Like a currency or interest rate swap, a commodity swap is a contractual agreement to trade one cash flow for another.
Commodity swaps are facilitated by Swap Dealers (SDs) who pair up various companies, mostly in the oil industry, who are looking to trade a floating (market price) cash flow outlay for a fixed one, or vice-versa.
Swaps are over-the-counter instruments that are customizable for each situation. Commodity swaps are not unlike interest rate swaps in the Forex market, but instead of the floating rate being dependent on LIBOR or the Federal Funds Rate, it is dependent on the market price of a commodity.
A Swaps Dealer effectively pairs two companies who would like to trade a fixed price of goods in the future for a floating price (spot price) of the same kind of goods in the future. It is possible that this arrangement gives the recipient of the floating leg a discount from the actual spot price in the future.
Consider how the local power company might give a customer the option of paying a flat fee per month (based on previous usage perhaps) instead of paying as-you-go (which is analogous to spot pricing in this example).
The power company could then go take those two groups of cash flows to a swap dealer to see if there would be a hedge or advantage that they could pick up from swapping cash flows with another company in the industry.
Like an interest rate swap in the forex market, no principal amount is exchanged, only the cash flows based on a notional principal amount.
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