Imp Comm Mkts > Commodities Markets Imp

Commodities markets will sustain only on strong agriculture- Dr. R.Radhakrishna Mumbai, October 11 - Both Prime Minister Manmohan Singh and Mr. Sharad Pawar, Minister of Agriculture, recently emphasized a need to strengthen agriculture in India to give a fair deal to farmers and ensure livelihood for over 60% of population living off agriculture. They also called for stepping up investment in agriculture and allied activities by pointing to the fact that GDP growth would have been better if agriculture had done well in 2004-05. They rued the fact that agriculture grew by a measly 1.2% in 2004-05. Their regret has not come a day too soon. In fact, in many quarters deceleration in Indian agriculture in recent years has become a cause for concern. Dr. R. Radhakrishna, eminent agricultural economist, Director, Indira Gandhi Institute of Development Research, Mumbai, and former member of the Government of India's Committee on `Long-Term Grains Policy' 2001-03', under chairmanship of Dr. Abhijit Sen, says, " I can understand a need to step up economic growth. A rise in GDP growth rate does impress foreign investors. But high economic growth need not necessarily mean high economic development. Social and human dimensions of economic development are more important than growth numbers. That will come only when agriculture grows on a sustainable basis. Of course, it is arguable that even the economy can grow without a strong agriculture as EU countries and Japan show. In these countries less than 10% of population depend on agriculture but farmers lobbies are very strong in influencing policies. But in India where close to 22% GDP comes from agriculture and 60% plus of population draws its sustenance from agriculture, farmers have little influence on policymaking. I would say Indian agriculture must grow at a healthy rate; sustained by steady public investment and research and development. Even commodities markets in the country need a modern , viable and steadily growing agriculture as it is the link between real and derivatives markets (futures)." He spoke to S.R.Kasbekar and Laxmikant Khanvilkar of the commoditiescontrol.com on a number of issues relating to Indian agriculture. Excerpts : Q: Prices of most commodities have been on the rise recently, do you see a commodity cycle in the making? A: It is true that some commodities have seen a rise in their prices. But I do not think there is commodity cycle of long duration such as 15-20 years. In fact I think the next 2-3 years will see a decline in prices of agricultural commodities. Of course, if subsidies are withdrawn prices will go up. Q: Commodities market being price sensitive, what role do you see for derivatives and futures trading? A: To be very frank not much. Derivatives and futures trading markets have very limited scope in determining commodity prices, particularly given the fact that domestic prices are relatively higher than those prevailing in international market. Not to forget is the fact that derivatives and futures have their own functional values. Q: But there is a feeling that commodities exchanges help farmers to get a better price, what is your opinion? A: Commodities markets may help in mitigating risk but I fail to see how can these raise farmers' income. At best there may be less volatility in prices. Prices alone are not important. A number of non-price factors such as technology, productivity, investment etc are crucial. In recent years , in the absence of new technological breakthrough, productivity in agriculture has declined for most crops. Yields have reached a plateau in most agricultural crops. In Punjab and Haryana belt this is evident more prominently. The belt also suffers from ecological hazards, resulting from excessive exploitation of surface water to feed water-intensive crops such as rice and wheat. Productivity has declined and more and more inputs such as chemical fertilizers are required to maintain productivity. This adds to cost of production. Because of a decline in productivity and lower return as a result of higher input costs , farmers fail to make enough money. Agriculture in Punjab has grown by lower than 2% a year. There are instances of framers committing suicides in Punjab much like in Andhra Pradesh and Maharashtra. Q: What is the reason behind this state of affairs in Punjab as elsewhere in India? A: The basic reason is a severe decline from the mid-80's in public investment in agriculture in the country. Gross capital formation as percentage of GDP in agriculture has declined to less than 2% , even lower than that in IT sector. This is pathetic. The deceleration in planned investment in agriculture started from the 8th five year plan particularly in irrigation and agricultural machinery.

Another issue is one of credit - short-term and long term loans or capital loans. Of total crop credit, co-operatives account for two-thirds. In total bank lending, co-operatives account for 25%, and rural regional banks (RRBs) just about 6%. Scheduled commercial banks (SCBs) do not lend much to agriculture for fear of NPAs. SCBs have not fulfilled their target of 18% loans to priority sectors. Therefore, SCBs must step up credit to farmers, especially marginal and poor farmers. It is a fact that small and marginal farmers who get loans at a high interest rate of 14%, rarely default. But treating them on a par with urban borrowers such as housing or consumer durables is not fair. I see a major problem facing SCBs in lending to small and marginal farmers is the high cost of transactions involved in servicing small accounts, say of below Rs 25,000 or so. That is why you will find the number of small accounts serviced by the SCBs has declined steeply over the years. The trend must be halted to ensure a fair deal to these farmers. Q: Why do you think this is happening? A: This is mainly because agriculture is a state subject. As it is, states are in a parlous state of fiscal deficits. They can not force banks to lend to agriculture. Even NABARD that is supposed to fund Rural Infrastructure Development Fund has not fared all that well. All in all, therefore, Indian agriculture suffers from poor infrastructure and farmers from lack of credit. Together these factors hamper agricultural productivity. Declining Gross Capital Formation (GCF) in agriculture worsens it. Q: What should be done then to improve the situation? A: I feel strongly that public investment in agriculture must go up. Gross capital formation in irrigation and machinery must improve. Private sector will not do this for obvious reasons. The central government must nudge states to do so. The centre can do so by linking general reforms at the state level with reforms in agriculture. The release of central funds to states must be linked to the degree of state level reforms in agriculture as well as in water as is done in China. The North-Eastern states still suffer from poor investment. In these states, as in Orissa and Bihar per capita investment in agriculture is poor. In Punjab annual per capita investment in agriculture is around Rs.2,000, in Bihar and Orissa it is Rs.250 and in Assam it is Rs.50! So banks must come forward to stimulate investment in agriculture. There is no alternative to a technological breakthrough in agriculture. Sadly, investment in technology has been stagnant. No worthwhile agricultural technology has emerged from institutions engaged in agricultural research. So my agenda to beef up agriculture in India includes: • • •

Research and Development must be beefed up. Investment in North-Eastern agriculture must be increased so that a large number of tribals in those states earn a fair livelihood. Institutional credit including that from SCBs to agriculture must go up.

More attention must be paid to dry land framing, crop diversification, technological breakthroughs and water conservation and utilisation in the future to stabilise Indian agriculture. Q: Contract farming is a relatively new concept in India. What is your view in this regard? Is the country ready for this change? A: Contract farming is a good concept but legal issues need to be addressed. Contract has to be enforced and should be binding on both parties. It should be beneficial to farmers and should be a vital link in supply chain development. Social orientation is must in any contract farming but that should not be a barrier to profit making. Farmers have to be informed in details about pros and cons of contract farming (media can play an important role here) and adequate measure should be taken to spread the awareness about legal issues. In all, contract farming is a good concept and, hence, calls for strong legislation. There are economies of scale in contract farming as well and the interest of all stakeholders should be taken care of. Commodities to surpass equities in the next 2-3years - Dr. Kewal Ram Mumbai, Oct 07 - Even when stock exchanges are enjoying an unprecedented boom and increasing investors’ wealth, it is the commodities that are making a steady progress. Commodity exchanges have not logged as much volume of trade and

as much value as securities have done, but there is no doubt that in the next five years or so the commodity exchanges will overtake stock exchanges in terms of volume and value. Commodity exchanges have made rapid strides since 1999. For a long time since the Forwards Contract (Regulation) Act 1952, commodity trading was in disrepute because of unregulated speculative activity. The attitude towards commodity trading was one of suspicion and frown. Now things are changing for the better as both the government and other stakeholders such as traders, investors, farmers, regulators and financial institutions have realized that it is not enough to set up commodity exchanges but a strong regulatory mechanism should be in place for orderly functioning of these exchanges so that both individuals and institutions participate on a large scale to bring about price discovery and stability to the market. The ultimate beneficiaries in this scenario will be farmers who deserve a fair deal in a predominantly agricultural economy of India. Dr. Kewal Ram, Member, Forward Markets Commission, spoke to the commoditiescontrol.com about the tremendous growth potential of agricultural commodities in the country on the sidelines of “an awareness programme on Introduction to Commodity Markets: Utilities & Opportunities” organised by the Indian Merchants’ Chamber, Mumbai on October 7, 2005. Commoditiescontrol.com: What is your assessment of commodities market in the country? Dr Kewal Ram: There is no doubt that the situation is a far cry from the one that prevailed towards the end of the 1960s. Then, commodities trading was looked upon with suspicion. Traders were seen more as speculators in commodities rather than market makers. This was because of high speculation that was order of the day then. Largely, wrong perception owed to the absence of regulatory mechanism. Today the situation is different as there is a regulatory mechanism in the form of Forward Markets Commission. But there is still a need to strengthen regulatory mechanism. There is also another aspect. No market can thrive without speculation; much less futures. Care should be taken to see that unrestrained speculation does not create unwarranted volatility in prices to the detriment of stakeholders. Commodities are no longer seen as speculators’ heaven as more and more investors - both individuals and institutional coming into commodities markets on a large scale. That is why you will see the volume of trade on commodities exchanges such as NCDEX, NMCE and National Board of Trade (NBOT) has reached Rs 7.5 lakh crore or (0 billion ) during the first five and a half month till September 15 of the current fiscal. The trading volumes on commodity exchanges surpassed that of futures on the capital market in August 2005 for the first time in the history of the domestic derivatives in the market. If the current trend in growth continues I have no doubt that the trade volume will cross Rs.10 lakh crore by 2010. Do you not think regulatory supervision of the commodities exchanges is a lot weaker than that of stock exchanges? What role do you see for institutions such as FMC and others in the commodities exchanges? Dr. Kewal Ram: I am absolutely convinced that the future of commodities in the country is bright. Yet I also feel strongly that for orderly functioning of commodities exchanges there is a greater need for efficient regulatory bodies. SEBI and other bodies have regulatory powers over the functioning of stock exchanges in the country. But it would be a mistake to draw a parallel between these two sectors. After all stocks are derivatives and commodities are real. So I feel there is a need for greater participation of financial institutions, banks, FIIs and general investors in commodities spot and futures, apart from of course, traders. This will ensure broadening as well as deepening of the commodities markets. Both price discovery as well as a fair return to farmers, the real actors in the entire drama, will be possible if there is wider participation of these bodies. We, at FMC have prepared a plan to strengthen regulatory mechanism more or less on the lines of SEBI but differing in some details in view of differential nature of stocks and commodities. After all the primary function of a commodity exchange is to facilitate the spread of correct information for all stakeholders so that transparency in transactions makes price discovery possible. A strong regulatory mechanism is also needed to check price-rigging, circulatory trading etc. Forward Contract (Regulation) Act 1952 is being amended to factor in changes in subsequent period. Once a legal framework is put in order commodities exchanges will become better and more efficient conduits of right information for stakeholders. We have developed a software somewhat like SEBI’s to facilitate online information. But it is not fair to compare our software with SEBI’s as that body has spent Rs.20 crore on it. It has also a long experience in stock regulation. Commoditiescontrol.com: Your final remark on the prospect of commodities market in India.

Dr. Kewal Ram: Prospects for commodities in this country is really bright. We have already overtaken the Mumbai Stock Exchange (BSE) in terms of value. I am sure that in the next 2-3 years will see an exponential growth of commodities trading. No reason for current fluctuations in mentha oil except speculation & cornering Mr Vishnu Kapur is the CEO of Neeru Enterprises, A government recognized export house located in Rampur UP. What is the supply situation (production and stocks)? Production is estimated at 15000 to 16000 tonnes for 2005-06 while the stocks are estimated in the range of 6000-7000 tonnes. What is the main season for mentha oil cultivation? Sowing starts in January, transplanting is done in March-April and harvesting is done in June-July. Major marketing season falls between July-October. What are export prospects for mentha oil? This time Nil for Mentha Oil as well as for their finished product. What is the composition of exports? About 80 per cent of mentha oil exports are in crystal and powder form, five per cent of exports are in the form of crude mentha oil and the remaining 15 per cent is in the form of other products of mentha oil. What do you think about the current trends in prices? No reason except speculation & cornering Is there any specific reason for the current rally? Possible reason is the trading taking place at MCX or NCDEX. Is there any substitute for mentha oil? No Substitute How do you think the market will move in the near future? It depends on speculation on MCX and NCDEX, we were doing well & our trade was earning approximately Rs 600 crores of foreign exchange but now, it looks that we can't export due to the present fluctuations in the market. What are the prospects for next season? Raising of nursery has begun in some areas whereas it will be started at all places within a fortnight. Inter-cropping with wheat has already started in a small extent of area.

Kisorilal F Jhunjhunwala, President, East India Cotton Association ( EICA ), has been in the family business of raw cotton since 1961. His group company, Jhunjhunwala Company, and others deal in raw cotton in domestic, export- import and other businesses. He says Indian cotton economy is in transition as it has transformed during the last three years, in terms of production, productivity and quality of cotton. However, India has to go a long way before it can supply high grade cotton quality and strengthen its position in the world market. Mr K Jhunjhunwala talked to Vijay Trivedi of commoditiescontrol.com. on a number of issues relating to cotton economy in India in the context of the international cotton scenario. Excerpts:

Why, despite bumper cotton crop this year, are cotton prices bullish ? Cotton prices across the mandis were on average marginally above the Minimum Support Prices (MSP) in the recent past. However, currently cotton prices have moved up in the local markets and on futures exchanges as well. It has been seen that local mills and exporters have a number of orders on hand and accordingly cotton prices are currently up in the market.

Further, international cotton prices play a vital role for local players, and currently, on New York cotton futures prices are more or less sluggish. However, locally higher consumption by the mills and export orders have kept cotton prices upwards. Looking at the last year's cotton prices in the domestic market, prices have more or less remained range- bound. In fact, a large bulk of transactions is to take place in December as pressures on trade has to come about. Currently, at the markets, mostly local small mills and exporters are active aggressively. In the long term prices would depend upon the demand from big mills. This apart, China's decision to cover its cotton requirements would also play a big role in case of future price behaviour on the domestic as well as international markets. What is the state of market arrivals of cotton? According to estimates, daily cotton deliveries have at times reached around 1,00,00 to 1,25,000 bales, comprising 30,00040,000 bales in the Northern Zone; 40,000-45,000 bales in Gujarat, and the rest in Madhya Pradesh, Maharashtra, Andhra Pradesh and elsewhere. Cotton arrivals have taken pace along expected lines and so far there is no report of pest attack on cotton crops across the nation. Some patches of pest attacks may have been there, but there is no confirmation of the same as yet. What do you have to say about production and trade structure of cotton? The Indian cotton scenario has metamorphosed during the last three years, in terms of production, productivity and quality of cotton. During the cotton season 2002-03, the average productivity per hectare was 301 kgs, which has since surged to 463 kgs in 2004-05, recording a rise of 54 per cent. Based on the estimated area under cotton cultivation and projected production in the current season 2005-06, the productivity is expected to rise to 480 kgs per hectare. According to EICA's analysis, the productivity will reach an impressive level of 660 kgs per hectare in 2009-10. This will translate into production of 350 lakh bales of cotton. As per reports, the cotton growing area during 2002-03 to 2004-05 has increased by 16 per cent, the production has escalated by 79 per cent. This is mainly on account of 54 per cent jump in productivity. Where as cotton consumption has gone up by 17 per cent, exports have dramatically gone up too, imports have declined. Market sources say that from the local markets till date around seven lakh cotton bales have been contracted for export. And many more export orders are in the pipeline, but it is very difficult to put a figure on it. India's raw cotton export on an average are placed at around 10-12 lakh bales. India can witness higher cotton export in days ahead. So far as import is concerned, India normally imports approximately 7-12 lakh bales that, too extra long staple (ELS) fibre and other grade varieties. This year cotton import may be on a similar scale as it does not cultivate much ELS varieties and as there is no demand for the same as of now. What do you think of trends in the future? Recently, the South India Textile Research Association (SITRA), Coimbatore, has brought out a publication, 'Quantitative and Qualitative Requirements of Cotton by 2010'. According to the SITRA study total quantity of cotton requirement by 2010 will be 305 lakh bales. This does not take into account cotton consumption in non-mill sector and exports of raw cotton. If these aspects are taken into account, the requirement of cotton will be around 350 lakh bales. This almost matches EICA's estimate of cotton production of 350 lakh bales in 2009-10. Below is given quantitative requirements of cotton for different count groups as worked out by SITRA:

Cotton for different count groups Sl. No.

Count Groups (Ne)

1 2 3 4 5 6 7

1s -10s 11s - 20s 21s - 30s 31s - 40s 41s - 60s 61s - 80s 81s and Finer Total

Quantity Required for 2009-10 (Lakh Bales) 38.9 57.7 65.4 88.0 38.4 9.5 6.6 304.5

How to cater for India's needs of long and extra long staple cotton? It has been observed that quality of long and extra long staple cotton has not kept pace with the requirement of modern high speed spinning machines. Consequently, the consuming industry has to depend on imported cotton. In the era of globalization, while import in itself cannot be faulted, India has the capacity to produce superior quality of such cotton, which is not being exploited on a required scale. In fact, India has the reputation of producing best quality extra long staple cotton like Suvin and DCH. I strongly feel that all the stakeholders should come together to revive these varieties and explore other long staple cotton. I am confident that cotton scientists and researchers of India will take up this challenge and chalk out a suitable strategy for augmenting the production of high quality cotton of long and extra long staple varieties. How do you place India's share of cotton cultivation in the world? It terms of area under cotton cultivation, India accounts for 25 per cent of the global acreage of around 35 million hectares. However, in terms of production, India accounts for 17 per cent. This is primarily because of lower productivity of around 463 kgs per hectare as against world average of 733 kgs per hectare in 2004-05. This underscores the need for accelerating our efforts for rapid improvement in productivity. Is cotton consumption increasing in India? World cotton consumption increased by 5.5 per cent in 2004-05, the largest expansion since 1986. The increased consumption came about because polyester prices were higher than cotton prices. Having regard to high level of oil prices, this trend is likely to continue. Consequently cotton consumption is expected to rise in future. The share of cotton consumption in the total fibre consumption at the global level hovers around 38 per cent. In respect of India, the percentage share of cotton consumption in 2004-05 was 58 per cent as against 54 per cent in 2003-04. With the elimination of quotas from 1st January, 2005 and immense potential for exports of cotton-based products, especially home textiles and apparel, cotton consumption is destined to go up. In fact, several units, which were producers of man-made and blended yarns, have switched over to cotton. Further, there is considerable expansion of production capacity to cater to the rising demand for cotton-based products in overseas markets. All these developments augur well for the future of cotton economy. Why is there thin trading in cotton futures on MCX, NCDEX ? Mostly, on both the exchanges currently there is thin trading or hardly any trading taking place, which is a disturbing factor for the exchanges. Even the EICA faces similar problems of thin trading and we wonder why players are not coming forward in a large number. Most cotton players know very well know that the futures as an instrument is good for hedging risk against uncertainty. Currently, traders are active, but still companies other cotton fraternity, should take part as such a tool is available to them. EICA has been trying to encourage various cotton players to take part in the same. But it is now up to the industry to consider the option.

he regulatory body, Forward Market Commission (FMC), should encourage the industry players by cutting down on procedural formalities for registration and other stringent rules and regulations. This may help to increase their participation in trading volumes on future exchanges. “No market is an island”, commodity markets worldwide exist because of arbitrageurs: Mr Venkataraghavan Recent volatile moves in commodities markets left everybody gasping for an explanations. While few would have managed to come to terms with the volatility - a necessary element in the market - large section of investors still fill undone by such moves. In an effort to understand the dynamics of commodity derivative markets it is apt to raise such question to one who keeps an eye on derivative markets movement and what prompts market to behave that way. Mr Srinivasan Venkataraghavan, Vice President - Head Research and advisory practice, Altos Advisory Services Ltd. New Delhi/Hong Kong that deals in commodity research and advisory services, replied to email queries of Mr Laxmikant Shridhar of TV18Commoditiescontrol.com. He explained how the different parameters; from fundamentals (demand/supply) to volatility, extended support to recent surge in commodity prices. He said “No market is an island”, commodity markets worldwide exist because of arbitrageurs who seek to profit out of the vagaries whenever the interplay between supply and demand arises. Here are excerpts from his email replies: Q: Last year was the best for commodity trading (derivative markets), what factors you think has prompted to rejuvenation in commodities market? A: Speaking from the perspective of global markets, I can think of only one reason the “ROGERS COMMODITY INDEX” (RICI) which suddenly got the attention of most hedge fund managers who realized that their jobs where in danger!!, only the KOSPI (the Korean index) did better than the Rogers index last year (2005). Since its inception in August 1998 the Rogers Index of 35 commodities is up by more than 200%, and delivered an annualized compound return of 18.8% up to the end of March 2005. This is the best performing index of any of the major global capital market indices, nothing has done better. The index was developed by Jim Rogers to be an effective measure of the price action of raw materials on worldwide basis. The broad based representation of commodities contracts is intended to provide two important characteristics: The large number of contracts and underlying raw materials represent "diversification" and the global coverage of those contracts reflects the current state of international trade and commerce. Its manager is the Wall Street legend Jim Rogers who founded and managed the Quantum Fund with Georges Soros in his younger years before retiring at the age of 38. The commodities fund was originally born in 1998 when he was going off on a trip around the world and wanted to leave his funds safely, invested while he traveled. Mr. Rogers was also one of the first investors to realize that a 20 year bear market in commodities was over and that a bull market was about to begin, albeit his timing was out by a few months at the beginning. Many more analysts are now starting to share this view, and Mr. Rogers reckons the bull market for commodities has another 13 to 20 years to run. So there is still plenty of time for investors to jump aboard this particular bandwagon. From an The reason for success of the Indian derivatives markets are • • • • • • • •

Indian

perspective;

Government’s mandate for Futures Exchanges India - Largest Consumer - Producer - Exporter – Importer of several commodities Large size intermediaries to penetrate commodities market, which was struggling with cartelization and absence of transparent price discovery. Banks to finance commodities – Futures a secured route, Using Exchange Network for various products & Services BPO & Trade Interest will attract International players: MCX tie up with TOCOM, DMCC, Baltic Exchange,NCDEX with Chinese exchanges etc, Geographically a strategic Hub for value added services & food processing New class of commodity Traders & Value Investors (thanks to Roger Indices et all)

• • •

Commencement of National Online Multi Commodity Exchanges – to ensure a transparent price discovery and risk management mechanism in Agri-commodities. List of commodities for futures trade – increased from 11 in 1990 to over 100 in 2003. Futures trading in Bullion, Industrial Commodities, Agri-Commodities has picked up with involvement of actual hedgers. • Institutionalization of agriculture - Contract Farming, Corporate Farming. • Amendment of the APMC Act for modernizing and liberalizing marketing of agri-produce. • Reforms with regard to sale, storage and movement of commodities initiated. • Shift from administered pricing to free market pricing – WTO regime. • Enhanced involvement of banks in agriculture – Warehouse Receipt linked financing.

Q: Do you think the active trading interest in commodities derivatives is guided by strong fundamentals (demand/supply dynamic) or purely technical play? A: “No market is an island”, commodity markets worldwide exist because of arbitrageurs who seek to profit out of the vagaries whenever the interplay between supply and demand arises, as long as a class of investors namely “arbitrageurs” exists there can never be any markets, which exists independent of the above two cases. Q: Volatility ruled the highest in certain commodities. Do you see volatility to be a stumbling block in commodities emergence as investing/speculative avenue? A: Markets exist because different people think differently on the SAME thing, this is the basis of Volatility. There are segment of people for some volatility is a must for some it doesn’t exist (lack of awareness) and for others it doesn’t matter (the hedged categories), this is a classical case of “Half full or Half empty”. As long as market participants have contingent plans under the unlikely event of high beta, there is no problem. The matrix below explains how different players profit out of participating in the derivatives markets volatility or no volatility! Players Price Discovery Farmers Producers Manufacturers

Action

Benefit

Follow Futures Prices Follow Futures Prices Follow future price's

Purchasers Price Risk Management Farmers

Follow Futures prices

Decide on cropping Decide on Production intent Decide on manufacturing intent. Decide on procurement intent

Farmers & Traders Agro Lenders

Exporters Importers Domestic Producer

Sell in futures for upcoming crop Sell in futures for Stored Quantity Sell in futures for value of credit exposure. Buy in futures for Export Commitment Sell in futures for Import commitment Sell in futures for Output requirement

Protection against price fall Protection against price fall Protection against NPA in the event of default by borrower due to falling price of commodity Protection against price rise Protection against price fall Protection against price fall.

Domestic Users Liquidity Seekers Investors

Buy in futures requirements Invest based on cheap value.

Speculators

Speculate on High Intra and Inter Seasonal price variation

Arbitrageurs

Take counter positions in Spot and Futures and also amongst the Commodity Exchanges

for

Input

High Profit probability on value realization. High profit probability on right market prediction and Volatility squeezes. Earn on price disparity in different markets

Q: What influence do you see in commodities prices (crude, gold, silver) having on World Economy during 2006? This is in light of crude oil prices expected to average above a barrel. A: I would like to say that high commodity prices (especially the precious metals) prevalent currently is the market discounting the “world economy outlook 2006”. The US is running a current account deficit of around 6.5% of GDP; a level considered to be unsustainable by the IMF over the longer term. This deficit is a consequence of global excess savings (the Global Savings Glut and the eager willingness of US consumers to absorb foreign savings to finance their robust consumption). As Kambar in Ramayana puts it “Kadan Petrar Nenjam Poll Kalanginan Ilangya vendhan”(Like a borrowers heart melts in sorrow looked Ravana the King of Srilanka), Ben Bernanke assumes his post as the new head of the Federal reserve this January mid, with no other go but to print more notes to save the Great Nation from sinking further, almost any economist worth his salt believes that Inflation ahead is a no brainier. In the near term this imbalance can persist for as long as the rest of the world remains willing to finance the US current account deficit. Albeit in the medium term an adjustment must take place. In its most benign form, this adjustment would occur through a gradual rebalancing of relative savings rate. There is however, a sure possibility of Hard Landing ahead. This could occur if foreign investors in US treasuries (read China) decide that the US authorities are incapable of leading the savings rate adjustment processes and that the market should act instead. This would lead them to liquidate their dollar denominated investments and force the currency to depreciate rapidly. The US Hard Landing and The Asian EconomiesThe impact on Asian economies of a fall in the value of the dollar would not be as significant as in the other regions. Latin America would be the worst hit with a fall of almost 5 percent points lower GDP growth for every 10 percent depreciation in the value of the dollar by the year 2009. Africa would be the next worst hit, followed by the eastern Europe. Only the OPEC bloc would remain untouched because the fall in the trade weighted value of the American currency would be against the US’s main trading partners which excludes most countries from the OPEC bloc. The reason why most ASIAN nations (barring Hong Kong ,Singapore, Taiwan and Philippines) would not be badly hit is because a large portion of its trade is within other Asian countries, which provides significant insulation from the loss of competitiveness against the US. The impact would be least on India and China which is not technically a 100% “free market” as yet, probably why the rationalization for the liquidity chasing the Indian and Chinese businesses. Q: Agri-commodities such as soybean, sugar, pulses etc are looking to enter different trajectory - prices moving

constantly higher-were do you see them stabilizing in the near to medium term? Please enlighten us on their fundamental outlook. A: May 2004 saw a historical high of Soya complex at 1000+ Usc/Bushel levels and this was purely based on the Consumptive glut based on the exaggerated Chinese demand, but all of a sudden what appeared to be irrational a few years back looks to be a distinct possibility with the Chinese appetite not seeming to slow down. Speaking purely from the Demand Side in the Indian context commodity prices are looking to enter into a new trajectory thanks to a single governmental policy, which is being overlooked by the most market participants, THE NATIONAL RURAL EMPLOYMENT GUARANTEE SCHEMEThe National Rural Employment Guarantee Bill, 2004 promises wage employment to every rural household, in which adult members volunteer to do unskilled manual work. Through this Bill the government, aims at removing poverty by assuring at least 100 days' employment. The word 'poor household' was replaced by 'household' for guaranteeing jobs in every household for one person. The original Bill had laid down that it would be applicable only to families living Below the Poverty Line. Jean Dreze, a Belgian economist, who is currently with the Delhi School of Economics, is the chief author of the scheme. The new employment guarantee scheme provides an indispensable lifeline to the millions of poor in the rural areas of the country. This social security measure, for the first time makes the right to work a fundamental legal right - a new, radical deal for India’s poor. The impact of this scheme would be phenomenal on the commodity markets both in India as well as the global commodities outlook. A disruptive demand shift in consumption patterns of rural India where people move from the vicious cycle of poverty to the virtuous cycle of affluence would as a whole lead to a shift in trajectory of commodity prices across the board. If authorities seize this opportunity and strengthen the spot markets in India, India will go on to be the global commodity derivatives market leader for a long time to come. Q: Your outlook for 2006 in commodities trading and segments to watch out for. A: The cue for 2006 outlook for commodities can be got by the GSCI index recast done this year. Goldman Sachs Inc. announced the 2006 composition and weights for the Goldman Sachs Commodity Index (GSCI®) trading at CME, world’s the largest and most diverse financial exchange. The first futures contract to be affected by the change is the February 2006 contract, which is scheduled to be listed on the CME® Globex® electronic trading platform on Nov. 16, 2005. The GSCI is a world production-weighted commodity index, which in 2006 will be composed of 24 liquid exchange-traded futures contracts. The GSCI includes energy, industrial metals, precious metals, agricultural and livestock products. The 2006 GSCI will include all of the futures contracts in the 2005 GSCI. No new commodities will enter the index and no existing commodities will be removed from the Index. The GSCI has become the premier global commodity, benchmark for measuring investment performance in the commodity markets. Designed as a reliable and publicly available benchmark, the GSCI tracks real economic activity as well as measuring the level of world commodity prices. CME introduced futures and options on the GSCI Spot Index in July 1992. For the first six months of 2005, more than 250,000 CME GSCI Index futures contacts traded, an increase in volume of 18.5 percent over the same period in 2004.

Commodities Outlook for 2006 based on GSCI Index Rebalance on 24th October 2005

GSCI Commodity Index Aluminium Zinc Nickel Lead Copper Gold Silver Live Cattle Lean Hogs Feeder Cattle Corn Soybeans Wheat CBT Hard Red winter wheat Coffee Cocoa Sugar Cotton Crude Oil Brent Crude Oil Heating Oil Unleaded Gas Gas oil Natural Gas

Number of Underlying futures contract size with NC For 2005 5404.621(WEF 24th October 2005) 5.53 1.53 0.80 1.10 2.59 3.62 0.51 7.68 6.34 1.27 21.05 5.22 14.29

Number of Underlying futures contract with NC for 2004 5636.621 5.32 1.49 0.78 1.09 2.52 3.6 0.49 8.01 5.68 1.14 21.2 5 13.95

Change in 2005 as % 3.947368 2.684564 2.564103 0.917431 2.777778 0.555556 4.081633 -4.11985 11.61972 11.40351 -0.70755 4.4 2.437276

My Bias Based on Allocation change for 2006 Bullish Bullish Bullish Bullish Bullish Bullish Bullish Bearish Bullish Bullish Bearish Bullish Bullish

5.09 1.76 1.37 11.43 3.71 49.58 24.78 12.27 12.11 9.14 12.54

5.62 1.74 1.36 11.41 3.71 49.24 25.04 12.39 12.46 9.02 12.84

-9.4306 1.149425 0.735294 0.175285 0 0.690496 -1.03834 -0.96852 -2.80899 1.330377 -2.33645

Bearish Bullish Bullish Bullish Unchanged Bullish Bearish Bearish Bearish Bullish Bearish

BASIC CONCEPTS Purpose of futures trading Trading in Futures has been realized as an important strategy for price risk aversion in commodities. The commodity futures markets provide a means to transfer risk between persons holding the physical commodity and other hedgers or persons speculating in the market. Futures exchanges exist and are successful based on the principle that hedgers may forgo some profit potential in exchange for less risk and speculators will have access to increased profit potential from assuming this risk. Mechanics of futures trading Forward contract is an agreement between two parties in which the seller agrees to deliver to the buyer a specified quantity and quality of an asset or commodity at a specified future date at an agreed upon price. A forward contract is a privately negotiated bilateral contract that is not conducted on an organized marketplace or exchange. The contract terms are not standardized but are determined by what the parties agree on. The price generally is determined when the contract is entered into, although there are some forward contracts where the parties may agree to transact at a price to be determined later in a manner that is specified on the day the contract is entered into. Forward contracts are primarily merchandising vehicles, whereby both parties expect to make or take delivery of the commodity on the agreed upon date. It is difficult to get out of a forward contract unless both the parties/persons agree to

extinguish the contract. To enter into a forward contract, it is also necessary to find someone who wants to buy exactly what you want to sell when and where you want to sell it. As such, forward contracts are commonly used as merchandising vehicles in a variety of commodity and currency markets; however, forward contracts lack certain features that make futures contracts especially useful for hedging.

Futures contracts are very similar to forward contracts, but futures contracts typically have certain features such as the ability to extinguish positions through offset rather than actual delivery of the commodity and standardization of contract terms that make them more useful for hedging. Traditionally, futures contracts have been traded in an open outcry environment where traders and brokers shout bids and offers in a trading pit or ring. But, recently, trading in many commodities as well as financial futures has been migrating to electronic trading platforms through a computerized trading system. Futures contracts have standardized terms as determined by the exchange including •

Contract size, delivery months, the last trading day, the delivery location or locations, and acceptable qualities or grades of the commodity.

The exchange specifies that different varieties and grades can be delivered at various fixed differentials (premiums or discounts) to the contract price. This standardization enhances liquidity, by making it possible for large numbers of market participants to trade the same instrument. This liquidity makes the contract more useful for hedging.

Forward contract Bilateral agreement Flexible covenant Replaces spot transactions on many occasions Form of contracting totally appropriate for commodities Credit risk fully present Flexibility regarding the optimal transfer of goods

Futures contract Standardized instrument Necessity of a physical delivery or termination of the position before maturity Buyer and seller only refer to the clearing house Central clearing mechanism generating ‘market prices’ Price transparency Liquidity & low transaction costs

Clearinghouses Futures trades that are made on an exchange are cleared through clearinghouses that act as the buyers to all sellers and the sellers to all buyers. When a trader/participant enters into a futures contract, he is technically buying from or selling to, the clearinghouse rather than the party with whom he executed the transaction on the trading floor or through an electronic trading platform. Thus, since he ultimately buys and sells from the same party, if he buys a futures contract and subsequently sells it, he has offset his position and the contract is extinguished. On the other hand, if he buys a forward contract and then sells an identical forward contract to a different person, he has obligations under two contracts (one long and one short).

Margins In futures trading, the entire value of a contract need not be paid rather, a margin that is typically between 2 per cent and 10 per cent of the total value of the contract need to be paid while entering into the contract. Initial margin When a futures trader enters into a futures position, he or she is required to post initial margin of an amount specified by the exchange or clearing organization. Thereafter, the margin becomes "marked-to-market" and the margin account will be adjusted automatically according to the changes in futures price.

Maintenance margin: The minimum level at which the equity in a futures account must be maintained. If the equity in an account falls below this level, a margin call will be issued, and funds must be added to bring the account back to the initial margin level. The maintenance margin level generally is normally 75 per cent of the initial margin requirement. If the amount of money in the margin account falls below the specified maintenance margin, the futures trader will be required to post additional variation margin to bring the account up the initial margin level and if the futures position is profitable, the profits will be added to the margin account. Risk management strategies Primary purpose of derivatives trading in commodities is aimed to reduce the risk mainly from the price fluctuations. The strategies of risk aversion include hedging, speculation and arbitrage. Hedging is an economic function that helps to reduce the price risks in commodities significantly, if not eliminate altogether. Hedging is the practice of off-setting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Futures markets believed to be originally developed to meet the requirements of hedgers or producers who wanted to safeguard against the price risk. However, the scope of commodity futures has expanded latter with widespread participation of producers and users of commodities. Hedger is the person who basically wants to avoid the risk and enters into a contract with speculator. Hedging as a mechanism of avoiding exposure to risk of fluctuating prices in futures markets will be effective only when the following requirements are met •

Driven by the demand and supply over a period the prices of cash and futures markets tend to move together

•

As the maturity date approaches, cash and futures prices tend to converge or reach a predictable difference called the basis.

Process : Hedging in the futures market in general is a two-step process, depending upon the hedger's cash market situation First step : If the hedger is going to buy a commodity in the cash market at a later time, his first step is to buy futures contracts. Or if he is going to sell a cash commodity at a later time, his first step in the hedging process is to sell futures contracts. Second step : when the cash market transaction takes place, the futures position is no longer needed for price protection and should therefore be offset (closed out). Depending on the initial position taken long (long hedge) or short (short hedge), hedger would offset his position by selling or buying back the futures contract. Both the opening and closing positions must be for the same commodity, number of contracts, and delivery month. For example, in June if a farmer expects an output of 100 tonnes of soyabean in October. soyabean prices in October are expected to rule relatively lower as it is harvesting season for soya bean. In order to hedge against the price fall, the farmer/producer sells 100 contracts of one tonne each at Rs 1347 on June 22, 2005. On a fall of price to Rs 1216 per tonne in October he makes a profit of Rs 131 per tonne. Speculation: contrary to the hedging, speculation involves risk but no offsetting of cash market position. Speculators on the other hand, wish to take risk that hedgers want to avoid with a motive to make profits and provide the necessary liquidity through bids and offers that result into a continuous flow of transactions. Commodities are becoming increasingly attractive to investor and hedge fund managers as an alternative asset class that may allow reduction in overall risk of financial portfolio and enhance returns. For example if an investor wants to diversify his investment portfolios, he can chose commodities as a bright option. Unlike in spot markets, he has to invest only a margin amount instead of the total amount and can gain profits to the total extent.

Arbitrage: A third category of market participants is the arbitragers. Arbitrage is a risk-less profit realized by simultaneous trading in two or more markets. However, arbitrage opportunities are very desirable but not easy to uncover, as they do not last longer since the prices get adjusted soon with buying and selling

Arbitrage is possible when one of three conditions is met: • • •

The same asset must trade at the different prices on all markets ("the law of one price"). Two assets with identical cash flows must trade at different prices. An asset with a known price in the future, must trade today at a different price than its future price discounted at the risk-free interest rate.

For example , spot price of gold in Mumbai is Rs 7000 per 10 gm and at the same time the futures contract on MCX is traded at Rs 7200 per gm then the trader buys a kg of gold in cash market and simultaneously takes a short position in the futures market. On the expiry of the contract he opts to deliver the physical gold and gains at the rate of Rs 200 per gm. Basis and Basis risk Understanding basis risk is fundamental for hedging in futures trading Basis t, T = Spot price t – Futures price T (t)

Where T is maturity period and t is a specific date

It is normally quoted as premium or discount in relation to the cash price. If Sp > Fp then basis is said to be OVER future and called premium If Sp < Fp then basis is said to be UNDER futureand called discount Example : on a particular day (October 1) if a trader purchased soyabean in Indore market at a price of Rs 1180 per quintal and on the same day, October futures contract closed at Rs 1208 per quintal then the basis could be calculated by subtracting the futures price from spot price (Rs 28) The basis is partly determined by the interest on difference between margin deposit and the total value of the contract and partly by storage costs. Thus, futures prices for physical commodities are typically higher than spot prices, a situation known as Contango. Differences in quality and grade as well as expectations about future supply also can affect the basis. If expected future supplies greatly exceed current supplies, futures prices may be lower than spot prices, a situation known as backwardation. Basis risk exists when futures and spot prices do not change in the same magnitude and may not converge at maturity on account of an underlying similar but not identical source of risk and also the physical attributes of the commodities including grade, location and chemical composition etc., It is now common that the market participants analyse their risk in a mark-to-market perspective at date ‘t’. As a result, the basis risk is often defined as the variance of the basis (Geman, 2005). s 2 (S t – F T (t)) = s 2 (S t) + s 2 (F T (t)) - 2 r s (S t) s (F T (t)) Where, r is the correlation coefficient between the futures and spot price series The equation shows basis risk is zero when variances between the Futures and spot prices are identical and r equals one. Practically, the correlation between spot and futures is the stringent factor and the magnitude of basis risk depends mainly on this Price Discovery Futures contracts are often relied upon for price discovery as well as for hedging. In many physical commodities

(especially agricultural commodities), cash market participants base spot and forward prices on the futures prices that are “discovered” in the competitive, open auction market of a futures exchange. This is considered to be an important economic purpose of futures markets. In financial futures contracts such as stocks, interest rates, and foreign currency, the price discovery role of futures occurs in tandem with the cash markets, which also contribute significantly to price discovery. Termination of contracts : can be of three ways By taking prior to maturity a symmetric position in an equal number of contracts in order to nullify the position and avoid the cumbersome and expensive procedure of physical delivery. • •

Taking physical delivery By entering into an exchange for physical (EFP) agreement

Players in futures market Hedgers : Futures markets believed to be originally developed to meet the requirements of hedgers or producers who wanted to safeguard against the price risk. However, the scope of commodity futures has expanded latter with widespread participation of producers and users of commodities. Hedger is the person who basically wants to avoid the risk and enters into a contract with speculator. Speculators : speculation is the opposite of hedging Speculators on the other hand, wish to take risk that hedgers want to avoid with a motive to make profits and provide the necessary liquidity through bids and offers that result into a continuous flow of transactions. Commodities are becoming increasingly attractive to investor and hedge fund managers as an alternative asset class that may allow reduction in overall risk of financial portfolio and enhance returns. Arbitrager : A third category of market participants is the arbitragers. Arbitrage is a risk-less profit realized by simultaneous trading in two or more markets. However, arbitrage opportunities are very desirable but not easy to uncover, as they do not last longer since the prices get adjusted soon with buying and selling

Commodities Vs Stock markets Stock markets Commodity markets One unit of a security does not differ Each commodity/product have several grades or from another of the same type in varieties and each lot in a grade may vary from other terms of its face value and lots in the same grade characteristics. Quality also deteriorates due to improper storage and transport conditions. Commodity deliveries therefore have far greater implications for buyers and sellers than mere payment or receipt of contractual price, as in the case of buying or selling of securities Most investors in securities do not A commodity futures market is primarily a hedging need any facility for hedging. They market, and not a market for delivery. Deliveries need invest in securities either to earn to be issued and received only in a residual sense to regular income from dividend or maintain a parallel or near-parallel relationship interest, or to profit from the between the physical and futures market prices to subsequent price rise. facilitate efficient hedging Price Discovery Security futures prices have no such Price discovery by a futures market also has a much equivalent role. more basic role to play in a commodity market than in the securities market. Factors Not many (its supply is almost fixed, Factors affecting commodity prices are far too many with demand varying as per the financial performance of the Quality

company, or the authority, and general market expectations),

and complex Supply side: depends on conditions such as area or production capacity, weather, infrastructure supplies and inputs like water, power, seeds, yields or processing/ manufacturing out-turns, imports and exports.

Contract Specifications

Demand is determined by the population growth and shifts in demographic characteristics, changes in incomes and exports, besides the diverse elasticities of incomes and prices. For an individual security futures, or More complex and involves specification of quality, even for an index futures of several delivery, duration etc., securities put together, is a relatively simple exercise

COMMODITY FUTURES IN INDIA Evolution Organized trading in commodity derivatives was initiated in India with the set up of Bombay Cotton Trade Association Ltd in 1875. Following this, Gujarati Vyapari Mandali was set up in 1900 to carryout futures trading in groundnut, castor seed and cotton. Forward trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up in 1927 for organizing futures trading in Raw Jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in existence at several centres at Punjab and U.P. The most notable amongst them was the Chamber of Commerce at Hapur, which was established in 1913. Futures market in Bullion began at Mumbai in 1920 and later similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Calcutta. During the Second World War Futures trading was prohibited. However, after independence, the Constitution of India brought the subject of "Stock Exchanges and futures markets" in the Union list. As a result, the responsibility for regulation of commodity futures markets devolved on Govt. of India and in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted. • • •

An association recognized by the Government of India on the recommendation of Forward Markets Commission, The Forward Markets Commission (it was set up in September 1953) and The Central Government.

Forward Contracts (Regulation) Rules were notified by the Central Government in July 1954. The Act divides the commodities into 3 categories with reference to extent of regulation, viz: o o o

The commodities in which futures trading can be organized under the auspices of recognized association. The Commodities in which futures trading is prohibited. Those commodities, which have neither been regulated for being traded under the recognized association nor prohibited, are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission.

The ECA, 1955 gives powers to control production, supply, distribution, etc. of essential commodities for maintaining or increasing g supplies and for securing their equitable distribution and availability at fair prices. Using the powers under the

ECA, 1955 various Ministries/Departments of the Central Government have issued control orders for regulating production/distribution/quality aspects/movement etc. pertaining to the commodities which are essential and administered by them. In the seventies, most of the registered associations became inactive, as futures as well as forward trading in the commodities for which they were registered came to be either suspended or prohibited altogether. The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the major commodities. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. After the introduction of economic reforms since June 1991, the government of India appointed one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra in June 1993 and the Committee submitted its report in September 1994. Following this, the government of India has issued notifications on April 1, 2003 permitting futures trading in commodities. Trading in commodity options, however, is still prohibited. The lifting of the 30-year ban on commodity futures trading in India has opened yet another avenue for investors. Contract specifications Forward contracts are broadly of two types: • •

Specific delivery contracts Other than specific delivery contracts

Specific delivery contracts: Specific delivery contracts are essentially merchandising contracts, which enable producers and consumers of commodities to market their produce and cover their requirements respectively. These contracts are generally negotiated directly between parties depending on availability and requirement of produce. During negotiation, terms of quality, quantity, price, period of delivery, place of delivery, payment term, etc. are incorporated in the contracts. Specific delivery contracts are of two types: • •

Transferable specific delivery contracts (T.S.D.) Non-transferable specific delivery contracts (NTSD).

In the TSD contracts, transfer of the rights or obligations under the contract is permitted while in NTSD it is not permitted. Other than specific delivery contracts : Though this contract has not been specifically defined under the act, these are called as ‘future contracts’. Futures contracts are forward contracts other than specific delivery contracts. These contracts are usually entered into under the auspices of an Exchange or Association. In the futures contracts, the quality and quantity of commodity, the time of maturity of contract, place of delivery etc. are all standardised and contracting parties have to negotiate only the rate at which contract is entered into. Forward trading in TSD and NTSD contracts is regulated by the government. As per the section 15 of the FCRA, 1952, every forward contract in notified goods that entered into except t hose between members of a recognized association or through or with any such member is treated as illegal or void. The section 18(1) of the Act exempts the NTSD contracts from the regulatory provisions. However, over the years the regulatory provisions of the Act were applied to the NTSD contracts and 79 commodity items are currently prohibited for NTSD contracts under section 17 of the Act. Moreover, another 15 commodity items are brought under the regulatory provisions of the section 15 of the Act out of which trading in the NTSD contract has been suspended in 12 items. At present, the NTSD contracts in cotton, raw jute and jute goods are permitted only between, through or with the members of the associations specifically recognized for the purpose. Commodities allowed for futures trading in India

Presently, as per the list presented on Forward Market Commission (FMC), about 24 exchanges (list of commodity exchanges in India) are in operation carrying out futures trading activities in a wide variety of commodity items under 8 major categories

1. 2. 3. 4. 5. 6. 7. 8.

Vegetable oilseeds, oils and meals Pulses Spices Metals Energy products Vegetables Fibres and manufactures - Cotton Other – Guarseed, guar gum, Sugar

Inter-ministerial task force on convergence of securities and commodity derivative markets A Committee under the chairmanship of Ramamoorthy was set up by SEBI to look into certain issues relating to fruitful cooperation between financial and commodity markets and specifically asked to examine the possibilities of: o o o

Securities brokers participation in the commodities markets; Utilization of infrastructural facilities of stock exchanges by commodity exchanges; Stock exchanges as well trading in commodities derivatives

According to the report, the strengths of securities markets and the expected gains of convergence to commodity market are significant but the divergences, apprehensions and concerns are also many They include Removing restrictions on stock exchanges from trading commodity derivatives, would affect the viability of the exchanges, which have been granted in-principle approval only recently. It is apprehended that the established stock exchanges having huge reserves would easily be able to wipe out competition by leveraging their available resources and infrastructure. Though allowing commodity exchanges to trade securities would appear to be equitable on paper, in reality the existing commodity exchanges will not be able to meet the high regulatory bars set by the SEBI for grant of recognition. This is also true for intermediaries in the commodity derivatives market.

Divergences between security and commidties derivatives markets

Areas Online trading

Divergences Action required for convergence Besides domain knowledge of commodity Traditional outcry system may have to be markets, agri-products may require different allowed for some time during transition as process of online application giving flexibility for requested by largest Exchange, NBOT, Indore. outcry system. Cash Basis Agri-markets do not have liquid cash market to Integration of agri-markets and financial sector obtain price discovery. to speed up. Market Determinants Agri-products have different shelf life, demand- Standardisation of products and suitable supply factors, and price determination. Metals storage facilities need to be build up. notably gold also have different market conditions. Storage of products Scale and mode of depositing/warehousing Warehouse receipt system (WRS) a must for structurally different. commodity futures. Taxation Indirect taxation cascades in commodities. IT Losses due to speculation not adjusted in treatment also different. corporate taxation in case of commodity futures – only carried forward. Regulation Compliance of network, capital adequacy, Harmonisation possible though separate margins, exposure norms different for regulations to continue. commodity trading Role of banks and Under the Banking Regulations Act, Banks are Allow Banks to hedge their commodity Mutual Funds not permitted to trade in commodities exposure. derivatives markets. Unified Markets Various State and Central Government laws Fragmentation of commodity futures and impede the unification. markets to be overcome through agricultural marketing reforms. Market awareness Limited for nascent commodity futures Berries will take time to ripen. Centre-State Commodities and markets under purview of Inter-state harmonization of Acts and rules Jurisdiction State Governments needed Price Discovery Mostly in trading pit in commodity futures. Online trading positions in new exchanges Generally cash price quoted at a need to be supervised. premium/discount to the futures prices. Base of players Investors base 25 million and 9000 brokers in Farmers’ involvement can help expand the securities market. A few thousand brokers in base of commodity futures. commodity markets. Recommendations of the committee • •

It would therefore be necessary to address these concerns, apprehensions and, if necessary, find graceful transition paths through which the adverse impact upon existing firms and exchanges could be smoothed. Adversely affected entities may have to be given a limited period of time to adapt to the new institutional environment. Attaining growth in commodity market without convergence will need to replicate the infrastructure and regulation resources. This process may be slow.

Factors to be considered while trading in commodity futures In order to trade in commodity futures, the participants need to keep certain facts in mind. These factors can be broadly grouped into the following categories. Agricultural commodities • • • •

Carry over stocks : leftover stocks from the previous year’s production after meeting the demand. Expected demand : average level of consumption and exports during the past few years. Crop acreage : Extent of area sown under the crop . Production : Estimated output based on the acreage and weather conditions and pest infestation etc.,

• • •

Imports and exports : in case of the commodities that have a sizeable amount of external trade (either imports or exports) such as edible oils and pulses, the traders need to know the details of important sources and destinations of the external trade. Further, the traders have to monitor the crop status in the respective countries. Government policies : any change in government policy relating to the crops such as MSP: minimum support prices. Procurement : direct procurement by the government agencies and storage in warehouses change in tariff and base prices of externally traded goods will have a direct impact on the respective commodity prices.

Metals •

• •

Currency changes : main source of long-term volatility Variation in supply and demand for risk capital . Risk capital is largely provided from established routes such as debt and equity. Shocks : o Unexpected changes in production techniques, Massive changes in exploration techniques, Changing geopolitics Cartel instability o Environmental regulation with respect to production process. Changes in consumption trends, due in part to price elasticity Inflation : change in global inflation as well as inflation in the US and the respective countries

Crude (Energy) Futures • • • • • • • •

Stocks of Crude Oil and Petroleum Variance from five year average OPEC production variance from quota Strategic Petroleum Reserve (SPR) variance from target Demand factors OPEC spare capacity ( Saudi Arabia) Refinery capacity variance Interest rates US dollar

Has futures trading taken the right direction? Viewed: 3173

August 25, 2006 Trading in commodity futures was restarted in November 2003 with the economic objectives of price discovery and price risk management following the government notifications on April 1, 2003. Soon, trade volumes in commodity derivatives have posted a spectacular growth and even surpassed volumes of stock markets within two and half years of their start. The rapid expansion in volumes has drawn the attention of a large section of people with diversified interests. Nearly three-years of effective functioning of futures exchanges, it may be interesting to study the pattern of futures trading, factors driving and more importantly, to see whether futures trading has taken the right direction in terms of its economic objectives or not. To this end, we (TECL) have conducted a study and the results are presented in this report.

Trade pattern The total value of trade took place, across all the exchanges, has reached Rs. 21.34 lakh crores during 2005-06 from Rs. 5.71 lakh crores during 2004-05 recording a growth of 274 per cent (FMC, 2006). However, apart from this brighter side, commodity futures have witnessed some serious functional irregularities as well, which we have been bringing to the light regularly in our “Open letters to the FMC”. Trends in volume contribution on the three national exchanges – Multi Commodity Exchange (MCX), National Commodity Derivatives Exchange (NCDEX) and National Multi Commodity Exchange (NMCE) – are studied to understand the pattern of trade and major volume contributors. Pattern on Multi Commodity Exchange (MCX): MCX is currently the largest commodity derivatives exchange in the country in terms of trade volumes. Further, it has even become the third largest in bullion and second largest in silver futures trading in the world. Coming to trade pattern, though there are about 60 commodities traded on MCX, only 3 or 4 commodities contribute for more than 80 per cent of total trade volume. As per the recent data the largely traded commodities are gold, silver, energy and base metals. Incidentally, the futures’ trends of these commodities are mainly driven by international futures prices rather than the changes in domestic demand-supply and hence, the price signals largely reflect international scenario. Table 1: Volume trends on MCX Commodity Jul 2005 Crude oil Silver Gold Soy Oil Guar Seed

Share 40.2 21.5 20.4 4.9 3.4

Commodity Jan 2006 Gold Silver Crude oil Mentha Oil Soy Oil

Share 50.3 26.6 7.4 7.3 1.0

Commodity Share July 2006 (fortnight) Gold 58.6 Silver 17.7 Copper 10.0 Crude oil 3.5 Natural gas 1.9

Source: FMC Among agricultural commodities, major volume contributors include guar, urad, mentha oil etc., whose market sizes are considerably small making them vulnerable to manipulations. For instance, Mentha oil, with a market size of about 15000 tonnes, was the fourth largely traded commodity witnessing extreme volatilities in the last Dec-Jan apparently driven by operators (for details see “An open letter to the FMC2”). The FMC’s strict monitoring and regulations have brought down the volatilities and consequently volumes in menthe. But, immediately the volumes and volatilities were shifted to Burmese urad, another commodity with extremely small market size. Pattern on National Commodity & Derivatives Exchange (NCDEX): NCDEX is the second largest exchange in the country after MCX. However, the major volume contributors on NCDEX are agricultural commodities. But, most of them have a common inherent problem of small market size, which is making them vulnerable to market manipulations and over speculation. About 60 per cent of trade on NCDEX comes from guar seed, chana and urad (narrow commodities as specified by the FMC). Similar to the case of MCX, the trade pattern of shifting extreme volatilities and huge volumes one commodity to other, following the FMC’s regulations, has been observed on the NCDEX as well (for details see our open letter to the FMC3) - initially, in guar then to Burmese urad (Dec-Feb 2006) and subsequently to other narrow commodities. Table 2: Volume trends on NCDEX Commodity

Share

Commodity

Share

Commodity

Share

Jul 2005 Guar Seed Chana Pure Silver Urad Soy oil

Jan 2006 39.7 24.8 7.0 4.4 4.1

July 2006 (fortnight) Guar Seed 34.4 Chana 19.8 Gold 13.7 Silver 7.2 Pepper 6.5

Urad Channa Guar seed Silver Pure Gold

23.9 21.1 14.1 11.2 8.2 Source: FMC Pattern on National Multi Commodity Exchange (NMCE):

NMCE is the third national level futures exchange that has also been largely trading in agricultural commodities. Until a year ago, trade on NMCE had a considerable proportion of commodities with big market size such as jute, rubber etc., But, in the subsequent period, the pattern has changed and slowly moved towards commodities with small market size or narrow commodities. Table 3: Volume trends on NMCE Commodity Jul 2005 Raw-Jute Rubber Pepper Coffee

Share

Cardamom

37.8 34.9 24.2 1.6 1.5

Commodity Jan 2006 Rubber Chana Guar seed Pepper Cardamom

Share 31.4 26.0 25.7 11.7 2.1

Commodity Share July 2006 (fortnight) Guar seed 38.5 Chana 31.7 Soy Oil 9.3 Pepper 6.0 Kilo gold

4.1

Source: FMC

What is happening so far? The above analysis revealed the following trade pattern.. Major volume contributors: Majority of trade has been concentrated in a few commodities that are ·

Non-agricultural commodities (bullion, metals and energy)

·

Agricultural commodities with small market size (or narrow commodities) like guar, urad, mentha etc.,

Trade strategy: It appears that speculators or operators chose commodities or contracts where the market could be influenced and extreme speculation possible. ·

In view of the extreme volatilities, the FMC directs the exchanges to impose restrictions on positions and raise margins on those commodities

·

Consequently, the operators/ speculators chose another commodity and start operating in a similar pattern. When the FMC brings restrictions on these commodities, the operators once again move to other commodities.

·

Likewise, the speculators are moving from one commodity to other (from menthe to urad to guar etc) where the market could be influenced either individually or with a group.

Beneficiaries: So far the beneficiaries from the current nature of trading are ·

Exchanges – making profits from the mounting volumes

·

Arbitrageurs

·

Operators

In order to understand the extent of progress the trading in commodity derivatives has made towards its specified objectives (price discovery and price risk management), the current trends are juxtaposed against the specifications. Table 5: Specified and actual pattern of futures trade Progress Commodities

Trade strategy Beneficiaries

objectives

Ought to be Actual There should be large demand for and Largely traded are supply of the commodity - no individual or group of persons acting in concert should • bullion, metals and be in a position to influence the demand or supply, and consequently the price • commodities with small market size (or narrow substantially. Towards this, the major commodities) like guar, Burmese urad, mentha produced or consumed commodities in the etc., country such as wheat, rice, oilseeds, cotton, jute, etc., and India is the top first or second producer of these commodities. Hedging together with moderate speculation Over speculation and manipulation leading to wide to smoothen the price fluctuations fluctuations (see open letters for details). Farmers/producers, consumers and traders So far exchanges, arbitrageurs, operators, etc., either through direct participation or through price signals Further, there were instances of wrong price signals accruing losses to farmers in case of mentha, and to traders in case of imported pulses. Price discovery • Pure replication of international trends not taking into account of domestic D-S in case of non-agril. commodities. • Wide fluctuations from over speculation and manipulation in case of largely traded agricommodities.

Risk management

No such evidences and contrarily, the extreme volatilities in certain commodities are making futures more risky for participants

Source: FMC & TECL research

Thus, it is evident from the Table 5 that the realization of specified objectives is still a distant destination. It is further, evident from the nature of commodities largely traded on the national exchanges that the factors driving the current pattern of futures trade are of purely speculative. A similar exercise was done by us in December 2005 and interestingly, there is no significant change in trade pattern, despite various steps taken by the FMC except shuffle in largely traded commodities. Reasons for the prevailing trade pattern No wide spread participation of all stake holders of commodity markets. The actual benefits may be realized only when all the stakeholders in commodity markets including producers, traders, consumers etc., trade actively in major commodities like rice, wheat, cotton, etc.

To make futures markets as level playing fields for all stakeholders, certain basic requirements need to be met. They are … o

Creation of awareness among farmers and other rural participants to use the futures trading platform for risk mitigation

o

Contract specifications should have a wider coverage, so that a large number of varieties produced across the country could be included.

o

Development of warehousing and facilities to use the warehouse receipt as a financial instrument to encourage participation farmers.

o

Development of physical markets through uniform grading and standardization and more transparent price mechanisms

Banning futures trade won't cap price rise Viewed: 1232 Recent price escalations in majority of agricultural commodities have lead to significant rise in inflation and have become an issue of concern for the government as well as people. Towards this, some sections of political activists and traders are blaming the futures trading for the current rise in inflation. But, in reality, the rise in prices of major agricultural commodities has primarily been driven by their growing supply shortages. Although, futures markets are currently witnessing some functional irregularities (for details see our open letters to the FMC), which cannot be misinterpreted as perils of the very existence of futures markets. We strongly believe that the apparent rise in prices, more specifically pulses, wheat and sugar, has been driven by the expanding gulf between demand and supply in majority of agricultural commodities. Recent decision by the Government of India to liberalize imports is an evidence for it. In order to check empirical evidence, demand-supply scenarios of actively traded commodities such as pulses (urad, tur and chana), wheat and sugar are analysed. Pulses: The domestic demand has outpaced the supply during the late 1990s and imports have become a part of domestic supply thereafter. While the consumption demand has been growing consistently, production stagnated at about 13.5 million tonnes. As a result, India has become the largest importer of pulses, annually supplementing about 1.5 million tonnes of imports to the domestic supply, despite being the largest producer of pulses in the world. Further, among pulses, major volume turnover has recorded in case of imported pulses but that are not included under WPI list. Thus, among pulses, it is only chana (desi varieties) that’s traded on futures exchanges and included under WPI. Table 1: Trends in demand-supply of pulses (lakh tonnes) Production Imports Exports Supply Demand Carryover stocks 2003-04

149.1

17

1.5

156.4

146

10.4

2004-05

131.3

13

2.4

152.3

151

1.3

2005-06 139.2 15 Source: Ministry of Agriculture and DGCS, GoI

1.5

154.0

154

0.0

As revealed by the data presented in Table domestic production has fallen short of demand since 2004-05. The demand has been rising consistently with growing population and hence leading to more and more dependence on imports. Thus, the apparent surge in prices of pulses has been driven by the growing shortages in pulses but driven by futures trading. Table 2: Trends in demand-supply of chana Production

Imports

Supply

Consumption

(lakh tonnes) Ending

2002-03 54.7 2003-04 57.7 2004-05 56.3 2005-06 59.3 2006-07E 55.8 Source: DGCS, GoI and Statpubs

0.9 1.2 0.7 0.7 5.4

55.6 63.9 63.0 60.0 61.2

50.6 57.9 63.0 60.0 61.2

5.0 6.0 0.0 0.0 0.0

Sugar Similarly, outlook for sugar has also turned bullish during the past six months primarily on account of steep decline in production during the past two years to about 12 million tonnes from 18 million tonnes in 2002-03. Consequently, the stocks have depleted to about 2.9 million tones in 2005-06. As a result, although there is an expected record production at about 19 million tonnes in the current year, prices are expected to remain firm. On the other hand, in view of the depleting stocks, the government has allowed import of sugar at zero duty. But, the international trends are already bullish due to expansion in demand for ethanol and importers believe that the landed cost of sugar is higher than the current domestic prices even at zero import duty. As a result, domestic prices may remain firm as long as the domestic supplies meet the demand and may start rising in tune with international prices once we resort for imports to supplement domestic supply. Table 3: Balance sheet for sugar

Opening Stock Production Import Total Demand Consumption Exports Total Closing Source: ISMA and DGCS

2004-05 7.5 12.7 1.5 23.2

2005-06 2.9 19 0 21.9

18.5 0.3 18.5 2.9

19.1 0.6 19.7 2.2

(million tonnes) 2006-07e 2.2 22 0 24.2 19.8 2 21.8 2.4

Wheat On other hand, wheat situation has now turned out to be deficit and India has become net importer of wheat after long years primarily due to stagnation in yields and acreage. In addition, improper government policies, particularly with respect to foodgrains management have affected adversely. Further, the domestic wheat markets, that have been kept isolated, are suddenly exposed to international price trends. Global Demand and Supply: wheat output is expected to decline by 17 million tonnes to 599 million tonnes in 2006-07. According to the estimates released by an Australian agency (Abareconomics), the production is forecast to decline in China, the Russian Federation and the Ukraine. Production in the latter two countries is forecast to fall by 18 per cent and 25 per cent respectively, while production in China is forecast to fall by 4 per cent in 2006-07 as yields are expected to fall, reflecting return of average seasonal conditions. On the other hand, according to the latest USDA estimates, consumption in 2005-06 is expected to reach a record level of 624 million tonnes. However, the International Grain Council (IGC) forecasts that this year’s consumption may remain unchanged at 618 million tonnes. ABARE too predicts a nominal increase in wheat consumption in the current year as well as in the next few years. Table 4: World Wheat outlook

Production

2003-04 555

2004-05 625

2005-06 616

2006-07 599

2007-08 620

2008-09 623

(million tonnes) 2009-10 2010-11 627 632

Consumption Stocks

593 127

613 140

618 138

619 117

620 117

621 119

625 121

628 124

Source: Australian Bureau of Statistics; International Grains Council; USDA; ABARE There seems to be a change in consumption pattern of the BRIC economies, particularly of India and China, with rise in income and expenditure levels. Consumption of wheat-based food in the form of biscuits and bakery products (fast food) has increased dramatically during the past two years due to the present day work environment, especially in the case of BPOs and IT jobs. In addition, following the significant changes in their socio-political scenario, there is a potential rise in consumption demand from countries such as Iraq and Nigeria as well. As a result, there is a significant expansion in world wheat consumption demand seems to be inevitable in the next few years. Prices: With the expected rise in demand and a fall in world wheat supplies for 2006-07, the world wheat indicator price (US hard red winter, fob, Gulf ports) is forecast to increase by 2 per cent in 2006-07 (ABARE). Domestic outlook: Domestic scenario, as we have explained few months ago in our Issues & Analysis section and presented in Table 4, has turned bullish primarily on account of steep fall in stocks and the resultant shortage in supplies. Prices have started firming up in January itself (as presented in Chart 1) as the stocks reached about 4 million tonnes lower than the prescribed buffer stocks.

Although, the government has allowed private traders to import wheat and eliminated the duty, lack of availability of quality wheat seems to have become an important constraint. Recently, tender floated by the State Trading Corporation in May to import 1.5 million tonnes for replenishing buffer stocks has lapsed, as the bids could not meet the prescribed quality specifications. As a result, wheat prices may be contained only if the imports by private traders take place at agreeable quality specifications. Otherwise, the prices may firm up further in the latter part of the current marketing year. Thus, the apparent price rise has been driven by the fall in stocks but not by futures trading. Table 5: Trends in demand and supply of wheat (million tonnes) Open stocks 2001-02

21.5

Output 69.7

2002-03

26.0

72.8

-3.9

94.9

79.3

15.6

2003-04

15.6

65.1

-4.0

76.7

69.8

6.9

2004-05

6.9

72.1

-2.8

76.2

72.1

4.0

2005-06

4.0

72.0

-0.4

75.5

73.5

2.0

3.5

78.5

77.0

1.5

2006-07E 2.0 73.0 E: Estimates by Commoditiescontrol.com research

Net imports

Total supply

Demand

End stocks

-2.6

88.6

62.6

26.0

Source: DES of Ministry of Agriculture, However, futures markets can give signals for price movements in physical markets. There are reports that the farmers in Punjab, probably for the first time, have sorted for hedging on futures markets in the current year. It was further noted that, for the first time, market prices of wheat were reported higher than the MSP even at the start of marketing season (April-May). Conclusions Thus, the apparent price rise is a consequence of growing shortages in majority of essential commodities including wheat, pulses, sugar etc., but not instigated by the futures trading. Hence, ban on futures may not help the situation to bring down prices Despite being the largest producer of many agricultural commodities such as pulses, cereals, sugar etc., India has now turned out to be net importer of these commodities. Hence, the scope for bringing down the prices is apparently negligible as there is a limited supply available from the rest of the world. Supply side management: Considering the above factors, in order to contain prices, the government must take steps to increase supply of the major agricultural commodities through o o

Raising yields by better package of practices, HYVs, etc., Reducing wastage and losses in transportation and storage by providing the required infrastructure facilities either solely or in partnership with private sector.

Price management: growing population together with rise in income levels has driven up the aggregate consumption levels rather steeply during the past few years. Hence, the price rise seems to be inevitable due to the prevailing supply shortages. Thus, in view of WTO commitments and the restricted scope for immediate expansion in domestic supply, The government must strengthen the public distribution system and provide essential commodities to the targeted vulnerable sections at subsidized prices without intervening the general market operations. How to make futures markets more effective? Viewed: 1842 The FMC has initiated a few steps to bring regulations after April 2006, as the chairman has promised (in an interview with TECL in March 2006). But, a lot more need to be done. Considering the important role the futures trading can perform particularly in the price risk minimization, there is an urgent need for correcting the existing irregularities in the futures trading. A few suggestions in that direction are.. Selective trading: Trading in commodities with small market size as well as with greater government intervention may be restricted. If they need to be traded then there should be a limit on positions proportionate to their deliverable market supplies. Even on the CBOT, one of the largest and the oldest commodity exchanges in the world, does not trade in so many commodities. In this context, it is appropriate to remember the apprehensions expressed by Prof K N Kabra, the Chairman of Forwards Markets Committee (well-known Kabra Committee 1993-94). He had suggested that futures trading should be selective and initially be restricted to non-essential commodities rather than immediate permission for all commodities across the board. He opined, “Futures trading in essential commodities might amount to introducing an additional destabilising and escalating factor in prices”. The current nature of futures trading and price trends particularly, in pulses and wheat corroborate his predictions. More delivery centres: the number and coverage of delivery centres need to be expanded so that the objectives of market integration and price discovery can be achieved. Quality specifications: must accommodate majority of the common grades & varieties so that the arbitrage between futures as well as spot markets is facilitated Settlement Price: currently, every exchange is deriving its own settlement price claiming that they have a unique method to do it. As a result, there is no unique price and method prevailing for final settlement of futures contract. This creates more

confusion on the part of the trader. In order to avoid this, there should be at least a common process, if not the price, to derive the settlement price Contract specifications: Open position should be proportionate to the marketable surplus and deliverable supplies. Number of contracts can be limited and lean season contracts can be restricted. Wider coverage: futures contract must include as many number of varieties as possible so that the maximum amount of supply becomes fit for delivery To bring an efficient and smooth functioning of futures markets and to fulfill their economic objectives, the FMC and exchanges must bring in suitable guidelines after a thorough impact evaluation of the present nature of futures trading on various facets of commodity markets in the country.

NCDEX Cash-Futures Arbitrage Calculator Gram-Nov2006

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Annual Return : -42.10% Spot Price : Quantity(1 Lot) : Spot Market : Interest Rate (p.p.a.) :

Exchange : Contract : Contract Month: Contract Entry Date : (mm/dd/yyyy)

Contract Expiry Date:

Brokerage Amount : Fixed Costs Quality Certification : Handling Costs : Standard Exchange : Total Fixed Cost : Warehouse Charges Per Warehouse Cycle Duration : Cycle : Total Warehouse Charges : Net Spot Price : Futures Trading Costs Days of Margin Utilization : Futures Price : Brokerage Rate(Rs. per Margin Amount : lakh) : Interest Rate On Margin (p.p.a.): Brokerage Amount : Cost of Margin : Net Futures Price : Results Of Calculation Net Return (Arbitrage) : Rs.Per 100.00 Kg % Anualized Return Arbitrage : Note : Calculations are done on the basis of volume i.e. :10 MT This indicates annual return of :42.1% can be obtained by selling the commodity in spot market and buying in futures market