13. Commodity-Linked Financing
Teaching rewrite of how commodity production and trade are financed: secured lending documents, project finance and the DSCR, the asset conversion cycle, repos, tri-party margin financing, prepays, supply-and-offtake deals, lending risks, and loans with embedded commodity optionality. Original wording; worked numbers recomputed. Not investment or legal advice.
Introduction
Every stage of a commodity supply chain — mine, smelter, refinery, fabricator, ship, warehouse — ties up cash before it earns any. Structured commodity finance covers anything more than a plain unsecured loan: the lender takes security over the commodity, or the deal embeds derivatives to make repayment more certain or cheaper.
Lenders include commercial banks and, increasingly, trading houses (e.g. Glencore, Trafigura) that lend to suppliers and even governments — sometimes called shadow banking.
This lesson covers:
- Loan types and security documents: pledges, bills of lading, trust receipts, letters of credit, warehouse receipts
- Two borrowing-base case studies (coffee)
- Project finance and the debt service coverage ratio (DSCR)
- The asset conversion cycle, repos, tri-party margin financing, prepays, prepaid variable forwards
- Lending risks, the commodity carry trade, supply-and-offtake agreements
- Long-term debt with embedded optionality: option-subsidised loans, knock-in collars, digital and range-accrual swaps
13.1 Loans and security
Two loan shapes
| Revolving facility | Term loan | |
|---|---|---|
| Drawdown | Draw, repay, redraw up to a limit | Full amount up front |
| Balance | Fluctuates with need | Amortises to zero |
| Typical use | Working capital (inventory, receivables) | Projects, capex |
Ownership, possession, pledge
| Concept | Lender’s position |
|---|---|
| True sale (ownership) | Holds legal title — can sell or transfer the goods |
| Possession | Controls movement of the goods but has no title |
| Pledge | Borrower keeps title but gives the lender the right to sell on default, via documents of title or the goods themselves. Works only if the lender has real control |
Key documents
| Document | What it does |
|---|---|
| Bill of lading | For sea freight: (1) receipt for cargo, (2) contract of carriage, (3) document of title |
| Trust receipt (TR) | Lender releases pledged goods or documents so the borrower can sell; the borrower holds goods and sale proceeds in trust for the lender |
| Letter of credit (LC) | Buyer’s bank promises to pay the seller (beneficiary) up to a limit against documents that comply on their face — solves “I won’t pay before I see the goods” vs “I won’t ship before I’m paid” |
| Metal warrant | Exchange-warehouse title document (lesson 5) |
| Warehouse receipt | Issued by a warehouse: location, depositor, date, type/quantity/quality, and release instructions (to depositor, a named party, or on written instruction) |
Title can pass by endorsing a negotiable document — no goods move. But there is no global standard for warehouse receipts; never assume one is negotiable without specialist legal advice.
sequenceDiagram
participant B as Buyer
participant BB as Buyer's bank
participant S as Seller
participant SB as Seller's bank
B->>BB: Apply for LC
BB->>SB: Issue LC in seller's favour
SB->>S: Advise LC
S->>S: Ship goods, get bill of lading
S->>SB: Present documents
SB->>BB: Forward documents
BB->>SB: Pay (if documents comply)
BB->>B: Release documents → buyer collects goods
Case study 1: a borrowing base
A coffee trader gets a USD 10 million revolver secured on a pool of bills of lading, warehouse receipts (paper and electronic), trust receipts, and assigned receivables. The pool is marked to market daily off futures, adjusted for grade and location (basis). If it falls below a threshold, the trader repays part of the loan.
Case study 2: warehouse-to-buyer financing
A Latin American exporter stores beans in an agreed warehouse; the lender holds the warehouse receipt, and beans move only with its permission.
- Advance = 80% of FOB value off the front-month future. The 20% haircut covers: freight to the nearest delivery port (Miami, New Orleans, Houston), price falls, and fire-sale losses.
- Daily mark-to-market; if cover falls below 80%, the exporter tops up with cash.
- On shipment, the lender takes assignment of the sales contracts; lending is capped at the lower of sale value and futures value, and the buyer pays directly into the lender’s account.
Example: 1,000 t of coffee with an FOB value of USD 4,000/t → advance 0.80 × 4,000,000 = USD 3,200,000. If the value falls to USD 3,700/t, cover needed = 0.80 × 3,700,000 = 2,960,000 → the exporter repays USD 240,000.
Checkpoint 1: security
Checkpoint — section 13.1
1 / 5Which bill of lading function lets a bank take security over cargo at sea?
Pick an answer to see if you are right.
13.2 Project finance
Lenders care less about profit than about cash to repay principal and interest. Forward sales make that cash more certain.
Example: a nickel mine
Borrow USD 70 m + USD 30 m equity; build for 2 years, produce for 5. Sales at the LME cash price on delivery; 40% hedged with forwards (12,500 → 12,900 over years 1–5); planning price USD 12,000 for unhedged metal.
| USD m | Y1 | Y2 | Y3 | Y4 | Y5 |
|---|---|---|---|---|---|
| Output (t) | 5,000 | 10,000 | 10,000 | 10,000 | 10,000 |
| Unhedged revenue (60% × 12,000) | 36.0 | 72.0 | 72.0 | 72.0 | 72.0 |
| Hedged revenue (40% × forward) | 25.0 | 50.4 | 50.8 | 51.2 | 51.6 |
| Operating costs | (30.0) | (70.0) | (72.0) | (75.0) | (75.0) |
| Capex | (5.0) | (3.0) | (3.0) | (3.0) | (3.0) |
| Cash available for debt | 26.0 | 49.4 | 47.8 | 45.2 | 45.6 |
| Principal | — | (17.5) | (17.5) | (17.5) | (17.5) |
| Interest | (6.300) | (5.513) | (3.938) | (2.363) | (0.788) |
| Cash after debt service | 19.700 | 26.387 | 26.362 | 25.337 | 27.312 |
| DSCR | n/a | 2.15 | 2.23 | 2.28 | 2.49 |
DSCR = cash available for debt ÷ (principal + interest). Year 2: 49.4 ÷ (17.5 + 5.513) = 2.15. Higher is safer; lenders typically set a minimum covenant.
The source shows year-5 interest as a positive 788,000, giving cash after debt service of 28.888 m and a DSCR of 2.73. Interest is a payment: 45.6 − 17.5 − 0.788 = 27.312 m, and DSCR = 45.6 ÷ 18.288 = 2.49.
How much to hedge? If forwards (12,500–12,900) sit above the expected spot (12,000), or prices are expected to fall, hedging more makes sense. If both sides expect prices to beat the forwards, hedging gives that up. Options (lesson 5) are an alternative.
Interest is floating — e.g. SOFR + credit spread.
13.3 Working capital and the asset conversion cycle
Working capital = current assets − current liabilities, but the cycle tells the story better:
flowchart LR
A[1 · Buy raw materials<br/>→ payable] --> B[2 · Work in progress<br/>labour, energy]
B --> C[3 · Finished goods<br/>storage, transport]
C --> D[4 · Sell on credit<br/>→ receivable]
D --> E[5 · Cash received]
E --> A
Goods in transit that neither seller nor buyer wants to fund are “orphaned” — a bank can step in. Companies fail because they run out of cash, so gaps in the cycle must be financed.
Commodity repos (inventory monetisation)
The borrower sells inventory to the lender spot and buys it back forward — economically a secured loan, but the lender has full title (inventory must be segregated).
Terms: 3-year facility on 50,000 bbl of crude, reset every two weeks; rate = index 1.50% + margin 1.25% = 2.75%; prepayment (haircut) 10%; act/360.
| Step | Calculation | Result |
|---|---|---|
| 1. Spot value from the 2-week forward (USD 50.00) | 50 ÷ (1 + 0.0275 × 14/360) | 49.95 |
| 2a. Haircut, method 1 | 49.95 ÷ 1.10 | 45.41 |
| 2b. Haircut, method 2 | 49.95 × 0.90 | 44.96 |
| 3. Cash lent (method 1) | 50,000 × 45.41 | 2,270,500 |
| 4. Prepayment amount | 50,000 × (49.95 − 45.41) | 227,000 |
| 5. Repaid at reset | 50,000 × 50.00 − 227,000 | 2,273,000 |
The two haircut methods give different numbers — the contract must specify which (or state it in USD/bbl).
The source says the refinery pays 2.75%. Because the haircut is subtracted from both legs without accruing interest, the interest (2,500) is charged on the full collateral value but the cash received is smaller: 2,500 ÷ 2,270,500 × 360/14 ≈ 2.83% on the cash actually borrowed.
Haircut drivers: volatility, liquidity, quality (LME vs non-LME metal), transfer method (warrant, receipt, bill of lading), term, currency mismatch (EUR loan vs USD oil), credit quality.
Default: the second leg simply doesn’t happen — each side keeps what it holds. Hence short resets and remargining if prices move. The lender may return equivalent (not identical) barrels. The borrower pays storage, insurance, duties.
Structured repos embed optionality to cut the cost:
- Sold deep-OTM call: the refinery pays out if prices soar — but then its returned inventory is worth more. The premium reduces the repurchase price.
- Extendible: the lender can extend the repo — exercised if rates fall, locking in an above-market rate.
Tri-party agreements (margin financing)
flowchart LR
C[Customer] -- lending facility --> L[Lending bank]
C -- futures hedging account --> F[Futures broker / FCM]
L -- margin payments --> F
A lender requires the borrower to hedge; the TPA lets the bank fund margin calls at the broker. It must settle: security, who pays margin (bank directly or via the customer, perhaps backed by a standby LC), segregated accounts, who sets the hedge strategy (contracts, maturities, hedge ratio, proxies, pre-approval), withdrawal controls (hedge gains are often the lender’s security), and what happens if the broker or bank fails.
Prepays
The buyer pays the present value of future deliveries up front; the producer then delivers. Useful for producers who can’t borrow easily.
Example: 1 t of copper a year for 3 years at forwards 6,000 / 6,100 / 6,200, zero rates 1% / 1.5% / 2%:
| Year | PV |
|---|---|
| 1 | 6,000 ÷ 1.01 = 5,941 |
| 2 | 6,100 ÷ 1.015² = 5,921 |
| 3 | 6,200 ÷ 1.02³ = 5,842 |
| Total prepaid | USD 17,704 |
A credit margin would lower the prepayment. Variants: partial prepayment then “cash for commodity” exchanges.
Prepaid variable forward
A prepay plus a zero-cost collar, giving the producer a floor and some upside.
| Term | Value |
|---|---|
| Producer sells to bank | 10,000 t thermal coal, 1 year (forward 60) |
| Floor (bought put) | 55 |
| Ceiling (sold call) | 67 |
| Advance | PV of floor: 55 ÷ 1.03 × 10,000 = USD 533,981 (FV 550,000) |
Settlement ratio (fraction of the 10,000 t delivered, or its cash equivalent):
- P ≤ 55 → 1
- 55 < P < 67 → 55 ÷ P (delivers exactly USD 550,000 worth)
- P ≥ 67 → 1 − 12 ÷ P (keeps 12 × 10,000 = USD 120,000 of value)
| Price at maturity | Ratio | Coal delivered (t) | Value delivered | Coal kept, value | Total to producer (FV) |
|---|---|---|---|---|---|
| 40 | 1 | 10,000 | 400,000 | 0 | 550,000 |
| 55 | 1 | 10,000 | 550,000 | 0 | 550,000 |
| 60 | 0.91667 | 9,167 | 550,000 | 50,000 | 600,000 |
| 65 | 0.84615 | 8,462 | 550,000 | 100,000 | 650,000 |
| 70 | 0.82857 | 8,286 | 580,000 | 120,000 | 670,000 |
| 80 | 0.85 | 8,500 | 680,000 | 120,000 | 670,000 |
Total = advance (550,000 FV) + value kept → floor 550,000, cap 670,000, and market value in between. Below 55 the bank loses (it sold the put).
The source’s table shows ratios of 60/P for prices of 60–70 and totals of 550,000 / 600,000 / 650,000 at 60 / 65 / 70 — inconsistent with its own floor of 55 and with its statement that the producer earns market value between the strikes. Using the term sheet’s formula, the totals are 600,000 / 650,000 / 670,000.
Checkpoint 2: project and working capital finance
Checkpoint — sections 13.2 and 13.3
1 / 6Cash available 30 m; principal 15 m; interest 5 m. DSCR?
Pick an answer to see if you are right.
13.4 Lending risks
| Risk | Example |
|---|---|
| Fraud | Goods don’t exist, or are pledged twice. Qingdao (2014) and Hin Leong (2020) involved collateral pledged to multiple banks; Trafigura (2023) found “nickel” cargoes that were largely worthless metal |
| Counterparty credit | A buyer walks away from a fixed-price purchase after prices fall — market risk turns into credit risk |
| Wrong-way risk | Exposure rises as the borrower weakens — e.g. a metal producer’s loan secured on its own output: lower prices hit both the collateral and the ability to repay |
| Force majeure | Events beyond control excuse performance — invoked by some LNG and copper buyers in early 2020 (COVID) |
| Position risk | A borrower allowed to speculate can lose heavily |
| Quality | Spoilage (ags), off-spec products (energy) — control storage, testing, inspection |
The commodity carry trade (China)
Borrow cheap USD against copper, convert to CNY, invest at higher local rates.
| Step | Value |
|---|---|
| Collateral: 1,000 t × USD 6,000 | 6,000,000 |
| Loan after USD 1 m haircut, 1% for 1 year | 5,000,000 → repay 5,050,000 |
| Convert at 7.00 | CNY 35,000,000 |
| Invest at 5% | CNY 36,750,000 |
| Convert back at 7.00 | USD 5,250,000 → profit USD 200,000 |
| …at 6.00 (CNY stronger) | USD 6,125,000 → profit 1,075,000 |
| …at 7.50 (CNY weaker) | USD 4,900,000 → loss 150,000 |
It worked while CNY rates were high and the managed currency was stable. It collapsed amid fraud — the same metal (even photocopied warrants) pledged to several lenders.
Supply-and-offtake agreements
An intermediary (bank or trader) takes over a refinery’s working capital: it buys existing crude and product inventory, buys all new crude, stores it on site, owns and sells the products, and pays the refinery the crack spread (plus location premium) less a per-barrel fee.
Refinery: 50,000 bbl/day, crude USD 50.
| Financing piece | Refinery alone (10% WACC) | Intermediary (2% funding) |
|---|---|---|
| Crude purchase terms | Prepays 14 days early: 50 × 10% × 14/360 ≈ 0.19/bbl → 1.5 m bbl/month × 0.19 = USD 285,000/month cost | Pays 30 days after delivery: 50 × 2% × 30/360 ≈ 0.08/bbl → USD 120,000/month benefit |
| Inventory: 750,000 bbl crude × 50 + 500,000 bbl gasoline × 60 = USD 67.5 m | × 10% = USD 6.75 m/year | × 2% = USD 1.35 m/year |
Saving on inventory = USD 5.4 m a year — both sides win if the intermediary’s fee and margin are below that. (Per-barrel figures are rounded to cents, as in the source; unrounded, the monthly amounts are 291,667 and 125,000.)
At maturity the refinery must buy back the inventory, so it has price risk: hedge with futures/forwards (watch basis) or a zero-cost collar (lesson 5).
13.5 Long-term debt with embedded commodity optionality
The idea: sell optionality that pays out when the borrower can best afford it, and use the premium to cut interest costs.
Option-subsidised airline loan
A 3-year SOFR loan, quarterly. Each quarter the airline sells a USD 20 put and buys a USD 16 put on 40,000 bbl (a bull put spread — it collects a net premium).
| Quarter-average crude | Airline’s payment on the spread | Fuel bill | Net effect |
|---|---|---|---|
| 25 | 0 — keeps premium | High | Cheaper loan |
| 18 | (20 − 18) × 40,000 = 80,000 | Lower | Premium − 80,000 |
| 12 | Capped at (20 − 16) × 40,000 = 160,000 | Much lower | Premium − 160,000 |
The loss arrives exactly when jet fuel is cheap — a natural offset.
Pricing with a backwardated curve (spot 25, 3-year 20): early quarters are far OTM (cheap); late quarters are near the money (dearer). Downward-sloping vol term structure and skew also matter. (A bull spread with calls costs premium but has a better risk/reward than the cash-generating put version.)
Interest-rate building blocks
Swap: fixed vs floating on a notional. LIBOR has been replaced by risk-free rates — SOFR (USD), SONIA (GBP), €STR (EUR) — which are overnight rates compounded in arrears over each period.
Example: GBP 10 m, 182 days, fixed 2.5% vs floating 2.0% (act/365):
- Fixed: 10,000,000 × 2.5% × 182/365 = 124,657.53
- Floating: 10,000,000 × 2.0% × 182/365 = 99,726.03
- Net 24,931.50 to the fixed receiver
(The source’s floating line repeats 2.5% in the formula; the result shown uses 2.0%.)
Caps and floors: strips of caplets/floorlets.
- Caplet = max(rate − strike, 0) × notional × days/basis
- Floorlet = max(strike − rate, 0) × notional × days/basis
- With term rates like LIBOR, the first period is already fixed, so a 3-year semi-annual cap has 5 caplets
- Cap–floor parity: long cap + short floor at the same strike = pay fixed on a (forward-starting) swap
USD LIBOR ceased in June 2023. New loans and swaps reference SOFR (or term SOFR), and caps on compounded RFRs usually cover every period, including the first.
Zero-cost collar with a copper knock-in
A copper producer with 3-year floating debt (swap rate 2.62%) is offered zero-cost collars:
| Buy cap | Sell floor |
|---|---|
| 4.00% | 2.00% |
| 3.50% | 2.21% |
| 3.00% | 2.46% |
| 2.66% | 2.66% (= forward-starting swap rate) |
Enhancement: make the 3.50% cap knock in only if LME cash copper < USD 5,000 on each reset date. The cap is cheaper, so the floor improves from 2.21% to 1.90%.
- Copper high → no rate protection, but strong revenue
- Copper low → rates capped at 3.50% just when cash is tight
Caveat: high rates usually come with strong economies and high copper, so the protection may rarely activate. A backwardated copper curve (forwards below 5,000) makes knock-in likelier and the cap dearer; contango makes it cheaper.
Example caplet: SOFR 4.20%, cap 3.50%, USD 10 m, 91 days (act/360), copper at 4,800 → payout 0.70% × 10 m × 91/360 = USD 17,694. With copper at 5,500, the caplet isn’t knocked in → 0.
Swap with a commodity-linked digital
Copper producer, USD 10 m, 3 years: receives 3-month floating; pays floating − 1.25% if copper < USD 6,000 on the payment date, else floating + 1.50%. That is a strip of sold quarterly digital calls on copper: cheap debt when copper is low, dearer when copper is high.
Per quarter (¼ year): copper low → saves 1.25% × 10 m × 0.25 = USD 31,250; copper high → costs 1.50% × 10 m × 0.25 = USD 37,500.
Range accrual on sugar
A sugar producer, USD 5 m, 3 years, quarterly: pays 1.5% + 5% × N/D (N = days sugar settles above USD 0.10/lb, D = days in the quarter) vs a vanilla fixed rate of 3%. Sugar is at 0.12, so the daily digitals start in the money.
- Sugar above 0.10 every day → 6.5%; never → 1.5%
- Break-even vs 3%: N/D = (3 − 1.5) ÷ 5 = 30% of days
- Example: 60 of 91 days above → 1.5 + 5 × 60/91 = 4.80%
The producer has sold a strip of one-day digital calls; it does well while sugar stays low.
Checkpoint 3: risks and embedded optionality
Checkpoint — sections 13.4 and 13.5
1 / 6A loan to a gold miner secured on its own gold output is an example of…
Pick an answer to see if you are right.
Rank: financing practice
Financing practice
1 / 2Rank the commodity repo steps.
OrderDrag the handle to rearrange — top should be first.
- 1Remargin or reset every two weeks
- 2Borrower repurchases at forward less prepayment
- 3Lender pays cash and takes title
- 4Discount the forward to a spot value
- 5Apply the haircut
Drag items into the correct order (or use ↑↓), then check.
Check: commodity-linked financing
Commodity-linked financing
1 / 6What makes a deal “structured” commodity finance?
Pick an answer to see if you are right.
Calculate: numeric practice
Type the number (no units; minus sign for payments).
Formula sheet
| Item | Formula |
|---|---|
| Advance | collateral value × advance rate |
| Top-up | loan − advance rate × new value |
| DSCR | cash available ÷ (principal + interest) |
| Repo spot value | forward ÷ (1 + r × days/360) |
| Haircut (method 1 / 2) | spot ÷ (1 + h) / spot × (1 − h) |
| Prepay | Σ forward_t ÷ (1 + z_t)^t |
| PVF settlement ratio | 1; floor ÷ P; 1 − (cap − floor) ÷ P |
| Carry trade | (USD × FX₀ × (1 + r_local)) ÷ FX₁ − USD × (1 + r_usd) |
| Financing cost | value × rate × days/360 |
| Put spread payout | min(max(K_high − S, 0), K_high − K_low) × volume |
| Swap leg | notional × rate × days/basis |
| Caplet | max(rate − strike, 0) × notional × days/360 |
| Range accrual rate | base + digital × N/D |
Calculate: commodity-linked financing
1 / 17Coffee: 1,000 t at FOB USD 4,000/t; 80% advance. Loan amount?
Enter a number (at most 0 decimal places).
Randomized practice
Practice: financing drills
1 / 6Supply-and-offtake: inventory USD 20 m. Refinery funds at 12%, intermediary at 3%. Annual saving in USD m? Round to 2 decimals.
Enter a number (at most 2 decimal places).
Takeaways
- Structured commodity finance = lending with commodity security and/or embedded derivatives
- Know the documents: bill of lading (title), trust receipt, LC (pays against documents), warehouse receipt (check negotiability)
- Borrowing bases advance a haircut share of marked-to-market collateral; shortfalls are topped up
- Project lenders watch the DSCR; hedging output stabilises it
- Repos = spot sale + forward repurchase with a haircut; short resets limit exposure
- Prepays pay PV up front; prepaid variable forwards add a floor and a cap
- Risks: fraud (double pledging), wrong-way, force majeure, credit, quality, position
- Supply-and-offtake shifts inventory funding to a cheaper balance sheet
- Embedded optionality cuts borrowing costs by selling payouts that hit when the borrower can afford them
Further Reading
- Next: 14. Commodity investing
- 12. Agriculture
- 5. Base metals — warrants, collars, min-max structures
- 6. Crude oil — crack spreads, refinery hedging
- 2. Derivative valuation — discounting, put-call parity
- R. Jones, Commodity Trade Finance (2018); J. Gregory on counterparty risk and wrong-way risk
- Background: N. Schofield, Commodity Derivatives: Markets and Applications (Wiley) — used as a study outline