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

Investing in Precious Metals can be Tricky

It takes two to tango but a bunch of ill-informed commodity analysts to create hype around contango. Investors in precious metals must avoid the drove of commodities analysts – as there are few signs of intelligent-life.

Despite the tall claim that India is no longer a price taker for gold but a price setter, the claim does not cut much ice. We are all clueless of the happenings in the international market. Price and investment hype have come at a time when internationally one large market maker is sitting with the largest concentrated-position in the gold market in history (“short”), while the other large entity is sitting with the largest concentrated-position in the history of the silver market (also “short”). They are investing in commodity which has become genuinely “scarce”, due to the manipulation of the market.

The explanation of "hedging" by gold and silver mining concerns is even more amusing. Miners sell forward their future output, essentially selling naked, sometimes going out as many as several years. Then they cover part of their short position through purchases of call options. One can hedge physical gold, but can one hedge gold locked up in ore deposits!

In an Indian scenario a buy-and-hold strategy has become the profit-making proposition for many. The gold market has always been a contango market. This means that the gold spread has always reflected the carrying charge, the opportunity cost of carrying gold, most of which is foregone interest. The reason a large contango is rare is because it’s too easy to profit from it.

In the technical jargon of the futures markets, the basis is the spread between the nearest futures price and the cash price in the same location, but a strange phenomenon has manifested itself. Rather than remaining constant, the basis as a percentage of the rate of interest has been vanishing and now has dropped to zero. Has anyone checked the Indian “basis”? What about physical delivery… still a chimera or is it quality certification issue which ensures that this remains a chimera.

Growing numbers of investors are being drawn towards this market of buying precious metals. With festival and marriage season about to start….Gold, gold, gold...everyone may say...let us collect gold by which we shall remain wealthy... The banks, exchanges, analysts, brokers, mutual funds are misguiding people who seek to protect their wealth. Gold is a cleverly designed trap. This trap has caught the middle class, upper-middle class, and upper class, totally off guard. Hundreds of thousands of hard-working people will invest their savings in gold, believing that the risk is non-existent, and that their wealth is protected against severe market fluctuations and hyper-inflation.

Gold had lost nearly eight seven percent of its investment purchasing power between 1980 and 2000. That was during the best period for growing businesses in the twentieth century.  It is often said “Buy facts and sell fiction” but how does one distinguish which is the fact and what is the fiction …. at a time when analysts are manipulated and there are hardly any facts apart from the rumors. And what if the entire gold futures turn towards “backwardation”? Will that be a fact or fiction…..

Published in The Economic Times 06 Sep, 2010