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

Warehouse receipt system can help develop market mechanism

A well-developed process can provide a focus for improving the entire commodity chain.

The Warehouse Receipt System has a potentiality of a very high socio-economic payoff in India but it has not taken off due to various regulatory constraints.

The WDRA (Warehousing Development and Regulatory Authority) is authorised to regulate only the negotiable warehouse receipts of the commodity ecosystem.The authority has not been mandated nor does it have the jurisdiction to regulate the entire warehousing space, which remains a domain of various State Warehousing Acts. Even, non-negotiable warehouse receipts do not fall under the regulatory ambit of WDRA.

Since its constitution in 2010, the authority has not been able to convince the banks to use negotiable instruments for agricultural funding in any significant scale due to many structural defects in the WDR Act itself. The bankers privately confess that negotiability of the warehouse receipts in the current context of the Act does not give them adequate safety and assurance of repayment.

In case of default, the authority does not have the power to insulate the lender of safe return of the borrowed capital. The regulator has no direct control over the actions of the accredited warehouse, which may move stocks around without the knowledge of a regulator who is not on site.

The WDR Act has considered the structural robustness of the warehouse as fundamental to the accreditation process whereas in reality, the credibility of entities managing these warehouses has primacy on which the transactional business rests.

Therefore, it is important that warehouses should be adequately capitalised to carry on the activity. The adequacy of capitalisation and credibility of the warehousing entity has been totally ignored in the spirit of the Act.

Moreover, if a warehouse operator goes bankrupt, it may also be difficult for the bank to prevent priority being given to other creditors. To make the system successful, it requires careful analysis of the legal issues and a very rigorous set of guarantees and oversight mechanism.

Sometime back, the FMC (Forward Markets Commission) had directed the commodity exchanges to adhere to the standards of WDRA norms for accreditation of warehouses for exchange delivery. However, it must be noted that WDRA has no jurisdiction over any commodity exchange’s delivery mechanism. A registration with WDRA does not empower the authority to regulate the delivery on futures market.

The FMC is the supreme authority in case of anything that governs the delivery process along with the commodity exchange’s warehousing.

Warehouse receipt systems can play a central role in developing the framework of modern market institutions. A well-developed WRS can provide a focus for development of the entire commodity chain, providing incentives for a range of different parties including farmers, financiers, traders, processors and public sector buyers.

Difficulties stemming from the policy and institutional framework have made the introduction of WRS a difficult undertaking in India.

Published in The Business Line on 14th August, 2014

How far can Essential Commodity Act address hoarding?

No empirical evidence to prove that action against hoarders will bring down price of commodities

Doubts have been raised in the recent times about the effectiveness of the Essential Commodity Act in the current form to control prices. On the other hand, there is no empirical evidence to prove that acting against the hoarders will bring down the price of commodities.

The annual report of the Department of Consumer Affairs gives some interesting facts about the effectiveness of the Essential Commodities Act:

		2008-09	2009-10	2010-11	2011-12	2012-13
1	Raids Conducted	268,775	157,179	187,049	173,177	132,336
2	Persons Arrested	8,001	7,725	10,754	4,235	4,057
3	Persons Prosecuted	6,425	4,073	4,329	4,214	3,269
4	Persons Convicted	790	52	148	29	413
5	Goods Confiscated (Rs Cr)	60.95	164.23	104.55	61.73	229.78

Source: Compiled from the Annual Report of Department of Consumer Affairs

It is even more interesting to observe that the conviction to arrest percentage in the post-election period of 2009 was 9.87 per cent. It was 10.18 per cent during the pre-election period (2012-13) but fell dismally below 1.5 per cent during the intervening period.

The Essential Commodities Act is often supplemented by stock control orders. Thus in some cases, the regulatory authority or prosecutor are able to get direct evidence that stocking of the commodities was done with the intention for profiteering.

It is often difficult to get direct evidence – either through documents or testimony. State government has to enforce the provisions of the Essential Commodities Act.

The short-duration spurt in onion prices, which is encountered every year and seen this year too, needs to be seen whether it is a case of price rise or price gouging.

Price gouging (a term not often used) is a situation when a seller prices commodities at a level much higher than what is considered reasonable.

In the US, laws against price gouging have been held constitutional at the State-level as a valid exercise of the police to preserve order during an emergency and may be combined (like in India) with anti-hoarding measures. Laws against price-gouging have been enacted in 34 States in the US. Exceptions are prescribed for price increases that can be justified in terms of increased cost of supply, transportation or storage.

Proponents of laws against price gouging assert that it can create an unrealistic psychological demand that can drive a non-replenish able item into extinction.

As the new Government in India is embarking on enactment of changes in the Essential Commodities Act, we must understand that statutes generally give wide discretion not to prosecute. In some of the states in the US, only one-third of complaints were unfounded and a large fraction of the remainder was handled by consent decrees, rather than prosecution.

What if an anti-hoarding law is passed where arrests are non-bailable for hoarders to symbolise opposition to scarcity? Let’s abolish causes of scarcity. Will sending people to jail bring down the scarcity?

Published in the Business Line on July 31, 2014

Why the delivery system has to be strengthened

Price discovery has often been defined as the process of arriving at a transaction price for a quality and quantity of a commodity at a particular time and place.

On the other hand, to protect margins one has to look at price drivers such as storage cost, transportation cost and natural quality deterioration. Even the usage of old or new gunny bags for packing commodities affects transactional margins.

These dynamic elements have significant impact on the margins of trade transactions.

Arbitrage rates

Some of the commodity futures contracts introduced during the last decade have “dream arbitrage” where storage rates are fixed and quality deterioration has been considered to be the responsibility of custodian of the physical goods.

On the practical side, the price of storing a physical commodity from one month to the next is freely set in the storage market. No doubt, price occurs at the intersection of supply and demand for storage services, which changes over time. As the demand for storage services rises, the price of physical storage also rises, all else remaining equal.

In contrast, the storage fees for deliverable commodities are set by futures exchanges.

Naturally, a section of the ecosystem participants take advantage of the lacuna and make profit out of this surreal situation.

Frequent tweaking of contract terms on the exchange have also resulted in participation and volumetric inconsistency from year to year.

For some of the deliverable futures contracts, prices no longer represent the expected cash market price.

Instead, it represents the price of the delivered commodities which has higher value than physical commodities because it incurs artificial storage fees without any natural shrinkage and topped with predetermined premium fixed by the exchanges.

Naturally, the market does not converge at the expiry.

Delivery structure

Non-convergence leads to welfare losses among less informed market participants, so futures exchanges and stakeholders have an interest in preventing such future episodes.

During most period of 2005-10, the price of expiring US corn, soyabeans and wheat futures contracts settled much higher than corresponding delivery market cash prices and are most likely to be repeated elsewhere if unintended results of the market delivery structures of traditional market are ignored.

We must appreciate the fact that in India (unlike CBOT/CME) we do not deal with deliverable instruments and shipping certificates. We first need to strengthen the delivery issue based on our own ecosystem.

The sooner some of these “dream arbitrages” are controlled and a move is made towards “normal arbitrage” contracts aligned to the reality of physical market, the faster agricultural futures markets will grow. This will also result in wider participation and deeper penetration.

Published in The Business Line on 17 July, 2014

Develop physical market for commodities

It will help futures market, suffering from lack of multiple pricing points, succeed.

Futures exchanges apparently have difficulty in predicting the success or failure of futures contracts. Only 15 per cent of the contracts that are introduced survive before they get delisted.

Physical market size, risk-reduction ability of the contract, cash price variability and liquidity costs influence the volume of trade and open interest of futures contracts.

During 1994-98, 140 new commodity derivatives were introduced across the world. During 2005-13 almost the same number were introduced in Indian commodity futures. In India, major farm commodities such as cotton, oils and oilseeds and jute have lost their importance in the futures market arena.

A few other agricultural commodities such as guar, chana, castor, cottonseed oil cake, rubber and mentha oil display volumes though metals (precious and base) and energy products continue to preponderate on the commodity futures scene.

The attributes of commodity that are considered crucial for qualifying for futures trade are: Commodity should be durable and it should be possible to store it; units must be homogeneous; commodity must be subject to frequent price fluctuations with wide amplitude; supply and demand must be large; supply must flow naturally to market and there must be breakdowns in an existing pattern of forward contracting.

Though the attributes mentioned above answers the question whether commodities are suitable for futures trade, however, it does not answer a more important complementary question whether the market will adopt a commodity contract for trade or not.

The economic utility of a commodity futures contract for effective price discovery and efficient price risk management depends on wide participation of the physical trade in the commodity and also non-commercial participation, giving it a desired equilibrium.

Lack of multiple pricing points in physical market and supplier concentration often causes contract failure. Energy futures contracts without the participation of the energy players (crude and natural gas producers and users) would have sufficient ingredient for failure. A market deserted by hedgers is unlikely to survive for long, as it will surely be neglected by speculators.

Without getting into the argument of “chicken or the egg”, we need to appreciate that a futures market for any commodity presupposes a close correlation between the prices in physical market.

And if the landscape of the country for the commodity has a controlled price mechanism or an oligopolistic market structure, the futures contract will have very remote chances of success beyond a certain time, however well the contracts may have been designed.

It is important that the country should direct its efforts toward developing active physical cash market with multiple players and multiple pricing points, the success of futures market will follow naturally.

Published in The Business Line on 3rd July 2014

What Modi recommended on futures trade in essential items

Heading a panel, the Prime Minister had called for integration of spot and futures markets

More than three year ago, Narendra Modi, chairing a working committee to suggest steps for reducing gap between the farmgate and retail prices and recommending an action plan for better implementation and amendment to Essential Commodity Act (ECA) had submitted a report.

This report is insightful, constructive and radical in its approach.

The highlights are: speedy reform of APMC Act across the country and liberalisation of agri-markets; explore unbundling of FCI operation in terms of procurement, storage and distribution functions; to set up a ministerial level coordination mechanism at the national and the regional level for coordinated policy making for evolving single national agriculture market; recommended that offences under Section 10-A under the Essential Commodities Act should be made non-bailable and special courts should be set up for speedy trial of offences under the ECA.

The report had touched on the issue of information asymmetry both on the demand as well as on the supply side.

Data flow

It had pointed that if the collation and capturing of data is supplemented with the flow of information then it would fundamentally change the face of market. If necessary, it could done by creating a dedicated agency for the purpose.

Needless to mention that India’s commodity futures market has brought in a significant change in the last ten years where “reference price” are often used by the trade for purchase as well as production decisions. The report had observed that “until effective integration of futures and spot markets is achieved, we should be cautious about the futures trade in essential commodities.”

The report further said: “Since food security being the utmost concern, for the time being there should be a ban on the trading of essential commodities in the futures market” ( Point 2.7, Page 8).

Futures market

Today, as Modi is the Prime Minister of the country and embarking on a paradigm shift what does one expect? Does this mean that the futures market should keep the essential commodities such as wheat on the watch list for possible trade suspension? The report has, however, said that futures of the other commodities can be permitted. (Page 17, Point e.4)

The report also mentions about the “market failure” and traders making excessive profits. However, no evidence or empirical data has been provided to substantiate the point.

The report talks about the creation of agri-infrastructure and, in its recommendation, has laid emphasis on post harvest linkages. It talks about the Government providing financial assistance for construction of godowns at village levels along with godowns at PACS (Primary Agricultural Co-operatives Societies). While it is appreciated that the recommendation has looked at “small is workable,” it has may have erred in recommendation of PACs in the role which does not have any specialised functional expertise.

This report is a document which gives 20 recommendations with 64 detailed actionable points that will facilitate expeditious implementation.

The report has largely been ignored till now, however, the committee needs to be complimented for taking the bull by its horns and addressing the issue which will have significant impact during the tenure of the current government.

Published in The Business Line on June 18, 2014

Asset-backed trading becoming the norm in commodity market

Helps companies link market and financial intelligence to remain competitive

From the middle of the last decade, large banks world-wide got involved in business far removed from their traditional lending activity – trading in physical commodities.

Currently, these banks are retreating from this activity. The shift is empowering commodity trading houses to consolidate their control over supply chains for food, oil and metals.

Commodity traders are rapidly expanding from the traditional intermediary business model of buying and selling, where margins are very thin, to “asset-backed trading models”, where they are investing in production, processing, and logistics.

This new trend has been triggered because across the traditional commodity market, the competitive advantage from superior price information has largely disappeared, and to protect margins, the traders are seeking to own and operate physical assets and arrange an end to supply chain solutions. These supply chains provide unique profit pools.

Some traders are also venturing into territorial specialisation such as distribution system supply and operatorship which gives them unique access to exclusive and unpublished market information.

Integrated framework

By developing deep insights into all the fundamental value-drivers in a trading portfolio, an integrated framework is providing the radar to identify the market and credit developments to which the firm’s financial performance and liquidity are particularly sensitive.

As trading houses are investing greater amounts in industrial and agricultural assets, they are being forced to raise more capital from outside investors, which in turn is threatening the private ownership model, historically favoured by the industry. In some cases sovereign funds and para-statal agencies are investing in the large trading houses. A few traders are already publicly-listed companies while others are considering floats. A few of the companies are using hybrid strategies of tapping capital markets and simultaneously seeking strategic investors while maintaining the flexibility.

The asset-backed trading is a style of commodity trading which is used to seek and exploit market volatility in order to monetise the operational assets owned by the trading entity.

It views physical assets as portfolios of traded instruments. Today, companies are linking manufacturing excellence to market and financial intelligence to remain competitive. No doubt, it poses a challenge on the business process as well as on the IT landscape.

An asset-backed trading strategy consists of control over the production (e.g. mining, plantation), processing (e.g. extraction, refining) and logistics (warehousing, tankage, railway, shipping) along with control over physical commodity.

Along with an appropriate set of financial hedges not necessarily subject to physical risk, this contributes to margin through operating efficiency and flexibility, utilisation and turnaround. Taking all these together, it is intended to extract value from market price movements and add to the valuation of trading entities.

Published in the Business Line on June 5, 2014

Why there is no perfect strategy for hedging in commodity markets

The key to optimal decision making is to understand the trade offs that are occurring

Inventories for storable commodities have always played a crucial role in price formation. It acts as a buffer that helps absorb shocks to demand and supply affecting spot prices.

However, there is a possibility of a stock-out implying that the basis can surge in times of shortages. In case of importable commodities, such situations are sometimes created by squeezing the supply lines for a time period.

On the other hand, larger processors of soyabean, mustard and maize hold commodities to reduce costs of adjusting production over time and also to reduce marketing costs by facilitating production and delivery scheduling and avoiding stock outs.

If marginal production costs increases with the rate of output and if the demand fluctuates, processors can reduce their costs over time by selling out inventory during high-demand periods and replenishing inventories during low-demand periods. Selling out of inventory during high-demand periods can reduce the adjustment costs.

Processors most often try to determine their own production levels with the expected inventory drawdown or build-ups. However, the information on the real stock and inventory level is never available from a reliable source in India.

It is mostly hearsay or a trade rumour. Prices and inventory level fluctuate considerably from time to time which may partly be predictable due to seasonal production and the unpredictability part is generally brought by the market players in response to demand expectations.

Very often the decisions are made in light of two prices – a spot price for sale of the commodity itself, and a price for storage.

Thus there are two inter-related markets for a commodity, the cash market for immediate, or “spot,” purchase and sale and the storage market for inventories held by both producers and consumers of the commodity. Because inventory holdings can change, the spot price does not equate production and consumption.

Instead, it characterises the cash market as a relationship between the spot price and “net demand,” i.e., the difference between production and consumption.

Total demand in the cash market is a function of the spot price and other variables such as weather, aggregate income and random shocks reflecting unpredictable changes.

Processors and consumers often seek ways of hedging in the markets in response to the price volatility. Whether this is done by way of financial instruments such as futures contracts or by physical instruments such as inventories depends on the appetite of entities in the value chain.

Rarely is there one perfect strategy, hence the key to optimal decision making is to understand the tradeoffs that are occurring in deciding on the actual strategy.

Published in Business Line on 22 May 2014

The importance of storage rates in commodity trade

Having variable rates will promote convergence of prices in spot and futures markets

Commodity futures market convergence is the process where prices in the spot and futures markets come together or converge at futures market expiration.

Convergence occurs at the expiry date of every futures contract because of arbitrage. If spot prices remain below futures prices, a market participant could buy in the spot market and sell in the futures market and make a risk-free profit.

Similarly, if the spot price is above the futures price, a market participant can buy in the futures market, take delivery and sell in the spot market and earn a risk free-profit.

Storage space crunch

Convergence can be problematic whenever a commodity is in oversupply relative to available storage space which is often the case in India.

Spot prices may be at a discount to futures prices during a delivery, when there is a lack of warehouse space and the spot price discount to futures is tied to the cost of putting the commodity into storage.

When a warehouse is full with a certain allotment for commodity storage, the cost to store an additional quantity of commodity can increase significantly due to the lost opportunity of using that space for other commodities.

To address this issue, if the cost to store a commodity changes, one needs to examine how to also change the returns from storage to keep the costs and benefits in alignment. The benefits from storage are discovered in the price spreads between different expiration months in the futures market.

However, this has got restricted in India on account of exchange pre-determined storage rates which are not market-driven.

Variable rates

This creates a fundamental market flaw as the exchanges, in order to keep the transaction cost low, keep the real storage cost artificially lower than the market for exchange delivered commodities and thus affecting the convergence of the prices.

CME has already introduced variable storage rates (VSR) to promote convergence from July 2010. The results of this implementation have had a positive impact on convergence during expiration.

In case of CME contracts, if the market expects storage rates to increase following the current contract expiration, the spread between current to further month contract can widen. Now, storage rates can change under VSR mechanism.

It is rather interesting to observe that in India, participants on futures platform are given a fixed rate of storage while market driven rates are offered to the spot market user which is ever changing, market determined and dynamic in nature.

We need not ignore a situation where sustained non-convergence would make hedging less effective, send confusing signals to the market, threaten the viability of a contract and ultimately lead to a misallocation of agricultural resources.

Published in The Business Line on May 7, 2014