Driving Discussions: Hedging opportunities in European waste biofuels

Author Argus

This episode looks at the developments in UCOME biodiesel with Paul Wightman at CME Group covering the introduction of new price risk management products for this growing market.

Listen in as Josefine Ahlström, VP - Business Development for Europe discusses UCOME risk management with Paul Wightman, Director for Research and Product Development for the CME Group.


Josefine: Hi, and welcome to another episode in the Argus series, "Driving Discussions" podcast where we look at market development in the transport fuel markets. My name is Josefine Ahlström, VP Business Development Europe, and in this episode today we are looking at how to manage risk for UCOME, in other words, biodiesel based on used cooking oil.

As you may be aware, in previous episode we have discussed the importance of used cooking oil, which is the feeder stock used to produce UCOME and the role it plays here in Europe on the journey to decarbonize the transport fuel markets. So, today we are discussing the finished biodiesel, the UCOME itself. Biofuel that we have seen gaining popularity a lot here in Europe thanks to its high greenhouse gas savings credentials, and as well as being double counting a number of countries across Europe.

So, as the waste-based market now develops, the demand for tools to manage the financial exposure is naturally also increasing. And to help me explore this topic in more detail, I have with me today the honor of an external guest, Paul Wightman, Director for Research and Product Development at the Chicago Mercantile Exchange, better known as CME Group. Great to have you here, Paul. Very welcome.

Paul: It's great to be here.

Josefine: And, Paul, let's dive into this straight away. So, let's start talking about, why do CME think it is an important market to support in all fairness? I mean, UCOME is a small market here in Europe compared to the main big transport fuels like diesel and gasoline. So, why is it so important to develop a risk product for a niche market? Do you believe the market is ready for this?

Paul: Thanks very much. So, I think it's fair to say that the landscape for European energy markets is changing significantly, mainly thanks to the Renewable Energy Directives I and II. These directives are gonna see a higher usage of second-generation or advanced biofuels coming into the market. We fully expect waste oils, are expected to play a bigger role in this development, and therefore demand is expected to rise. I think it's fair to say that when you look at UCOME and UCO, both products have a promising future as the transportation sector continues to decarbonize.

The biofuels markets will transition from crop-based and animal-fat-based products to waste in greater numbers, which we believe will really support the UCOME futures markets. We also believe that by launching the futures at an early stage of its development, the financial tools will enable markets to transition to the futures markets using these lower carbon waste-based feedstocks, and also help manage the increasing volatility that is expected in these markets as they continue to evolve.

Josefine: Thanks, Paul. That's really interesting. So, CME, you launched recently a futures contract specifically tailored for this UCOME market. So tell us, what exactly is it? What are the details we should know about this contract, basically?

Paul: That's a good question. So, essentially about 12 months ago or so, we got approached to begin looking at the development of a futures market for green fuels. I think it's fair to say that we have lots of different conversations all the time with a number of different players in some of these markets. However, the resounding feedback that we received from the market was that waste-based feedstocks were going to be an area of strong growth for this market.

And given the changes which I referred to earlier for the Renewable Energy Directive across Europe, the landscape looks like it's set for significant change. There's gonna be changes to the regulations as we've discussed, especially around greenhouse gas emissions, and these bode well for enabling people to take price risk by the futures markets into some of these products.

Some initial client engagements were undertaken, and we worked very closely on the development of these products with the OTC brokers and yourselves at Argus Media to construct a contract spec for the futures that would work. The two products that we came up with were one based on an outright UCOME assessment provided by Argus media.

The second one was a spread contract to low sulfur gasoil, mirroring the way that some of the existing biofuel products are traded. The futures in both cases are cash-settled against the average UCOME prices over the calendar month. They're listed for 18 months forward with each contract month settling against the average of the UCOME Argus assessments over the month. They are very standard vanilla products, and we believe that these products will be of great use to the market as the sector continues to evolve.

Josefine: You mentioned the brokers here. So, what role do they play in developing this market here?

Paul: So, I think it's fair to say that the brokers are quite a critical element of the futures markets. The brokers essentially are working with their clients to solicit bids and offers and match the requirements in the former trades. These trades are submitted into CME Group for clearing via a mechanism called a block trade. This is essentially a hybrid model between a screen-traded futures contract and an OTC-cleared contract. This means that there's a minimum volume requirement attached to the trade. In the case of UCOME, it's 5 lots or 500 metric tons.

Once registered, the brokers are connected to the exchange, and it's up to the clearing members of each client's permissioned brokers to act on behalf of their clients. This enables us at CME Group to take in those trades by the brokers as and when they're done, knowing that they've been allowed to do so by their clients that they're working with. CME Group and the brokers will work together to identify new possible trading counterparties so that they can be registered for trading on the exchange if they are not set up already.

The brokers also provide a valuable service for our end-of-day settlement process. They essentially are working with the market to provide values for where they see the forward curve. Where there's open interest on a daily basis, CME Group will use these numbers in combination with other brokers and other data sources to come up with an end-of-day valuation or a mark-to-market service for the futures. These prices are produced and given to our clients via our website, and they are openly available for everybody to see.

The broker prices are used to settle all of the deferred contract months where there is open interest. However, one of the things to bear in mind is when you arrive into the spot month where the physical is being priced, it comes down to what the Argus UCOME assessments are during that contract month, and that's really the role that the brokers play. So it's quite an important role when it comes to the development of the futures markets.

Josefine: So, Paul, I think you actually almost answered my next question which was, so what is the role of Argus in the CME world? So it's about then providing the underlying value for settling those futures contract? Or, I mean, maybe you can explain how the prompt and the futures market there, sort of, work together to make it function.

Paul: Yeah. Absolutely. So, CME Group has always had a very good working relationship with Argus. We've listed many of the contracts that you guys assess. In the case of UCOME specifically, you guys are the underlying physical assessment, or the link to the physical market which underpins the futures contracts. So, what do I mean by this?

Well, essentially what I'm saying is, when the spot, or the forward, or the front-month contract begins to settle, or in our language, begins to price, basically what we take in is the average of your...or we take in your daily prices for UCOME, and we will essentially create what we call a floating price average, so you do a fixed-for-floating. So, during the contract month, we will take in your daily prices and we will essentially average those at the end of the month, and that price is used to settle the futures contract that you have traded.

So, for example, if you trade a December 2020 contract, in simple terms, we will use your prices when we get into December, to settle the value of the contract. And at the end of December, when the contract expires, we will then issue the average price of your assessments during the month to the marketplace, so they can work out whether they are effectively in the money or out of the money when it comes to calculation of the final settlement price for the futures.

Josefine: Okay. No. I think that makes sense, and I now understand just listening to what you were saying, but then if there are those market participants that are not experiencing hedging, I mean, what is the benefits of hedging, and how would that actually help them better run their business then?

Paul: So, I think it's fair to say that we come up against this question an awful lot. And what I would say to clients that are looking at getting involved, they may be not certain what they're actually getting involved with, I think the primary thing to bear in mind with UCOME futures, or any other futures contracts for that matter, they are essentially a price risk management tool. Essentially all you're doing is you are effectively locking in a price for a forward delivery of a commodity.

That is essentially what you're doing. So you are essentially trading a common future or futures like this, which is a fixed-for-floating basis. So you trade fixed price, and your settlement is the average of the underlying Argus assessment. And, therefore, they work out, if you traded that fixed price of, let's say, a certain level, and the average comes in above or below that price, if you bought the contract at a certain level and it comes in at a higher price, it'll be for the other side to settle you and pay the difference.

So, for example, if you wish to lock in a December 2021 contract, as an example, you would pay fixed price now for December, and you would receive the average Argus assessment for UCOME over the month to close out your position. If the average of the month is higher than the fixed price you've paid, you will receive the difference from the seller of the futures contract. Conversely, if the price is below the fixed price that you paid, i.e. the average comes in at below, you would end up paying the seller for the futures contract the difference between the two prices.

Now, if that were to occur, all that means is when you enter your trade physically, you would end up buying your UCOME at the lower price, knowing that you had hedged at the price level you did in the futures market. So, the way to look at it is there are two elements to the contract. One is your physical trading that you're doing today that is continuing separately to what you're doing in the futures markets.

The futures markets are purely a way to manage price risk against your physical trading book. But your trading counterparties that you trade with in the physical market, that is to be considered a separate transaction to what you're trading in the futures. It's purely a financial tool to manage your physical trading exposure.

Josefine: So, to simplify it, in other words, it means that I can sleep well at night because I know what is the price I will have in the future in a way? Is that what you're saying? Yeah.

Paul: That's exactly right.

Josefine: So, who then in the market do you see would benefit from trading this contract?

Paul: Well, I think, with a lot of contracts like this, and we would consider these products more niche, you know, they appeal to a certain sector of the market. I think anybody with physical supply interests in UCOME would be interested in these contracts. We note that in the physical market, there are lots of index-linked deals against the Argus UCOME assessments being concluded. So, therefore, this tells us that people have an automatic price risk exposure against the Argus price.

And that's why we chose Argus for the assessment basis for the UCOME assessments. This has become a very standard practice across the large number of energy-based contracts like this. So I think, typically, what we would then expect is, as and when liquidity starts to build, and we see more participants coming into the marketplace, it is possible for some contracts that you may see financial-based participants entering into that market. I think, typically they tend to avoid these markets at the beginning, mainly because of liquidity and they want to be able to get in and out quickly.

And, also, in some cases, they're not that interested in more niche products. They tend to go for the larger mainstream products. So I think, you know, we would say, in these products, the first interest group which would be trading these products would be our commercial clients, and that's where the immediate hedging requirement lies, and hence we believe that they would be the most likely candidates to trade our futures products.

Josefine: So, anyone who's not already well-versed in trading or doing the hedging, I mean, they should basically go to the brokers then to help out and get them started on it?

Paul: Yeah. So, what we would say is, if you are interested in trading the contracts, then we would suggest that you speak to your OTC brokers, many of which you're working with already for trading, either physically or trading in the paper markets, OTC. So, we would say that the best thing you would be able to do is to speak to your brokers to get involved.

Now, on these products specifically, the good news is that they have traded already. We've had a couple of trades come in on these products. The open interest, which we believe is a good measure on the success of the contract, is currently standing at 65 lots for the UCOME trades that were done. The UCOME trades were the differentials versus gasoil, so this equates to 6,500 metric tons in physical volume, because 1 lot is 100 metric tons.

Clients who want to get involved in UCOME trading, the first thing they need to do is to set up a futures account with a clearing bank. This may often be somebody that you're working with on financing, so they may be financing your physical trading operations, or you may have a futures account already because you clear other products.

Each client needs to be registered at CME Group. There's a simple registration to fill in to do this. You should signal your intention to trade to your brokers, as I said earlier. They will have the trades registered via a block trade mechanism on your behalf. They can work with other counterparties in the marketplace to generate more bids, offers, and possible trades.

If you'd like to get involved in UCOME, or other products, I would suggest that you get in touch with us directly at CME Group, and we can certainly help you walk through the finer elements of the setup process.

Josefine: Thanks, Paul. I think we all got it. That's great to hear, and it's also a pleasure to hear that it's already open interest in there, and, of course, we look forward to see how that will further develop. So, thanks again, Paul, for helping us on...

Paul: You're very welcome.

Josefine: Yeah, great. And, finally, I would also like to add that, I mean, anyone who wants to follow the actual prompt physical pricing on UCOME, so we publish it daily in our biofuels report, where we also cover feedstock such as used cooking oil, and we have extensive coverage on this market on the European side, but also on the Asian side. And we even have UCOME itself on our price discovery platform, Argus Open Markets, which means that you can follow how the market develops in real-time, where there are physical bids, offers, and trades initiated on this platform.

And, of course, finally, if you do want to listen to other podcasts in our "Driving Discussions" series, and stay updated on future episodes from Europe, as well as podcasts from Argus colleagues across the globe, please visit our website, so www.argusmedia.com/drivingdiscussions. Thank you very much for listening. Great to have you here, Paul, and have a good day today.

Paul: Thank you.

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