Czapp Explains Physical Differentials

Explainer Focus

  • Sugar and other commodity prices are often quoted as physical values.
  • This enables clearer price risk management.
  • In this explainer we demystify differentials.

 

Imagine you go into a shop to buy an apple and you see the following:

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You want one that’s sharp so that eliminates the Golden Delicious. But other than that you don’t care, so you end up buying a cox for $1. 

The next week you go into the shop and you see the following:

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You can’t really recall exactly how much you spent on your apple last week, perhaps around $1. But you remember it was a cox. But why did you buy the cox when the Braeburn was cheaper? Anyway, today you buy the Braeburn at $1. You barely noticed that the prices have all changed. After all, you bought an apple for $1. 

There is another way of looking at prices. Imagine you went into a shop and they displayed prices like this:

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The prices are exactly the same as your second visit, but expressed a slightly different way. This is how differential pricing works, and it applies to the sugar market. For example:

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If you are a buyer of raw sugar you can:
 

  • buy raw sugar futures to lock in the benchmark price and eliminate most of your price risk; 
  • buy physical raw sugar from a trade house to lock in the physical differential and the sugar’s origin/quality; 
  • fix both for complete price and supply certainty;  
  • do nothing.

Why is this helpful?

Shops generally sell spot: you go into the shop to buy food today with money presented today.  

However, in the futures market you can commit today to buy something in the future, and prices in the future can be different to prices today. Here’s how prices for Brazilian VHP look today for the future:

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This is helpful because buyers and sellers have needs stretching out far into the future. A mill has sugar to sell today, tomorrow and every day thereafter. A confectionary factory needs sugar 365 days a year to operate. The price at which they fix their sugar also isn’t necessarily derived on one day. A hedge can be made over a period of time….potentially an infinite period of time if they remain solvent and operational.  

Market participants can therefore use futures and physical markets to reduce supply and price risk now and in the future but as with everything in life, timing is everything. This is the essence of price risk management/hedging.