Commodity Markets - Business Potential

Invitation to IIM-A Commodity MarketsGraduates

Business8Potential and Strategy th March 2004 1

17th July, 2004

Indian Financial Markets and Regulators Ministry of Consumer Affairs

Ministry of Finance

Insurance Regulatory Development Authority (IRDA)

National Housing Bank

Housing Finance Companies

2

Insurance

Pension Funds

SIDBI

RBI

State Financial Institutions

Banking / NBFCs

Company Law Board

FMC

Commodity Markets

Corporates

SEBI

Capital Markets

NABARD

Co-operative Banks & Regional Rural Banks

The Indian Definition: FCRA (1952) z

Goods z

z

“Every kind of movable property other than actionable claims, money and securities.”

Securities z

“Shares, scrips, stocks, bonds, debentures, debentures –stocks or other marketable securities of a like nature in or any incorporated company or any other body corporate and also government securities.”

Inclusive definitions-Gaps exist 3

Objectives of Commodity trading z z z z z

Leads to price discovery Provides hedging option A smart investment choice Integrates players and markets Improves cropping pattern

….a win-win, or Pareto optimal, state 4

What are the risks in commodities? Commodity enterprises face three classes of risk: z

Price risk – risk relating to movements in the world price, the exchange rate and the basis between local and world prices)

z

Yield/Output risk (eg from weather)

z

Political risk

Exchange to facilitate hedgers to mitigate price risk Insurance and exchange traded derivatives to be made available for mitigating yield risk 5

Forwards z

z z z z z z 6

A bilateral agreement in which the buyer and seller agree upon the delivery of a specified quantity and quality of an asset at a specified date and agreed price Traded on an OTC between two FIs or one FI and a client Price of contract is called a delivery price: usually is equal to spot price plus cost of carry Contracts are custom designed Actual delivery has to take place No margin systems exist here No exchange guarantee

Futures z

Are exchange traded versions of forward contracts z z z z z z

7

Time, place and delivery price fixed between buyer and seller Buyer is taking a long position Seller takes a short position Contracts have standard specifications Brings in hedgers, speculators and those who want to discover prices Margin system reduces risk, provides liquidity and reduces volatility

Margin Requirements

8

z

Initial margin at time of contract

z

Maintenance margin which is lower than initial margin

z

Additional margin in volatile times

z

Mark-to-market margin on a daily basis

Exchange Vs bilateral trading

Exchange

Bilateral trading

Common platform for all traders

Restricted access

Price transparency

Traded prices unknown to other players

Low transaction costs

High cost and time consuming negotiations

Absence of counter party credit Counter party credit risk risk Market prices available to wider Difficulty in price dissemination world Standardized contract size

Customized contracts

Exchange - a common meeting ground for all industry participants 9

Types of trading Open-outcry

Online trading

Participants congregate in a “ring” to discover prices

Participants put orders on-line to discover prices

Physical presence in exchange premises required

Orders routed through electronic networks

Price quotations / traded prices not transparent

Quotations and traded prices available on-line

Cannot facilitate on-line real time price dissemination

Real time price dissemination possible

Monitoring of member’s positions and risk management practices cumbersome

On-line monitoring of member positions

Other functions such as margining and mark-to-market are similar 10

Capital Market vs. Commodities Capital Market

Commodities

Prices movements based on the expectation of future performance

Price movements are purely based on the supply and demand Seasonality

Price changes can also be due Price changes are due to changes policy changes to corporate actions zDividend announcements zChange in tariffs / duties etc zBonus shares / stock splits Predictability of futures performance is reasonably high zHistory of management performance to support 11

Predictability of future prices are not in the control zFailure of Monsoon zFormation of El-ninos at pacific

Options z

z

Gives holder the right but not the obligation to buy or sell an asset at a known fixed price for a premium Call option gives the buyer (of option) the right to buy an asset by a certain date z

z

Put option gives the buyer the right to sell the underlying asset z

z

12

The seller has the obligation to sell the asset

Seller has the obligation to buy the asset

Could be American option where right can be exercised before expiry date or an European option where it is exercised at the end of life of contract

Market Structure…

13

Commodity markets in India z Spot trading mostly in regional mandis & unorganized markets z Markets fragmented and isolated z Reduced Government procurement activity z Mostly restricted to cereals as of date z MSP distorting markets in favour of food grains z Restrictions on inter-state movement and warehousing of commodities z Futures trading largely regionalized & based on pit trading

There is an overwhelming need to develop commodity futures markets as a stabilizing influence 14

Mandi trading in India z Over 7000 Mandis z Trading in 140 crops z Farmers, Licensed Traders, Brokers & Wholesale Dealers z Mandi Inspectors issue type & quantity certificate z Mandi fees : Transaction fee, Taxes; total varies between 4% and 12% z Trading, Clearing and Settlement z Governance : State Agricultural Marketing Boards (SAMB), Mandi Board (Farmers, Traders, State) z Secretary, Clerks and Inspector

15

Issues in price dissemination, standards, certification and warehousing

Commodity futures

Precious Metals Agriculture 16

Other Metals Energy

Potential trade in commodities (Rs. in Billion) Current physical trade volumes

5 times multiple

Delivery Base (5% of Market)

Bullion

400

2,000

100

Metals

600

3,000

150

Agriculture

5,000

25,000

1,250

Energy

5,000

25,000

1,250

Total

11,000

55,000

2,750

Internationally the multiple for physical versus derivatives is much higher (In TOCOM Gold contract, the multiple is 70 times upwards) 17

Volumes as on March 2003 Commodity Exchange NBoT, Indore NMCE, Ahmedabad Ahmedabad Commodity Exch. Rajdhani Oil & OilSeeds Vijai Beopar Ch., Muzzaffarnagar Rajkot Seeds Oil & Bullion IPSTA, Cochin Chamber of Commerce, Hapur Bhatinda Om and Oil & Oilseeds Others (mostly inactive)

Products

Approx Annual Vol. (Rs bn)

Soya, Mustard

800

Multiple

400

Castor, Cotton seed Mustard

35

Gur

25

Castor, Groundnut

25

Pepper

25

Gur, Mustard

25

Gur

15

35

15

TOTAL 1400 * Current - annualized futures volumes are miniscule compared to underlying spot 18

market volumes and the potential

Indian Commodity Futures Exchanges FMC Commodity Exchanges National exchanges

NCDEX

19

NMCE

Regional exchanges

MCX

NBOT

20 Other Regional Exchanges

Functions of an Exchange z Product Conceptualization and Design z Price Discovery & Dissemination z Robust Trading & Settlement systems z Management of Counter party Credit Risk z Self Regulation to ensure z Overview of Trading and Surveillance z Audit and review of Members z Enforcement of Exchange rules

20

An Exchange provides a a common meeting ground for all industry participants

National Level versus Regional Exchanges z

Multi commodities

z

Transparency z Screen based trading Professionally run Best practices pursued Innovative products Large expanding volumes

z z z z

21

Current Mindsets z z z

Commodity exchanges are speculative markets not meant for actual users If commodity exchanges do not enable physical delivery, they are then only for speculators Awareness lacking amongst actual users z

z

22

Interest rate, exchange rate risk actively managed, but not commodity risk

Main impediments centred around safety, transparency and taxation issues

Benefits to actual users z z z z z

23

Farmers: Price hedging Contract farmers: Price hedging Metal manufacturers: Forward sale of production Metals consumers/farm produce consumers: Forward purchase of inputs Gold users: Hedging price for future

Price variations (Average annual %) Cotton

24

Zinc

Steel

Rubber

Copper

FY00

1.5

10.5

6.1

3.3

5.6

FY01

6.6

-0.03

-8.6

-1.9

8.0

FY02

-6.0

-24.8

31.2

5.9

-15.4

FY03

-2.3

-6.4

9.5

21.8

3.9

FY04

11.5

15.7

36.0

42.2

29.0

Industry Perspective Industry

Raw materials PBT (FY03) to COS % Rs cr

Textiles

62%

Steel

54%

+200

-1667

Edible oils

88%

148

-566

Gems and jewellery

86%

76

-216

Source: CMIE 25

Impact of 5% rise in raw mat prices (Rs -2265 cr) - 1429

Do actual users use Exchange platforms for physical delivery? z

They can, but do not.. View taking z Stocking sub-optimal z

z

Reasons z z z z z

Grades Logistics costs Sales tax/octroi Set off not permitted Most actual users use exchanges for hedging z

26

For commodity needs, bilateral arrangements preferred

Investors’ story..

27

Investors z

Portfolio diversifiers Lower margins z Lower risk z Better risk-adjusted returns z

z z

28

Mutual funds on the anvil PDs have sought enlargement of roles

Volumes in Commodity Derivatives Worldwide

z

Derivatives volumes of non-US exchanges in the last decade has been increasing

Source : World Federation of Exchanges, various websites

29

Comparison of Commodities & Equities zAverage

20 day historical volatility (1/91 till 8/02)

Equity Commodity

z 30

Commodities have less volatility compared to equity

Volatility comparison - Summary Average annual volatility z Sensex or Nifty - 25-30% z Govt Sec Index - 5-10% z Gold - 12-18% z Silver - 15-25% z Cotton - 10-12% z Oil seeds - 15-20% z

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Commodities are less volatile compared to equity market, but more volatile as compared to G-Sec’s

Correlation: 1997-03 Correlation coefficients in Indian m arkets Gold Silver Stocks Bonds Gold 1 0.089 0.206 0.741 Silver 1 -0.099 0.146 Stocks 1 0.112 Bonds 1 Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index

Benefit of diversification can be seen from the 32

Risk Adjusted Returns

Risk-Adjusted Returns:1997-03 Portfolio structure 100% Stock Portfolio Stocks (50% ) & Gold (50% ) Portfolio Stocks (50% ) & Silver (50% ) Portfolio 100% Gold Portfolio 100% Silver Portfolio 100% Bonds Portfolio Bonds (50% ) & Gold (50% ) Portfolio Bonds (50% ) & Silver (50% ) Portfolio

33

Ab s Cum ulative Returns

73.70% 47.80%

Risk of Risk Adjusted portfolio Return 3.017 24.43% 3.326 14.37%

3.634

48.30% 13.29%

21.80% 22.90% 25.20% 23.50%

7.92% 8.79%

2.001 1.742 3.182 2.673

24.00%

6.58%

3.647

NCDEX Value Proposition…

34

Why NCDEX z z z

Create a player without trading interest Foster professionalism and transparency Inculcate international best practices Demutualisation z Technology platforms z Information dissemination without noise z Low cost solutions z

z z

35

Nation-wide reach and consistent offering Bring together names the market can trust

NCDEX – Current shareholders

17%

17%

17%

10%

17%

14%

7%

Canara Bank to take additional stake 36

Consortium brings …. z z z z z

37

Institution building expertise Commitment to the agri sector Nation-wide reach Ability to bring in capital Technology and Risk Management skills

Governance z z z z

38

Independent Board Professionally managed organization Executive Committee Other Committees z Membership z Product z Risk Management z Arbitration

Commodities selected in Phase I Bullion

zGold zSilver

zSoya

bean

zSoya

oil

zRapeseed/Mustard

Agri-Commodities

zRapeseed zCrude zRBD

39

/ Mustard Seed Oil

Palm oil

Palmolein

zCotton

Seed

Commodities introduced in Phase II z z z z z z

40

Rubber Jute Pepper Chana (Gram) Guar Wheat

Commodities in Phase III Rice, wheat z Turmeric, chillies z Base metals z

z

Aluminium, Copper, Zinc and Nickel

Coffee z Tea z Other edible oil products z

z

Groundnut, Sunflower, Castor

Seed, oil & cakes z Energy products z Commodity Indices and weather derivatives z

z

41

Agri-commodity index, Metal Commodity index

NCDEX Landmarks….

42

Spot Prices: The only real-time source z NCDEX initiatives – Price discovery z Spot price polling from traders, exporters, mandis etc with multiple polling centers z Partners: CMIE and CRISIL market wire

z Bootstrapping to eliminate manipulation effect z Price collection from trade associations

The challenge ahead is price dissemination 43

Special mention by Economic Survey z z

Innovative spot prices polling process introduced by NCDEX Robustness of systems z

z

44

Convergence/closeness of the traded futures prices and the final settlement prices

“Has given a new level of near real-time access to reliable prices from agricultural markets in the country. This marks a milestone for the statistical system in agriculture, and sets the stage for modern development of commodity derivatives markets despite the presence of a fragmented OTC spot market”

Price Dissemination: Implemented z Real-time price dissemination z Extranet z Website (www.ncdex.com) z Tie-up with Reuters, Telerate z Corporate tie-ups for rural kiosks z ITC E-choupals

z Newspapers, Agri journals z AgmarkNet z Kissan call centres

Basic idea is to encourage farmers to choose cropping pattern based on future and not past prices 45

Price Dissemination: In process z Proposed vehicles of price dissemination z APMC boards at mandis z Agri extension service providers z Mahindra Shubhlabh, Rallis etc

z Govt. office outlets z Post offices z z

46

Bank branches FMCG dealer points

NCDEX spot price can be used for valuation of collateral for commodity- based funding by financial agencies

NCDEX Approach to Warehousing z Accreditation of Warehouses: parameters based z Promoting Collateral Management z The McDonald Approach

z Robust grading by international agencies like Geochem, Dr. Amin etc. to assure quality z Developing a scientific grading process for cotton z Project in co-ordination with CIRCOT

z Dematerialisation of Warehouse receipts z Reduction in physical/repayment risk to lead to lower lending rates

47

Pilots in Futures z NCDEX project with GujCot z Hedging mechanism for farmers on NCDEX platform z GujCot covers price risk z Facilitates price dissemination at grass roots level

z Two more cotton projects in Hyderabad and Warrangal

Options for farmers can be a substitute for MSP

48

Some facts z 1st to carry out delivery through dematerialized warehouse receipt for Feb’04 Gold contract z In June, 21 kgs of gold and 10 tons of pepper delivered z Warehouse accreditation z Spot price data base built for last 10 years z Presence in over 135 centers z Over 1800 trading terminals z 300 members enabled for trading as against target of 125 z Evening session of trading introduced on Feb 23, 2004- up to 11.30 p.m. z Saturday trading also introduced Working towards round-the-clock trading… 49

Activity on NCDEX z Recoded peak traded volume of Rs 283 cr on July 7 z Turnover of Rs 566 cr z 60% share of bullion and agricultural commodities

z Has highest open interest ratio to volume traded in gold and silver z Average daily number of trades is around 6,500 z Highest was above 17,000

z Average daily number of orders is around 10,000 z Highest was around 37,000

z Average daily client participation of around 650

50

Looking ahead…We are

51

Educating corporates Industry (data of 1500 companies)

% of Raw Material cost to Aggr. Turnover

Agro/ FMCG/ Edible Oils

70%

Auto/Auto Ancil.

90%

Chemicals

65%

Construction

40%

Consumer Goods

50%

Engineering/Industrial G.

50%

Fertilizer/Pesticides

45%

Livestock/Leather

65%

Metals/Mining/Steel

70%

Packaging

60%

Oil/Petro/Refineries

85%

Sugar

65%

Textiles

90%

Transport

40%

Source of data – ICICI Bank Corporate Infobank

52

Industry in India runs the raw material price risk, going Forward they can hedge this risk

Spreading awareness z Awareness Program during January – June 2004 z Over 75 programs z 5000 Participants

z Expect to conduct 200 programs during FY05 z To cover over 20,000 participants

z Certification Exam already being conducted by NCFM

53

Seeking changes in Banking Regulation z

Aggregators z

z

Accreditation of warehouses and quality of products z

z

Lending against commodities to be considered priority sector lending

Banks to lend against bullion z

54

Furthers bank lending against commodities

Change in Priority sector norms z

z

Banking Regulation Act to be modified

Need for hallmarking

Working towards Extension of players z

Mutual funds z

z

FIIs z

55

Commodities as an investment diversifier Either directly or through Indian arm

z

PDs

z

Insurance firms

z

Pension funds

Changing the face of Warehousing z z z

Electronic warehouse receipt (EWR) to be legally recognized EWR to be a negotiable instrument Depositories Act to be amended to cover commodities z

56

SEBI to notify that FMC is regulatory body for demat commodities

Inducing Policy changes z

Introduction of options z

z z

Will ably substitute the MSP programme of government

Permit weather derivatives Redefining commodities Goods not covered under ’securities’ z Products not covered under SCRA z

z

57

Physical delivery not to be mandatory

Budget proposals relating to Commodities z z z

Integration of commodity market with securities market Service tax on forward contracts to affect commodity brokers Significant omissions in light of other announcements Weather derivatives z Bank investment in commodities z

58

Thank you

59

Polling centres

60

Commodities

Priority Center

Non-Priority Center

Mustard Seed / Rapeseed

Jaipur

Alwar, Sriganganagar

Expeller Mustard /Rapeseed Oil

Jaipur

Sriganganagar, Alwar

Soyabean

Indore

Nagpur, Mumbai, Dhar, Dewas

Refined Soya Oil

Indore

Mumbai, Nagpur, Dewas

Crude Palm Oil

Kandla

Kolkatta

RBD Palmolein

Kakinada

Mumbai, Chennai

Medium Staple Cotton

Bhatinda

Abhor, Sirsa

Long Staple Cotton

Ahmedabad

Surendranagar, Kadi (Guj)

Polling Centre (Contd.)

61

Commodities

Center

Chana

Delhi, Indore

Guar

Jodhpur, Bikaner

Jute

Kolkata

Pepper

Kochi, Allepey, Angamaly

Wheat

Delhi, Khanna, Karnal, Bareilley, Kanpur, Shahjahanpur

Rubber

Kottayam, Kochi, Ernakulam, Palakkad