Gold Exchange-Traded Funds Come with Their Own ‘Risks’

Gold prices have gone beyond one’s imagination. Gold has always been considered a valuable precious metal and the value has increased dramatically over the past few years. As a store of value and hedge against inflation and failure of a currency system, few things can beat gold. Incorporating gold into a financial portfolio to increase diversi-fiction requires knowing about the different ways to invest in the precious metal.

Gold exchange-traded fund (ETF) is a passive investment strategy in which a fund manager invests in accordance with a pre-determined strategy that doesn’t entail any forecasting on the value of the gold. Riding the bull run in gold, a plethora of funds (ten by last count) have come to the market in India. However, to many it mayseem little “value add”. 

The biggest danger of passive investing is that it is confused with in-dexing. While index investing is a mature approach to investment, passive investment in a single asset class without any elbow room of adjustment is dangerous. An important question is whether passive commodity investment that seeks to replicate index returns might have wider malign consequences. The short answer is “yes”.

The idea of not responding to changes in prices (gold in this case) as a rational decision is an outgrowth of the efficient market theory which has outlived its utility. When one bets on the price of a single com-modity without a mechanism to hedge the downward price risk, then it can only be termed as speculation. Buy-and-hold investing makes a great deal of sense when employed by investors who make reasonable adjustments to their large-sized portfolio allocations in times of high prices. It does not make sense for those who have a small portfolio.

Buy-and-hold and passive investing are not for middle-class investors. Investing involves risk and investing passively increases the risk dramatically as there is no mid-term cor-rection. In a falling market (along with redemption pressures), the impact cost in the physical market (as a result of liquidity risk and off-take risk) is manifold compared to the organised stock market.

Many are attracted to passive investing because it appears to be a no-fuss approach to investing. They do so without making a correct as-sessment of the risk that this approach may cause down the line. After a good bit erosion of investment has been done, it becomes difficult for people to acknowledge that they were responsible for it; they seek ref-uge from taking responsibility for their mistakes in excuses and word games. Then the final resort comes by citing the “risk disclosure” statement in the offer document.

Since the amount of money invested in active strategies (physical gold) is much greater than the amount of money invested in passive strategies (gold ETF), it’s clear that most people still don’t believe oth-ers when it comes to managing the “gold instinct”.

Published in The Economic Times

India Needs Agri-input Protection Laws

Farm producers desperately need support from the government to balance power with large commercial entities who wield it in the marketplace and courts of law.Unless some of the guilty agricultural input (seed, fertiliser and farm equipment) manufacturers and dealers are hauled up and given exemplary punishment, selling sub-standard agri-inputs will remain a flourishing business for all kinds of operators.

There is a need to draft a ‘farm inputs liability bill’ which should include all the agricultural inputs like seed, fertilsers, agri-chemicals and agri-equipments in its ambit. The controversial draft of seed bill (opposed by states of Bihar, AP and Kerala) does not hold the seed suppliers liable for any damage or crop failure. The bill holds companies liable till the seed germinates. What if the seeds germinate but fail to yield crops?

In the past, agricultural implied warranty (for sale of animals, semen, seeds) in the West had followed the argument like this that if an entity sells a bull to a farmer, which is to be used for breeding and the bull is not fit for breeding, the buyer may hold the seller liable for breaches of implied warranties of merchantability and fitness for a particular purpose. Why cannot the same logic be extended to India? One form of civil liability is products liability. Products liability refers to the legal liability for personal injuries and asset damage caused by defective products. Either the user of the product or others affected by the use of the product may file suit mainly on two grounds i.e. (1) negligence and (2) breach of implied warranty.

On the agri-input side, product liabilities have often been ignored. Farmer consumers are mainly confined to rural areas and are struggling with subsistence and marginal farming, lacking the legal capacities to fight back with large commercial interest. Consumers of agriinputs certainly can also use warranties to file suit for products liability. In any situation, a seller warrants that the product is fit for ordinary purposes for which it is used. If a seller knows the purpose for which the products will be used and the buyer relies on the seller’s skill or judgment in selecting or furnishing goods, then the seller impliedly warrants the fitness of the product for the purposes intended.

A person wishing to recover under negligence must prove that the producer or seller failed to exercise reasonable care in producing or marketing the product, resulting in an unreasonably dangerous product. This is very difficult considering the negligible resources available with the consumers. On the other hand the suppliers often point that the consumer has failed to exercise due care in using the input (product) and thus contributory negligence prevents the consumer from recovering any amount for injury or damage.

Needless to mention, “failure to warn” by the sellers also tantamount to a product defect. In addition to the common law, India needs to enact agri-input protection statutes by providing for specific remedies for a variety of agri-input product defects.

Published in The Economic Times

A Force Majeure Clause is Quite Critical in Commodity Contracts

A force majeure clause is often added to a contract of commodities without careful consideration of its implications. An event must meet several conditions to be viewed officially as a force majeure. In the last few months, there have been several examples of force majure: ONGC Videsh (OVL), the overseas exploration arm of Oil and Natural Gas Corporation (ONGC), has invoked force majeure clause for its Libyan block (Cyrenaica offshore in the Mediterranean Sea) following a war-like situation in the African nation. In Japan, after the earthquake, several power companies and commodity suppliers have declared force majeure in order to postpone deliveries, orders and events. There is even talk that Japan may ask for exemption from the Kyoto Protocol in the wake of the disaster. 

The case of Japan reminds us that force majeure should cover multiple events as one event may lead to other relevant events including tsunami and nuclear leaks. It also indicates that force majeure clauses should be tightened to allow for exit, after a period of time. 

A force majeure (which means superior force in French) is defined as an event which is beyond ‘reasonable’ control. While force majeure clauses are drafted with varying degrees of sophistication in commodities contracts, the ability to enforce a ‘force majeure’ clause is determined by the precise drafting of the contract as several common themes run through a vast majority of clauses which are (1) force majeure event (2) causal connection (3) contribution to force majeure event and (4) Notice. 

The event and the causal connection must be outside the control of the parties and should typically be seen as ‘unforeseeable’ and ‘impossible’. A force majeure clause is critical in any commodity contract. It is viewed as fair because it is not only an “act of God” but one in which the parties would not have contemplated (e.g. truckers strike). However, if such an event occurs then the clause should take care of adequate risk cover. 

It is also important to understand the difference between a fortuitous event and force majeure. The former is what we would strictly describe as an “act of God” while the latter connotes the participation of human beings. A good force majeure clause would also allocate a period of time when the event continues before calling it quits. This allows the customer to exit the contract and have the option to search for alternative suppliers. This could be useful in a limited force majeure where the situation only affects a specific location. What is permitted to be a force majeure event or circumstance can be the source of much controversy in the negotiation of a commodity contract and a party should generally resist any such attempt by the other party to include something that should fundamentally be a business risk of the other party. 

Published in The Economic Times

Who Really Benefits From Agri-Corporatisation?

We are often advised that corporatisation will automatically take care of ills of agriculture (e.g. low productivity, lesser influence of middlemen). But who is driving the corporatisation agenda into Indian agricultural system? Consumers? No. Producers? No. 

The government’s primary economic function is to maintain competition. Instead, the top priority of the government has become to promote economic growth. Corporate interests have entered every aspect of agriculture — from the making (influencing) of laws to the delivery of basic public services. The corporations have gained so much influence in certain machinery of the government that not only does it fail to ensure competition; government at times has become a tool for corporate exploitation of both people and resources.

 
To cite the example of Bihar in maize: In December 2009-10, the state had to step in with distributed assistance to farmers. The state exchequer had to take on an extra burden of 61 crores, which it had to pay as compensation to farmers using private hybrids, on account of “non-formation of grain”. This is the first time a chief minister has dared to expose a large body corporate that in connivance with GEAC (Genetic Engineering Approval Committee) & ICAR began trials even before the environment ministry’s clearance. 

On the other hand, the “so called” success of BT Cotton in the states like Gujarat has been over emphasized by the political class. In the interlocked agricultural market, if individual commission agents at times have hijacked the chain in past on delivery side, it is more likely that institutionalised middleman with their stranglehold over the ability to influence policymaking will prove to be a curse both on supply and delivery side. 

As a consequence of farm politics, some commodities are more heavily subsidised than others. Majority of all food/farm subsidies goes to wheat, rice, sugar and that too in limited pockets of a few states. 

All over the world, some of the most blatant conflicts of interest in politics have occurred among politicians and others who serve in important agricultural policymaking positions and has substantial interest in doling out the subsidy baggages to the pockets of influence. They put the economic interests of corporate lobbyists ahead of the public interests of society in general. In certain cases, these influential persons have also become business partners of the corporate.

Past experience shows that big food retail has neither benefited the farmer nor the consumer. Contrary to popular belief, the big retail has not helped in creating jobs either. If the supermarkets were so efficient for the farm economy then why is the US providing massive subsidy to its farmers? 

In corporatised food value chain, the individual nutritional (protein, carbohydrate, vitamin etc.) components are highlighted over balanced diet (dal, roti & subzi). Problems of obesity, diabetes, hypertension, heart problems, and food-related cancers have become epidemic with growing corporate control of the US food system. Let us protect India from these. 

Published in The Economic Times

Does Branding Add Any Value to Bottomline of Commodity Cos?

Globalisation in the last two decades, along with the lowering of trade and investment barriers, advances in telecommunication and transportation technologies, has given rise to a faster price discovery of commodities. Hence, price wars have increased and profit margins have declined for commodity companies. In commodities like edible oil, wheat flour, basmati rice, milk and spices, a large number of companies are trying to beat the price trap of the commodity market through branding. Access to information (price, demand-supply and arrivals) has made it difficult for information arbitrage to remain for long on a sustained basis. Commodity-based sourcing advantages are narrowing which make it harder for companies to extract a price premium in most markets.

Just about every company is engaged in differentiation through branding. Edible oil companies can be seen often propagating virtues of good health through expensive advertisements (though doctors may suggest to the contrary). But, very few of them feel that continuous differentiation is a solution. They simply don’t get the results that they expect because everyone else is doing a similar thing. In some cases, the gestation time is long to break even with high brand-spend. This raises a fundamental question: does branding add any value to the bottomline of commodity companies?

The branding of commodities started in 1983 with the Tatas lending their name to salt to create product differentiation and to take advantages of a premium pricing in a commoditised product line. However, what difference does this make by branding commoditised petroleum products from IOC (Xtra), BP (Speed), HP or IBP? All brands of petrol (gasoline) and diesel are derived from same crude and in India it is sometimes from the same refinery (distributed through swap trades). Petrol and diesel retail prices remain regulated (irrespective of brands). Crores of rupees have been spent on the branding of the petroleum products. What value does it really add to the companies?

Companies are trying to sustain competitive advantage through product differentiation by highlighting unique features and benefits which are valued by retail buyers. In the bulk commodity world, the buyer’s perception has remained unchanged: It is price, price and price. This very “price trap” is where a company sees its competitive position being eroded so that it can no longer command a premium price in its market. In a price trap, buyers receive more product benefits for their money or pay lower prices for the same or lower levels of benefits. The result is that companies find that they can hold their prices and lose market share or they can hold market share only by lowering prices. In either case, the companies have lost their pricing power.

While many companies take commodity management as a core competency, almost all have experienced squeezed profit margins whether input costs rise or remain stable. Over time, product supplies become indistinguishable from others in the commodity market and consumers buy on price alone. 

Published in The Economic Times