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

Convergence of price is the core issue in commexes

Arbitage tends to reduce price discrimination by encouraging people to buy a commodity where the price is low and resell it where the price is high. Price convergence is what allows futures prices to be interpreted as reliable price benchmarks for forward contracting of commodities, both by commodity sellers and buyers.

The pressure on the Chicago Mercantile Exchange (CME) and other US wheat trading exchanges to solve the price convergence problem has become more acute with the release of Senate investigation into wheat prices in 2009.

The delivery on the exchange is one of the most contentious issues. In India, commodity exchanges have pursued two routes — one which has promoted mainly exchange deliveries and the other which has ensured that no delivery is made. Neither route solves the core issue which is the convergence of the spot price with future price. Overall, the empirical results do not support the convergence hypothesis but rather a pattern of fluctuating divergences has been observed.

The existence of high ‘badla’ (cash futures arbitrage) opportunity in agricultural commodities during the initial days was caused by flaws in futures contract design. It was assumed that the differentials (premiums & discounts) between different locations as fixed (constant) and thus premium and discounts were introduced as part of the futures contract. In reality, the differentials between locations are multivariate function of transportation, quality, supply and demand situation at a point of time and do not remain fixed over a period of time.

The point that was missed is that the differentials are market driven rather than a constant factor on a time axis. Differentials have the same variability attributes that of the commodity price. Therefore, by having a constant (fixed) premium and discounts embedded in the contract itself leads to a flawed price discovery, delivery issues and proliferation of speculators.

On the other hand, the non deliverable route has caused the physical market participants to look at the futures market as punters paradise. Price manipulation during the pre-tender trading period does not create sufficient fear among speculators of getting stuck with exchange delivery in the absence of a delivery mechanism and this causes huge volatility in trading.

Some of the contracts even have two kinds of allowable deliverable quality. All these flawed contracts continue to be allowed for trading on the futures platform. The non-convergence of settlement price and spot price throws non-existent ‘quality issues’. Obviously one never understood the underpinning of the problem and had been barking at the wrong tree with quality issues, storage protocols.

Constant (fixed) premium and discount matrix has caused trading shift from location to location on screen while the benchmark has remained theoretical. The price quoted on the futures screen becomes a derivative of the non-representational premium and discount prevailing in the spot market rather than a future price.

Published in The Economic Times