Evolution of Market Structure

When customers need to source materials, and bulk suppliers need to sell their product, one of the first sales channels is through term contracting, particularly for newer and less developed markets. Often, both parties give up something for a guarantee in another part of their business. Particularly in early days with outside capital investments, raw material suppliers will accept a lower, stable price for continued flow to ensure investors that the firm has consistent revenue to pay back capital costs. Buyers will accept a higher price for an input into their supply chain to ensure smooth operational flow. Depending on the capital investments and specific market volatility, the terms of the contract vary but can be decades long. Contract negotiations and pricing rely on a large amount of industry knowledge, assessment of company and market factors, and often rely on outside guidance to properly assess a starting point.

A manufacturing plant might since a multi-year electricity supply deal with a local utility at a fixed price for a number of years, or a natural gas liquefaction plant will sign a 25 year deal with power company. But as markets develop, fixed price term contracts are not as attractive as long term price forecasts are not only difficult but almost always wrong. If the market swings significantly down, the buying party can purchase product on the open market for significantly cheaper than the fix priced term contract, and vice versa for the suppliers. This makes parties much less likely to adhere to term contracts. And as initial capital costs are paid back, firms are more willing to take on different, more dynamic marketing and procurement strategies more flexible in fluctuating markets.

From this point, a smaller percentage of sales are through term contracts, the terms are shorter, and the balance volume is traded on spot markets for more transparent price discovery. As spot market hubs become more standardized and liquid, new players and traders enter the market looking to take part in the risk. “Speculators” often get a bad rep, but for a successful physical market there needs to be traders in the middle. A liquid physical market will close the basis differentials and arbitrage opportunities, maximizing economics and narrowing the spread on spot market hubs.

Derivative products often arrive later in the commodity market evolution cycle, but can arise at any stage. Derivative products, including futures, options, and swap contracts, allow speculators to enter the market without the need to make or take delivery on the underlying physical commodity. These contracts must have some connections to the underlying markets, whether through a physical delivery option, cash settled to an index, or settled against another derivative settlement.

PanXchange Market Structure

The PanXchange system develops market on any stage of the market evolution timeline. Our system allows physical market players to reach the next step in the evolution cycle, to bring price discovery and transparency. We consult market stakeholders on how best to achieve effective, liquid derivative markets.