What are the consequences of commodities price slump?

Producers will cut costs, while the corporate sector may consolidate

When prices of commodity rise they transfer riches from consumers to producers but when they fall consumers benefit. With so much at stake, the turning points are important. Currently we are standing at the cusp of such a turning point.

Commodity prices have fallen nearly 15 per cent since June-end, according to Bloomberg index. The Economist price index for Commodities has fallen by 16.5 per cent in terms of the dollar. Last week, the price of crude oil on NYMEX dropped to a four-year low of $74 a barrel from some $107 in June.

Prices of metals such as copper, platinum, silver and gold have also fallen sharply. Sustained low commodity prices are expected to help India in a big way, considering that it imported $178 billion worth of commodities in the last financial year. This amounts to 9.5 per cent of GDP.

Crude oil made up the largest part of imports. India will also benefit from lower prices for industrial commodities such as coal, metals, etc.

During the last quarter (June-September), the raw material cost, as a percentage of sales in corporate India, has come down, which is likely to drop further in the current quarter.

However, questions of end-users’ demand remains uncertain.

For agricultural commodities in the country, market yard prices will only start showing real downtrend when retail energy prices drop at the same pace.

The decline in the price of non-agricultural commodities can partly be explained by economic changes taking place in China. In the last two decades, China had been consuming coal, iron ore, copper, oil and other commodities with insatiable appetite.

While China’s economic transition was expected, stagnation in Japan and conditions pointing towards impending European deflation were unanticipated.

The big losers in all these are nations that depend on commodity exports such as Russia, Brazil and Iran. Russia and Iran have substantial economic problems because of Western sanctions and government mismanagement.

Brazil’s economy was slowing before the decline in commodity prices. Russia and Brazil are standing at the brink of their sovereign rating being relegated to a junk grade.

Demand in the days to come remains a primary concern. Since marginal cost of large producers are comparatively much less than the small producers in some sectors (iron ore, copper and coal), they continue to produce even after admitting to a global downturn.

Consumption has failed to keep pace with the rush by investors and producers to boost output across the entire commodity and resources spectrum over the last few years, creating a dangerous situation for markets where large stockpiles begin to build.

In the past, tough times have helped commodity producers become lean and mean through consolidation, mergers and cost-cutting. It is unlikely to be different this time too.

Published in The Business Line on 20 November, 2014

Is investing in gold a smart move?

The precious metal has not kept up with inflation since its great rise in 1980.

Except for the ritual purchase of gold during Diwali, retail purchase of gold coins in India originates from a fear “in case all hell breaks loose”. In times of prosperity, it also gives a sense of pride to the owner.

Gold, in recent times, has been hawked more like as an asset class for investment. If statistics are to be believed 90 per cent of retail traders actually lose money as they lose clarity on the purpose of investment over time – speculation, investment or security.

Powerful benchmark

However, on a macro scale, gold is a powerful competitive international benchmark and that, if allowed to function in a free market, will determine the value of other currencies, the level of interest rates and the value of government bonds. Gold's performance is usually the opposite to that of currencies and bonds. Hence, to defend currencies and bonds, gold prices have to be fought.

Imaginary supply

Despite gold’s tremendous price increase over the last decade, the precious metal has not kept up with inflation since its last great rise in 1980. Somehow, no one questions as to why it has not kept up with inflation. The answer is that gold derivatives have created a vast imaginary supply for which delivery has not been sought for, since most investors internationally choose to leave their purchases as deposit with the bullion banks that sell them imaginary gold.

On the other hand, in India, gold coins bought even from an established seller (e.g. banks, PSUs) cannot be sold back. So, if gold as an investment has inherent liquidity loss then what is the rational of buying?

Paper promises

All commodity futures markets have created paper promises of supply that could not be covered by real product and have always been settled in cash. RBI had estimated the ratio of paper gold to real gold at 92 to 1. (RBI Report on Issues Related to Gold Imports and Gold Loan – January 2013, Page 58).

Most commodity markets are for goods that eventually are delivered and consumed to a great extent. Gold is different. For gold is not consumed but rather hoarded, even as most gold purchased in the futures markets is never delivered at all (or in miniscule percentage). This system has produced a disproportionate amount of imaginary, elastic, but undeliverable supply, even as people buy gold precisely because they assume that its supply is not elastic, the supply is limited to total past production plus annual mine production.

Caution required

At this point, individual traders in India should be cautious. In view of the recent fall in gold prices, cautiousness rather than optimism should be the watchword.

Published in The Business Line on Nov 6, 2014

How commodity bourses can survive

The larger objective should be to strengthen price discovery mechanism and risk management in the economy.

In commodity, like any other trading one does not mind paying a transaction fee as long as profits are made. However, once an entity starts making losses, the concern on the high transaction fee becomes multi-fold. On the other hand, when commodity exchanges start making losses, they may be forced to increase transaction fee camouflaged under some other name to boost the revenue. This often causes narrowing of participation and alienation of new participation on the exchange platform.

Comexes, which till a few years ago were embarking on global ambitions, are now struggling for survival. Of the first three national exchanges that were granted license, one continues to make profit due to low cost of operation, the other is showing signs of operating losses while the third continues to struggle.

Of the three new exchanges that were granted licences, two have already closed down. The other is on the verge of closure unless it is merged with the most profitable exchange in future, considering that a common group of shareholder have significant minority stake in both. Since its inception, Indian commodity futures market had pursued a cash-carry arbitrage model for agricultural commodities and momentum trading for the globally-linked commodities. With markets maturing, the cash-carry arbitrage has shrunk for agricultural commodities and with global commodity market entering a bearish phase, participation has become a casualty on exchange that has global commodity linkage.

The exchange which has kept costs under control still has a fair chance of survival, whereas the other with high manpower and outsourced technology cost is limping for operating profit. These developments throw a very important question - what happens to shareholders’ value in these “financial infrastructures” of the country. Doesn’t it mean that erosion of the value of exchanges is causing an erosion of shareholders’ value? Is it not a provocation enough for those governing exchanges to do a deeper soul searching for the revival? While some PE investors as shareholders of exchanges maybe demanding active performance improvement from the management, they are often short of foresight, vision and definitive roadmap to revive the exchange as governors.

In such situations, it is important that the corporate and shareholder governors of the exchanges are actively engaged by the regulators and the Ministry for its survival plans. However, the buck should not stop with mere profitability plans for commodity exchange’s survival. The larger objective of the commodity exchanges are to strengthen the price discovery mechanism and risk management for commodities in the economy for which the futures trading were allowed in the middle of last decade. If the exchanges are to be taken more seriously by the policymakers, over the next few years those governing the exchanges have to be more contributory to the broader economic objective, similar to what Leo Melamed had done to CME in the seventies.

Published in The Business Line on 24 October, 2014

Raids on hoarders need to be carried out with diligence

Agencies involved in commodities should use more analytics and information for better results.

It is would be interesting to note that ahead of Diwali, food safety officials and civil supplies department suddenly become active to ensure that laws are abided in the commodities sector. What is more surprising is not the way these raids are conducted but their timing. The activism of the law enforcers before Diwali in the North and Onam, Ugadi and Pongal in the South has been consistent over the years.

Undoubtedly, law enforcement raids are most effective when they involve good intelligence and planning. On the other hand, most raids are blind and executed without adequate information.

Obviously, the raids-to-prosecution ratio is pathetic as raids are conducted without proper analysis of market information. Both Union and State Governments often promise a crackdown on hoarders and black marketers to curb artificial price rise. However, most often the theatrical raids are conducted to cover institutional impotence and incompetence in the middle of the trouble (scarcity & seasonal price rise).

Sometimes, raids by the government machinery are also done to settle personal scores. For example, in 1995 a State Civil Supplies Minister in Gujarat backed by the oil traders lobby had ordered raids on the edible oil tanks of the National Dairy Development Board (NDDB) charging them with hoarding. The fact was the Minster was enraged by the fact that he was advised to check with the Union Ministry when he sought details of stocks from the prestigious institution.

In recent times sugar, pulses and onions have become the commodities of choice for the raids. Commodities whose prices are on rise and the supplies of which are getting scarce become the targets of the raids. The agencies that suspect hoarding should monitor stock movements, trade flows and the historical consumption patterns with appropriate intelligence and market information so that the impact of the raids do not create panic in the market.

Currently, the effectiveness of income tax raids are more profound in the economy due to analytics and software support that has been put in place over the last few years.

It is time that State agencies involved in commodities should use more analytics and information for better effectiveness of the raids.

In a market economy there cannot be any bigger disaster than vanishing stocks from the shelves due to fear. Intelligent raids should be the last resort to bring semblance of logic rather than creation of fear psychosis in the commodity market.

Published in The Business Line on 9 October, 2014

How to determine black marketing?

In a market-driven economy, it is difficult to determine whether the price that is being charged is black-marketing.

Recently, the Chief Minister of Bihar, Jitan Ram Manjhi, stirred up a controversy when he said that hoarding and black marketing of goods by small traders will not be treated as a crime. He may have been politically incorrect yet he was logically correct.

The hoarding and black marketing by small traders have no material impact on the demand and supply of goods in the market as the quantity of goods being hoarded by these small traders are insignificant.

Black marketing might be socially reprehensible and ethically wrong but there is nothing to prevent a businessperson from increasing the price to meet the pressing needs of the escalating cost.

In a market-driven economy, where there is no price ceiling, it is difficult to determine whether the price that is being charged is black-marketing. In the case of commodities, where there is no concept of an MRP, the concept of black marketing is even more questionable.

Blaming the small traders of hoarding and black-marketing creates more panic than to actually resolving supply side concerns. In modern commercial economy, hoarding and black marketing is a flawed logic that is often blamed for price increase. Small traders with limited financial resources can hardly make any dent on the price of a commodity or its availability.

Politicians browbeat the mythical hoarders for price rise often forgetting that the activity of hoarding needs very large and continuous supply of finance which no small trader possesses in India.

The agricultural physical market in Bihar and other States do not operate on a leveraged model and is also not a heavily financed model, unlike the trade of crude and metals in the international scenario.

In the past, it has been conclusively proven that when non-binding price ceilings are put in place to prevent price gouging in the event of natural disasters, it may actually reduce incentives for sellers to be well-stocked with goods as they will be unable to command the full market price for the commodities.

Normally, the supply and demand dictate price. However, when prices are fixed, demand outstrips supply. Thus, shortages become inevitable. As experience with rent control shows, capping prices in times of scarcity has perverse effect of reducing quantity of commodity or the service supplied.

Consumers understandably get upset when they face dramatic price increases within a short time. However, capping prices would actually lead to less being sold, as suppliers reduce the quantity that they are willing to sell in order to avoid losses. Shortages are, therefore, exacerbated.

By contrast, anyone who tries to unreasonably price the commodity will find himself with unsold supply and will be forced to lower his prices to offload it. In reality, it can be very difficult to determine the extent to which price increases are greater than “necessary” and even more difficult to determine what is black-marketing.

Published in The Business Line on 25 Sept, 2014

How to make delivery in commodity futures foolproof

A third party audit should be done periodically to ensure stock quality and quantity

The Forward Markets Commission (FMC) must be complimented for circulating the draft norms on “Strengthening of warehousing facilities in commodity futures market” in the public domain. This initiative can achieve a lot more than just transparency. If executed well, it would drive trading traffic back to commodity exchanges, which are currently bearing the brunt of the lack of confidence on the part of market participants.

Fixing responsibility

In spite of earlier directives from the FMC, exchanges had said that the onus of quality and quantity of commodities lay entirely with the concerned warehouse service provider (WSP). The current draft norms (dated August 26, 2014) and an earlier circular (dated August 30, 2013) put to rest all confusion on this issue by explicitly clarifying that commodity exchanges are primarily responsible for delivery settlement of future contracts and that WSPs act only as agents of the exchange.

The norms of net worth for WSPs have also been prescribed. However, more than net worth, it is essential that the exchange delivery activity of a WSP (which is an independent business unit) be ring-fenced from other activities.

Over the years with fading cash-carry margins, exchange deposits and exchange warehousing margins have shrunk. Therefore, WSPs need other sources of revenue. So, it will be naïve of us to say that the WSP should not engage in any activity other than exchange delivery. Yet it is essential that the liability of other activities of the WSP’s not have spill over into exchange delivery, which may seriously jeopardise the price discovery mechanism.

Covering risks

Currently, exchanges are taking cash deposits and bank guarantees (as security) from WSPs to insulate the “incident effect” of any bad delivery liability. However, on a freeze frame basis, Collateral Under Management (CUM) to bank guarantee (BG) ratio is often insufficient. There should be a standardisation of norms in this regard so that at no point should exchange deliverable goods in warehouses remain uncovered and discretionary. This can also bring in adequate variable coverage ratio into play as hundred percent coverage will be commercially unviable.

The insurance policy for all the exchange WSPs should be standardised, which in turn can be endorsed in favour of the exchanges. In case of any event of fire and other perils, the bridge pay-out to the members can be made from the Investor Protection Fund till the time the final settlement is made by the insurance companies. Currently, exchanges disclose their stock and space availability, which may turn out to be a serious systemic lacuna. In the case of NSEL, we had already seen a fatal gap in this with the exchange’s stock positions.

Independent inspections

Therefore, a regulator-owned software should be made mandatory whereby all exchanges and WSPs should enter their stock and space availability at each location. There should be third party independent audits to periodically check stock both in terms of quality and quantity. The existing cross audits by WSPs at each other’s service location is not full proof and it can lead to messier situations.

In most jurisdictions, decisions regarding implementation of these measures are left to the discretion of the exchange, without the need for any prior approval, implicit or express, from the regulatory authority. This is dangerous and the loophole can be exploited. On the other hand, allowing member/clients to do their own inspections will lead to the collapse of the delivery system and unnecessary disputes and litigation. Therefore, these stock audits should be conducted by reputed and independent inspection agencies appointed by the regulator.

Last but not the least, virtually all of the harmful opacity can be ended with a common clearing house (incorporated outside the individual exchange’s domain) and by making physical stock management more transparent. This will ensure system, process and audit integrity in the exchange delivery and settlement space.

Published in The Business Line on 11 September 2014

Why FCI can’t assess its actual stock

Flawed data collection, huge wastage of grains plague the Corporation

On paper, the FCI (Food Corporation of India) is said to be holding around 67 million tonnes (mt) of stocks in its warehouse. However, no one knows how much of it exists in reality - physically.

For any Government or bureaucracy, it will be difficult to arrive and acknowledge the actual physical stocks position. Various innovations have been created over the last two years to bring down the reported stock from 80 mt.

The Modi Government had promised to clean up the mess of the previous rule. Will it be in a position to de-legitimate the legacy of the last 50 years (FCI was established in 1964)?

Two years ago, it was found in Indonesia and Malaysia that more stock of palm oil existed than what was actually being reported, primarily due to flaw in data collection. It was also a manoeuvre to keep prices at a desired level for exports with low stock reporting (the two countries being net exporter of palm oil).

The case of buffer stock in India is actually the opposite. Siphoning off huge quantity of grains in the guise of waste is one of the major issues for the FCI.

At a time when chances of lower production are looming large in the country due to lower-than-normal monsoon, it can be a disaster to even report a correct picture. The mess is being circumvented by trying to break a monolith called the FCI.

Recently, in China, the state-owned Citic Resources reported that about half of the alumina stockpiles it had stored at China’s Qingdao port could not be located, heightening concerns over the use of commodities for financing in the country.

In the case of FCI stocks, in the last 50 years, banks have never asked any stock statement assured by the fact that there is an underlying sovereign guarantee. This kind of dual reporting is not new; even the Soviet system (which India later adopted) had a complicated grain stock reporting method in which invisible stocks (nevidimeye zapasy) and visible stocks (vidimeye zapasy) were classified. These secrets were hidden under “osobye papki” (special files under highest secrecy).

No doubt, the Indian bureaucracy has developed these tricks into a fine art. The question remains whether the elected representatives can force the removal of the veil from such dark practices.

Published in The Business Line on 28 August, 2014