1
General Observations on the Physical Trading of Commodities

The physical trading of large commodities clearly differs from the trade of transformed products on several important points. Competition through prices plays a decisive role as these commodities are standardized and there cannot really be competition through differentiation in the product itself, only in the logistical services and financial conditions attached to the transaction. There may be large fluctuations in price, both in the short term as well as in the long term, which could be problematic for producers as well as intermediaries and transformers. Finally, given their strategic importance, states intervene in the trading of commodities either directly (as vendors, buyers or stockers) or indirectly through regulations that are put in place.

1.1. The standardization of commodities and commercial contracts

In the context of a commercial transaction related to transformed products, vendors and buyers negotiate both the technical characteristics and prices. In the case of commodities, the standardized physical characteristics are agreed upon by all operators and, thus, negotiations revolve chiefly around the prices. In practice, these negotiations are very brief: if, at a given point of time, a certain price is acceptable to both a buyer and a seller, an agreement is very quickly established between the two parties and the transaction is carried out. If the quality of the products delivered is better than standard quality, the vendor asks for a higher payment, if it is inferior to the standard quality, the buyer asks for a discount. Let us note that the conditions of physical delivery and the modes of the financial transaction may also be negotiated; nonetheless, the price remains the primary criterion.

For greater precision, the negotiation itself is standardized. This standardization is perfect when operators use an organized market (stock exchange) as the platform of negotiation. It is still of a high standard when the negotiation is carried out through direct telephonic contact between buyers and vendors. In this case, the language used by the negotiators is very highly codified and if an agreement is concluded, there are not many conditions (chiefly price, site and date of delivery, and the mode of payment). The various modalities of negotiations that we find either in organized markets or over-the-counter markets will be studied in greater detail in section 1.2. To illustrate the principle of the standardization of commodity trading, we use the case of the quality of milling wheat, traded on the futures market Euronext Paris1: "Wheat of good quality, conforming to a quality standard, and saleable, whose specifications are: specific weight 76 kg/hl, moisture content 15%, percentage of broken seeds at 4%, germ seeds 2%, and a maximum impurity content of 2%. The bonuses or deductions are applied as per Incograin formula no. 23 and technical addendum no. 2"2.

The standardization also relates to commercial contracts, for example:

"The Paris Syndicate [for Commerce and Seed Industries] establishes and diffuses the models for buying and selling contracts adapted to European commerce around primary agricultural products. These agreements are characterized by a balance between the interests of the buyer and those of the seller. These documents, known as the 'Incograin formulae' (for example: the Paris formulae) are periodically revised to take into account the evolution of commerce and uses, as well as of arbitrage decisions"3.

At the risk of oversimplification, we can thus consider that the price is the heart of the commercial negotiation on the physical markets for commodities. Further on we will examine, in detail, how prices are formed. This question is crucial to the study of the problem of price fluctuations, for which we use the term "volatility".

1.2. Price volatility of commodities

Most commodities see large fluctuations in price, as can be seen, for instance, in the World Bank price index for commodities.

Figure 1.1. Price index of commodities in agriculture, metal and fuels [WOR 17]. For a color version of this figure, see www.iste.co.uk/priolon/markets.zip

The concept of volatility encompasses two aspects:

• - the prices of commodities sometimes see large variations over the medium and long term, as can be observed from the graph shown in Figure 1.2, which represents changes in the price of corn between 2012 and 2017;
• - the prices of commodities also see multiple fluctuations in the short term, as can be seen in the evolution of the price of corn over 24 h, knowing that evolutions similar to those represented here are perfectly normal.

Figure 1.2. Corn prices in USD/BU: 2012-20174

Figure 1.3. Corn prices in USD/BU: December 20-21, 20175

In a general sense, the concept of volatility designates these fluctuations in price. In a narrower sense, volatility is a measure of these fluctuations. This measure almost exclusively takes the form of a variance, calculated either through the price itself, or the variations in price. We will point out right away that the formula for calculating volatility, as well as the parameters for this formula (periodicity of measurements, duration of observations, etc.) cannot be canonically defined. We will return to this point in Chapter 5. Knowing that volatility is often compared to an assessment of the risks taken by operators, we see that this lack of clarity on the optimal measurement results in problems in evaluating the risks operators take on the markets.

More importantly, perhaps, using variance is a questionable strategy. This is because this measure of distribution of a series "flattens out" extreme phenomena, which represent large risks. More generally, the Gaussian models, widely used in economics and financial mathematics, risk underestimating the magnitude of extreme phenomena. Among the many authors who support this idea is, notably, the mathematician Benot Mandelbrot [MAN 97], as well as his direct or indirect successors, sometimes grouped together under the term "econophysicists" [JOV 16].

Price volatility is a problem for the majority of actors operating on physical markets: producers, traders, stocking organizations and transformers. Finally, the consumers of those transformed products that incorporate the commodities whose prices are volatile are impacted by these fluctuations. In order to combat the problems brought in by price volatility, public authorities can schematically offer two strategies:

• - putting in place measures that aim to stabilize prices;
• - making available to operators the tools that are needed for private risk management as concerns prices.

We will review these public policies in detail in Chapter 8. We continue here with the study of causes for, and the consequences of, price volatility. The concept of "elasticity" is an essential prerequisite to understand this.

1.2.1. Elasticity

Generally speaking, elasticity is the ratio between two relative variations. If ?P/P designates a relative variation in price and ?Q/Q designates a relative variation in the quantities traded on a market, then the elasticity of price with respect to quantity is measured by the ratio . This dimensionless number measures the impact of a variation in quantity on the price. For example, if the quantity on offer increases, it usually translates into a decrease in prices. In this case, the price/quantity elasticity is negative. This is important information, but the absolute value of the elasticity is also key to understanding how a market functions. King's law illustrates this perfectly.

1.2.2. King's law

In the 17th Century, Gregory King, an English expert on the wheat market, made the following crucial observation: in a very general manner, when the quantities supplied (or demanded) vary by a certain percentage, the variations in price are more than proportionate. Today, we would say that, taking absolute values, the elasticity of prices with respect to quantities is greater than 1. This empirical observation reflects the fact that prices are very sensitive to quantities, which explains the high volatility of wheat prices. The variations in price tend to be more than proportionate with respect to variations in quantities. For example, a 5% increase in quantity produced could lead to a 10% decrease in price. The generalization of this observation to the majority of commodity markets is called King's law. It is important to note that the empirical observation may be associated with two different analyses depending on the chosen causal link:

• - if we study the impact of price on quantities, we can deduce that the demand and supply of commodities are not very sensitive to price variations, at least in the short term;
• - if we study the impact of quantities on prices, we can deduce that the variations in quantities induce more than proportionate variations in price.

Both readings are legitimate, are not necessarily contradictory, and are difficult to separate. If the objective is to stabilize prices, then...