swaps and other OTC products are common and can be cleared or uncleared.
Note that commercial participants, such as grain trading companies or oil exploration and production firms are less likely to make use of broad-based indexes, as they generally are seeking to manage specific risks arising from their business operations. Users of broad-based indexes are more likely to be speculators, financially oriented asset allocators, or individuals investing in ETFs.
What about narrow indexes? What are those for?
Narrowly focused commodity indexes have a much more specific remit. These indexes are not only relatively more narrow in the number of commodities that are included as constituents, but also have more tailored use cases. While a broad-based index will support a financial transaction by determining the settlement of a future or the redemption value of an ETF, a narrow index or fair value price assessment will support a physical transaction or contracted delivery between two commercial participants.
In commodity markets, the creation of these fair value assessments are typically produced by firms known as price assessment agencies. Firms like this, which include S&P Global’s Platts, Argus Media, and cmdty by Barchart, track physical market transactions and create fair values for commodities that can be used by market participants to settle contracts in their short-term or long-term commodity trading contracts.
Increasingly, as commercial market participants reduce the size of their speculative books, and look to proactively clear over-the-counter transactions to free up additional capital, price assessments are becoming more consistently used in the settlement of exchange traded derivatives such as futures. This trend is likely to continue as the relationship between price assessing firms and futures exchanges are mutually beneficial in driving scale to marketing efforts and integrating their respective offerings into the workflows of their customer bases. Once an assessment achieves “benchmark” status, it is difficult to displace and the maturity of a related futures market will only serve to entrench the price further.
The creation, marketing, and benchmarking of forward curves is also a critical component of narrow commodity indexes. Commercial participants not only have to consider front-month or spot fair values in their contracting, but also must account for longer-term contracts that go months or even years. Establishing the contract tenor and the settlement to be used at delivery is critical in these negotiations, and forward curves (with each delivery tenor representing an index), help facilitate this market.
So what financial instruments are used to transact commodity indexes?
This was largely covered in the preceding sections, but to recap, we provide an overview of each instrument type and how they are typically used as it relates to commodity indexes.
Where can I learn more?
Please contact us at email@example.com to learn more about commodity indexes or anything related to data and solutions for commodity markets.