Mcx Crude Oil Contracts-- Impact Studies

MCX CRUDE OIL CONTRACTSIMPACT STUDIES

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ABSTRACT This project studies about the market practices in the crude oil trading at MCX. In the first part commodity market, crude oil market, international crude oil markets are explained. After this crude oil spot market and development phases of the crude oil spot market which gradually leads to the establishment of futures market is described. Then later on the crude oil futures market along with its mechanics, various players of futures market, supply value chain, global trading patterns etc are explained which is followed by the comparison of the crude oil futures contract of MCX and NYMEX.

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TABLE OF CONTENTS Chapter1: Introduction 1.1Background 1.2Overview 1.3Purpose of study Chapter2: Organization 2.1 About MCX 2.2 Significant developments 2.3 Business operations 2.4 Business rules 2.5 Applicability 2.6 Eligibility of trading 2.7 Membership of MCX 2.8 Strategic regional alliances 2.9 Global alliances 2.10 Key shareholders 2.11 Associate co’s of MCX 2.12 Commodities traded on MCX 2.13 Firsts by MCX Chapter3: Identification of problems 3.1 Problem statement Chapter4: Literature review Chapter5: Research Methodology Chapter6: Analysis and Findings Chapter7: Assessment of contracts Chapter8: Conclusion and Recommendations Bibliography

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Chapter1: Introduction 1.1 Background Multi Commodity Exchange of India Limited (MCX) is a ‘new order’ exchange with permanent recognition from the Government of India for setting up a nationwide,

online

multi-commodity

marketplace,

offering

“unparalleled

efficiencies”, “unlimited growth” and “infinite opportunities” to market participants. MCX, a nationwide multi-commodity exchange, is an independent and demutualised exchange since inception. Promoted by Financial Technologies (India) Limited, MCX has introduced a state-of-the-art, online digital exchange for commodities trading in the country. In line with its strong belief of setting up a truly independent and a neutral platform, MCX is committed in its pursuit of braodbasing its ownership and has accordingly initiated several steps to make the exchange ownership pattern broader, representative and inclusive. 1.2 Overviews In MCX futures trading of around 70 commodities is done which includes futures trading of crude oil. At MCX the crude oil futures contract of Light sweet crude, Brent crude and Middle East crude were launched on 9th Feb, 2005,whose time period is three months and at a time three contracts runs simultaneously. Each contract has its own specifications decided by the exchange. Trading of these contracts is done on some common trading parameters which are as follows: •

Base price

•

Closing price

•

Dissemination of open, high, low,and last traded prices

•

Life of futures contract

•

Expiry date

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•

Due date rate

•

Traders work station (automated screen based trading system for online trading)

1.3 Purpose of study •

Current market practices in contractual obligations

•

Comparison of crude oil contracts of MCX and NYMEX

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Chapter2: Organization 2.1 ABOUT MCX MCX (ISO 9001-2000) is an independent and de-mutualised commodity futures exchange. Inaugurated on November 10, 2003 MCX has permanent recognition from the Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Today, MCX ranks amongst the top three bullion exchanges and top four energy exchanges in the world. MCX, also, has India’s first and only composite commodity futures price index which is COMDEX. It encompasses futures contracts drawn on commodities segments including metals, energy and agri products traded on MCX. The exchange has brought a paradigm change in the Indian commodities sector through its innovative application of technology, path-breaking ideas, novel products & unique alliances. Its continuous strives for global best practices blended with global outlook; technology expertise and unique commodity domain knowledge give MCX an edge. The average daily turnover of MCX is approximately USD 1.5 bullion (INR7, 100* crore) with a record peak daily turnover of USD 3.98 billion (INR 17,987 crore) on April 20, 2006. MCX holds over 55% market share of the total trading volume of all the domestic commodity exchanges. The exchange has also affected large deliveries in domestic commodities, signifying the efficiency of price discovery.

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2.2 SIGNIFICANT DEVELOPMENTS In its endeavor towards establishing India as a major hub for global trading in commodities, MCX has taken up the initiative by entering into tie-ups with major international exchanges and commodity trading centres. Some of these are: MCX signed Memorandum of Understanding (MOU) with the Tokyo Commodity Exchange on November4, 2004. MCX enters into strategic collaboration with The Baltic Exchange, London to start ‘Freight futures’ in India MCX and the London Metal Exchange (LME) sign a licensing agreement allowing MCX to use LME prices as the basis for setting futures contracts New York Board of Trade (NYBOT) and MCX sign a Memorandum of Understanding MCX registers record turnover of USD 3.98 bn (Rs 17,987 crore single sided) MCX and New York Mercantile Exchange(NYMEX) enter into an exclusive Licensing Agreement for launching mini-NYMEX energy contracts on MCX MCX becomes the first to launch futures trading in Natural Gas in India MCX signs a licensing agreement with Euronext. Liffe MCX signs MOU with Zhengzhou Commodity Exchange (ZCE) MCX signs Joint Venture with the Institute for Financial Markets (IFM) ,an affiliate of the Futures Industry Association (FIA) and became the first commodity exchange in India to become a member of the FIA 2.3 BUSINESS OPERATIONS OF MCX MCX is conducting trading in derivatives contracts in various commodities permitted by the Government of India under the Forward Contracts Regulations Act, 1952 subject to approval of the Forward market Commission.

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2.4 BUSINESS RULES Business rules of MCX is subject to the provisions of the Forward Contracts Regulations Act, 1952, and rules framed under, Articles of Association, rules and Bye-laws of MCX, as applicable to the Members of the exchange, their Representatives and their Clients. 2.5 APPLICABILITY These rules are enforceable on the Members of the Exchange, Clearing Banks, Clients, Constituents and all other participants operating on or through the Exchange in respect of their rights and obligations relating to trading on MCX. They are subject to jurisdiction of the Courts of Mumbai irrespective of the place of business of the Members of the Exchange or their customers and clients in India or elsewhere. 2.6 ELIGIBILITY FOR TRADING At MCX, only the Members of the Exchange, who have been admitted as such by the Board, are eligible to participate in trading. Persons, who are not Members of the Exchange, can participate in trading only as approved users or clients through a registered member of the Exchange. 2.7 MEMBERSHIP FOR MCX Presently there are three categories of membership available at MCX, depending upon the Trading and the Clearing Rights. These are: Trading-cum-Clearing Member (TCM) Institutional Trading-Cum-Clearing Member (ITCM) Professional Clearing Member (PCM)

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Membership Details Net Worth Criteria Category Admission Initial fees (Rs) TCM-1 TCM-2 ITCM PCM

Security

Deposit(Rs) 20,00,000 30,00,000 10,00,000 65,00,000 10,00,000 50,00,000 NIL

50,00,000

Annual

Corporate

Partnership Individual

Subscription (Rs)

(Rs)

(Rs) 75000 75000 1,00,000

75,00,000 75,00,000 100,00,00

75,00,000 75,00,000 N.A.

75,00,000 75,00,000 N.A,

1,00,000

0 500,00,00

N.A.

N.A.

0 *admission fees paid by a member are non-refundable

2.8 STRATEGIC REGIONAL ALLIANCES •

Bombay Bullion Association (BBA)

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Bombay Metal Exchange (BME)

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Solvent Extractors’ Association of India (SEA)

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Pulses Importers Association (PIA)

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Shetkari Sanghatan

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The United Planters Association of Southern India (UPASI)

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India Pepper & Spice Trade Association (IPSTA)

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Rajkot Seeds, Oil and Bullion Association

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MCX has also established the National Gold Delivery market in partnership with the World Gold Council. 2.9 GLOBAL ALLIANCES

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The Tokyo Commodity Exchange (TOCOM)

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The Baltic Exchange, London

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New York Mercantile Exchange (NYMEX)

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Chicago Climate Exchange (CCX)

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London Metal Exchange (LME)

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Dubai Multi Commodities Centre (DMCC)

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New York Board of trade (NYBOT)

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Bursa Malaysia Derivatives, Berhad (BMC)

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Euronext .liffe

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Zhengzhou commodity Exchange (ZCE) 2.10 KEY SHAREHOLDERS

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Financial Technologies

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State Bank of India & it’s associates

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NABARD

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NSE

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Fidelity International

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Corporation Bank

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Union Bank of India

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Canara Bank

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Bank of India

•

Bank of Baroda

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HDFC bank

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SBI Life Insurance

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State Bank of Indore

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State Bank of Hyderabad

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State bank of Saurashtra 2.11 ASSOCIATE COMPANIES OF MCX

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National Bulk Handling Corporation Ltd (NBHC)

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National Spot Exchange Ltd (NSEL) 2.12 COMMODITIES TRADED ON MCX

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Around 70 commodities are traded on MCX. These are

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bullion (gold, silver etc)

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energy (crude oil, Brent crude oil, ME crude oil ,natural gas, furnace oil)

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grains (wheat, rice etc)

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plastic (polypropylene etc)

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metals (ferrous and non-ferrous)

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oil & oil seeds (mustard seed, castor seed etc)

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fibres (kapas, cotton long staple etc)

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spices (black pepper, red chilli etc)

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pulses (chana, tur etc)

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sugar (gur, sugar medium grain)

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plantations (rubber, arecanut) and

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Others such as mentha oil, cashew kernel, and guar seed, guar gum, potato. 2.13 FIRSTS BY MCX

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Starts futures trading in steel, mentha oil and cashew globally

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Starts futures trading in plastic in the Asia Pacific region

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Launches futures trading in crude oil and natural gas in India

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Enables real time wireless internet trading in India

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Initiates an evening session to coincide its trading with trading on international exchanges

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Only exchange in the country, which has insured its ‘Settlement Guarantee Fund’

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MCX-COMDEX is India’s first composite Commodity Futures Index

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Chapter3: Identification of problem PROBLEM STATEMENT: Study of the three different crude oil contracts of MCX and their market participants (the role of market participants; hedgers, speculators, arbitragers) Comparison of the crude oil contracts of MCX and NYMEX

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Chapter4: Literature Review Markets in petroleum futures developed in response to instability of spot prices. The first generation of petroleum futures, including a crude oil contract on the New York cotton Exchange and a Bunker C & gasoil contract on the NYMEX was introduced in 1974. These first generation contracts failed because the petroleum prices did not fluctuate as expected. In the second generation petroleum futures heating oil and heavy oil contract was introduced on NYMEX in November, 1978, which was successful. As a result of this success NYMEX in March 1983 introduced crude oil contract which expanded the potential for trading petroleum futures and substantially intensified the interaction between the futures and spot markets. In India commodity futures trading was started only after MCX was established in the year 2003, before that there was no futures exchange and all the commodities were traded on the spot market. On 9th February, 2005 all the three future contracts of crude oil was launched at MCX. The volume of crude traded is in fluctuating nature and the highest volume of crude traded is around 9,000,000 barrels in July, 2005 since the launch of contracts.

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Chapter5: Research Methodology Data Collection Source: Secondary data Kind of Research: Exploratory research The data for the project has been collected from the articles and reports available on the net, reference material and books in the library of MCX and also intranet of MCX that helped me in preparing project as per the expectation of my External Guide.

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Chapter6: Analysis and Findings INTRODUCTION COMMODITY MARKET- Overview A market where commodities are traded is referred to as a commodity market. It is a market where a wide range of commodities such as agricultural commodities (soyoil, palm oil, coffee, food grains such as rice and wheat, pulses, pepper etc), bullion (gold and silver), base metals (aluminum, copper, zinc etc), energy products (crude oil, natural gas etc) are traded. It is important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market. The concept of market started with trading of agricultural products where farmers brought their produce to a central place (mandi) in a town/village where grain merchants and traders would buy the produce and then transport, distribute and sell it to other market. In traditional markets, negotiations use to take place between the parties and deal was to struck after the mutual agreement on the price and the quantity to be bought/sold. Due to mutual agreement the parties involved could not predict the market prices of the commodity which lead them to bear loss in the form of either increase or decline in prices, wastage of their produce, to bear extra cost etc, in a given period. As a result of this situation the farmers and the food grain merchants in Chicago started negotiating for future supplies of grains in exchange of cash at a mutually agreed price. This type of agreement was acceptable to both parties

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since the farmer knew in advance how much he will receive for his produce and the dealer was aware of his cost of procurement. This effectively started the system of commodity forward contracts, which gradually led to the establishment of futures market. Among the various commodities market, the crude oil market is unique in complexity and diversity, which have tremendous advantage and benefits for an economy not only in terms of business generation but also provides growth in employment opportunities. The scale is international and the trading instruments range from the physical to the financial. As a result , the oil market has attracted the broadest possible set of participants ; not only oil co’s but also banks, commodity traders, government agencies, ship owners, airliners etc are all involved in the business of trading crude oil. HISTORY OF COMMODITY MARKET In India, the futures market for commodities evolved by the setting up of the “Bombay Cotton Trade Association Ltd.”, in 1875.A separate association by the name "Bombay Cotton Exchange Ltd” was established following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. With the setting up of the ‘Gujarati Vyapari Mandali” in 1900, the futures trading in oilseed began. Commodities like groundnut, castor seed and cotton etc began to be exchanged. Raw jute and jute goods began to be traded in Calcutta with the establishment of the “Calcutta Hessian Exchange Ltd”. in 1919. The most notable centers for existence of futures market for wheat were the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar , Moga, Ludhiana , Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and

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Muzaffarnagar, Chandausi, Meerut , Saharanpur , Hathras, Ghaziabad, Sikenderabad and Barielly in U.P. The Bullion Futures market began in Bombay in 1990. After the economic reforms in 1991 and the trade liberalization, the Govt. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The Committee recommended that futures trading be introduced in basmati rice, cotton, raw jute and jute goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them, rice bran oil, castor oil and its oilcake, linseed, silver and onions. All over the world commodity trade forms the major backbone of the economy. In India, trading volumes in the commodity market have also seen a steady rise - to Rs 5, 71,000 crore in FY05 from Rs 1, 29,000 crore in FY04. In the current fiscal year, trading volumes in the commodity market have already crossed Rs 3, 50,000 crore in the first four months of trading. Some of the commodities traded in India include Agricultural Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute, Rubber, Spices, Cotton, Precious Metals like Gold & Silver, Base Metals like Iron Ore, Aluminum, Nickel, Lead, Zinc and Energy Commodities like crude oil, coal. Commodities form around 50% of the Indian GDP. Though there are no institutions or banks in commodity exchanges, as yet, the market for commodities is bigger than the market for securities. Commodities market is estimated to be around Rs 44, 00,000 Crores in future. Assuming a future trading multiple is about 4 times the physical market, in many countries it is much higher at around 10 times. BENEFITS/IMPORTANCE OF TRADING IN COMMODITIES •

In the commodities market all the participants across the value chain of commodities are exposed to price risk, due to the time lag between

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subsequent transactions. Commodity derivatives market enables these participants to avoid price risk by utilizing hedging techniques. •

Participants in the market would be able to determine the “fair value price” as a result of automation and electronic trading system

•

Due to globalization of economies , commodity markets are extremely transparent i.e. manipulation of commodity price is extremely difficult (because prices are benchmarked across different countries)

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Commodity trade is useful to the producer as they can get an idea of the price likely to prevail in the future and therefore can decide between various competing commodities, in which to invest.

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The consumers get an idea of the prices at which the commodity would be available at a future point of time, so he can do proper financial planning and cover his purchases by making forward contracts.

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Commodity trading also helps corporate entities in hedging their risk even if the commodity traded does not meet their requirements of exact quality/technical specifications.

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As fair value price can be predicted well in advance so it helps the exporter in quoting a realistic price and secure an export contract in a competitive market.

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•

Since the contracts for the commodities are standardized, it becomes essential for the producers/sellers to ensure that the quality of the product is as specified in the contract.

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On seeing the huge potential of the commodity market, more and more banks, financial institutions etc are coming forward to offer credit facilities for commodity trading.

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There is a benefit of leveraged trading transactions because one can control commodity futures contract with a margin deposit, which is usually between 5% and 10% of the value of the commodity whereas in equity market investor has to put up the full amount of the equity value to buy the shares due to higher volatility in the equity market.

•

Exchange members could access to a huge potential market much greater than the securities and cash market in commodities and they can also trade in multiple commodities from a single point, on real time basis.

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COMMODITY MARKET ECOSYSTEM

• • • • • • • • • • • • •

LOGISTIC

Farmers Manufacturers Wholesalers Distributors Farmers cooperatives APMC mandis Traders State civil supplies corporation Importers Exporters Merchandisers Oil refining co’s Oil producing co’s

COMPANIES

TESTING

&

CERTIFYING COMPANIES

Central

&

SPOT

Warehousing

MARKETS

Corporations

State

COMMODITY EXCHANGE

Private Sector Warehousing WAREHOUSE RECEIPT SYSTEM

Corporations (WAREHOUSE RECEIPT SYSTEM)

LENDING AGENCIES

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OIL MARKET For the global oil industry, oil trade represents the key nexus between the two main centres of activity: upstream exploration and production, and downstream refining and marketing. Not only does it determine the value of upstream output, but it also defines the cost of the main downstream feedstock. Operational decisions about combining output from various fields to create a specific crude oil export stream with certain characteristics are constantly tested in the market against refiners’ requirements for specific feedstocks to meet final demand for a changing combination of products. Due to the extensive vertical integration of the oil industry until the early 1970s, these decisions were largely kept under the umbrella of major oil companies .Increased crude price volatility since the early 1970s after the nationalization of oil companies, in combination with OPEC output quotas, for example, signaled national governments in oil-importing, developing countries such as South Korea, India, and Brazil to invest in refining capacity to mitigate both refined product volume and price risks. These same trends also created an incentive for governments in oil-exporting countries, notably Iran, Kuwait and Saudi Arabia, to build refineries in order to capture the value added in turning crude oil into refined products. Ever since the simplest distillation units were invented more than a century ago to refine oil and produce illuminating kerosene, it has been the value of the end products that ultimately determines and drives the value of crude. Each unique stream of crude oil generates different combinations of final products, all of which compete in independent markets. The value of the crude oil is therefore derived from the combined value of these co-products, which range from the lightest liquid petroleum gases and sophisticated gasolines to the heaviest fuel oils for ships. The price of oil emerges from a complex interaction between the signals provided

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by product markets through the purchasing decisions of refiners, and the varying revenue objectives of producers. This process has rarely been purely economic, and it has had political overtones since the early 1900s because of oil’s strategic importance. While OPEC is currently the most visible expression of this political dimension to oil prices, other countries and political groups within them have strongly held stakes. Although most large industrial countries have adopted a pro-free-market stance, even these big consumers have clear concerns and preferences about the level, direction, and volatility of oil prices as they affect their economies. The structure of the markets and their importance as a source of tax revenue are also key political issues. Because of all of these political influences, oil markets do not single-handedly determine oil prices. Rather, they help to define the general level. INTERNATIONAL CRUDE OIL MARKET Oil is the world economy’s most important source of energy and is, therefore, critical to economic growth. Its value is driven by demand for petroleum products, particularly in the transportation sector. Petroleum products power virtually all motor vehicles, aircraft, marine vessels, and trains around the globe. In total, products derived from oil, such as motor gasoline, jet fuel, diesel fuel, and heating oil, supply nearly 40 percent of the energy consumed by households, businesses, and manufacturers worldwide. 1 Natural gas and coal, by comparison, each supply less than 25 percent of the world’s energy needs. 2 The principal activities, as illustrated in Figure 2, involved in moving crude oil from its source to the ultimate consumer are: Production, which involves finding, extracting, and transporting crude oil;

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Refining, the process by which crude oil is turned into products such as gasoline; and Distribution and marketing, which focus on moving those products to final consumers. These activities occur within a global marketplace – an extensive physical infrastructure that connects buyers and sellers worldwide, all supported by an international financial market. The physical infrastructure encompasses a vast array of capital, including drilling rigs, pipelines, ports, tankers, barges, trucks, crude oil storage facilities, refineries, product terminals – right down to retail storage tanks and gasoline pumps. It links an international network of thousands of producers, refiners, marketers, brokers, traders, and consumers buying and selling physical volumes of crude oil and petroleum products throughout this chain of production. The international market also includes futures and other financial contracts that allow buyers and sellers to efficiently insure themselves against significant price and other business risks, thereby minimizing the impact of price volatility on their operations. In sum, the global oil market comprises thousands of participants who help facilitate the movement of oil from where it is produced, to where it is refined into products, to where those products are ultimately sold to consumers.

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OIL SUPPLY CHAIN

Gas Station

Exporting Wellhead

Transport

countries

Shipping

(Storage

facilities 1)

Refinery

Importing countries

Spot

(Storage facilities 3)

(storage

market

facility2)

This supply value chain includes the physical segments of the industry, i.e., production, refining, and distribution, as well as the financial sector, where the knowledge and expectations of thousands of buyers and sellers interact and where prices for current and future delivery of oil are ultimately formed.

PLAYERS OF OIL MARKET

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Oil Producers There is a great deal of concentration in the world oil industry: just ten companies control 68 percent of the world's proven oil reserves. Nine of the ten biggest oil reserve holders are state-owned National Oil Companies (NOCs). Many of these were formerly private sector companies that were nationalized in the 1970s. Eight of the ten largest oil producers in the world are NOCs. The others are large integrated private sector energy companies. World's Top 10 Crude Oil Producers

Source: Oil and Gas Journal, 2006 Since 1960 the world oil market has been significantly influenced by the Organization of Petroleum Exporting Countries (OPEC). The goal of OPEC is to stabilize oil prices by adjusting their production levels and influencing the world's oil supply and demand balance. There are currently eleven members of OPEC, most of which are located in the Middle East and Africa. OPEC countries control

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close to 70 percent of the world's proven oil reserves and in 2005 accounted for about 41 percent of the world's supply of oil. Canada holds the second largest oil reserves in the world, with over 178 billion barrels of oil. Over the next decade, Canada's importance as a leading oil producer is expected to increase, as oil sands production is projected to triple. Other key non-OPEC producers include: Russia, the United States, Mexico, China and Norway. World's Top 10 Crude Oil Reserve Holders

Source: Oil and Gas Journal, 2006 Oil Consumers Oil refineries are the primary users of oil. They convert crude oil into useable petroleum products such as gasoline, diesel, jet fuel and home heating oil. The refining industry's need for crude oil is driven by the demand for these products. The main consumers of oil continue to be the industrialized countries of the

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Organization for Economic Cooperation and Development (OECD), particularly the United States, Europe and Japan, which together consume about half of the world's annual oil output. However, consumption in emerging market regions is expanding at a faster pace (especially in China) as these markets grow rapidly and their use of energy in transportation, industry and residential sectors expands. The transportation sector accounts for about two-thirds of the oil used in the world and for about half of the oil consumed in the United States. OIL TRADERS Oil is a commodity that is widely traded around the world. Similar to other commodities, like coffee and soybeans, oil attracts investors who see an opportunity to make money by speculating on its price volatility. These traders are not generally involved in the actual production or use of oil - they buy and sell paper contracts, not actual oil - but can often have a significant influence on market prices. BROKERS Brokerage firms are often one-man operations. Many are general brokers for whom oil is only part of their business, they hold no title to the cargo traded but is a paid go- between who discovers availability or needs and brings together buyers and sellers. Brokers are compensated on a commission basis and are therefore not exposed o the risks involved in price fluctuations. The commission is normally specified in dollars per ton and is paid by the seller. Brokers are a useful source of market intelligence, since they need good knowledge of the market in order to operate. And are occasionally prepared to impart such information in return for a commission. Brokers operates from a position of neutrality and ,as such, is less controversial than the traders because for traders, clients are adversaries, and makes his profit by purchasing cheaply and selling dearly at the clients’ expense.

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Why crude oil is traded? Crude oil is arguably the world's most important and actively-traded commodity. Oil trades in a world market, and is bought and sold in relation to global prices. Because there are many different varieties and grades of crude oil, buyers and sellers have found it easier to refer to a limited number of reference, or benchmark, crude oils. Other varieties are then priced at a discount or premium, according to how their quality compares to that of the benchmark. Over the last two decades oil market has become the biggest commodity market. During this period oil trading has evolved from a primarily physical activity into a sophisticated financial market. In the process it has attracted the interest of a wide range of participants who now includes banks and financial institutions as well as the traditional oil majors’ independents and physical oil traders. As well as being the largest commodity market in the world, it is also the most complicated. The physical oil market trades many different types of crude oil and refined products and the relative values of each grade are continually shifting in response to changes in supply & demand on both a global and local scale. The industry has therefore developed a complex set of interlocking markets not only to establish prices across the entire spectrum of crude and product qualities, but also to enable buyers and sellers to accommodate changes in relative prices wherever they might occur. The initial momentum for the expansion of the oil market came from the changing structure of the oil industry. Prior to 1973 oil trading was marginal activity for most companies who only used market to resolve any imbalances in supply & demand that might emerge. Trading volumes were typically small and usually

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spot and prices were much less transparent than they are today. And the industry was dominated by large integrated oil companies that had little use for external markets either as a means of obtaining suppliers or as a basis for selling prices. However, the structure of the oil industry changed drastically in the 1970’s with the nationalization of the major oil companies in the Middle East and elsewhere and trading became an essential activity of any oil co’s supply and marketing operations. Having lost access to large volumes of equity oil the major oil companies were forced to buy at arm’s length from their former host governments and the physical base of the international oil market expanded rapidly. With more oil being traded, eternal markets began to set the prices for internal transfers as well as third party sales and co’s started to buy and sell oil if better opportunities existed outside their own supply network fuelling the growth of the market.Driving force behind the rapid growth in “OIL TRADING” is the huge variability in the prices of oil. Crude oil can be traded both in the spot as well as in the future market. Although the two markets are separated, but they are interrelated to each other. It can be physically bought and sold on a negotiated basis in the spot market, which is generally considered as the actual physical market for immediate delivery. Most often, the contract requires for the actual delivery of the commodity traded to be made. It may also specify for immediate or forward delivery in the future at a set time. The physical markets for the commodities deal in either cash or spot contract for ready delivery and payment within 11 days, or forward contracts for delivery of goods and for payment of price after 11 days(in India). These contracts are essentially party-to-party contracts and are fulfilled by the seller giving delivery of goods of a specified variety of commodity as agreed between the parties. In case of unforeseen /uncontrolled situations which prevent

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buyers/sellers from receiving/giving deliveries then in such cases contracts may be settled mutually.

CRUDE OIL SPOT MARKET The starting point of trade for all commodities has been the spot market; it is the “natural” market. Hence spot market in crude oil refers to short-term trading usually involving one cargo of oil per deal, with each deal struck at an agreed price for prompt lifting or delivery. It is a process by which cargoes of petroleum are exchanged on a day-to-day basis rather than under long-term contracts. The spot market is not a formal institution. It is an informal worldwide network of personal and professional contacts that facilitates the carrying out of cargo-bycargo sales and purchases of crude oil. Rotterdam, New York, or Caribbean, the refining and storage place became the important center for spot trading, although market participants can be located anywhere. Participants do not meet to match bids and offers; the transactions take place through telexes of trading office. The transaction process has become more complex because the trading volume has increased to a greater extent and also more number of oil companies and market participants have involved. Since the size of trading volume have increased and also it may be worth of at least million of dollars, banks involved in financing the transactions, insurance arrangements have to be made, quality and inspection procedures must be defined in detail. The most common disputes that arise in the spot trading are:

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•

Nondelivery

•

Delayed delivery,

•

Quality disputes and price differentials,

•

Inspection disputes,

•

Payment disputes, and

•

Bankruptcy disputes.

Spot Market Key Role The size of the international crude oil spot market is extremely difficult to gauge, but its enormous influence and its significance for virtually all aspects of the oil business are unquestioned. While spot deals are estimated to account for around one third of physical sales of crude oil, the prices generated by these transactions are now the primary determinant of almost all other world oil prices. This presence is most apparent in the formula pricing systems now used for the bulk of term crude oil sales by OPEC and many other producer countries such as Mexico. Formulas typically specify direct price linkages to particular spot crude oil quotes. Spot prices are also closely tracked by the countries and companies that sell crude oil on the basis of postings or retrospective pricing arrangements. In today’s market, crude oil sellers have little scope for deviating from the trends established by the spot market which comprises the trading of individual cargoes or partial shipments for immediate delivery,

outside

of

any

continuing

supply

commitment.

Beyond their dominant role in international crude oil pricing, spot markets have a significant impact on everything from an oil company’s share price to its investment plans. The spot market and closely linked futures trading are also used as the main barometer for measuring OPEC’s success at balancing global supply and demand. While oil companies tend to gear their long-term investment plans to future price expectations rather than to current market levels, it is also clear that

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spending plans are slowed or accelerated over the course of the year depending on the strength of current spot markets and on changes in exploration and development costs. Spot prices are used as the yardstick of a firm’s future cash flows, which are key determinants of capital investment expenditures.

One of the distinguishing characteristics of the physical crude oil spot market since the early 1980s has been its extreme price volatility. Wide swings in prices

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have fostered the growth of large forward and futures markets and an array of risk management tools that are effectively an extension of the physical spot market. The futures markets are dependent on the physical spot market in that they are linked to them at the point of delivery, but the two are constantly responding to each other and have grown mutually intertwined and dependent. Futures markets trade oil volumes for future delivery that far overshadow the spot market. The New York Mercantile Exchange, or Nymex, and London’s IPE crude oil futures exchanges together trade the equivalent of over 300 million barrels in each session, or four times the volume of physical crude oil produced around the world daily.

VARIOUS STAGES OF DEVELOPMENT OF CRUDE SPOT MARKET Spot transactions in crude are as old as the industry itself. Rotterdam, Gulf of Mexico, Caribbean, Singapore and Dubai are the major centers for spot trading which have established in the past three decades. They have developed in four distinct stages, which are explained below: STAGE 1: The Spot market functioning as the residual market Almost all oil companies face the problem of matching their refinery output with the market’s current demand for various products. They have deficits of some product and surpluses of others. The company may balance these deficits and surpluses through the use of storage or shipment facilities. But it is more economical to balance them by swapping or selling and buying some products on the spot market. The role of the spot market at this stage can be described as a residual channel of oil trade because at that time major oil companies use to take

35

part in the spot market just to balance demand and supply. At this stage the volume of trading was very small i.e. insignificant. STAGE 2: Shift from a residual to a marginal market After the 1973-74 oil crisis, the spot market began to play a marginal role in petroleum trading, small but significant trading as opposed to the small and insignificant trading of the residual market. When the spot market serves a residual role it basically follows contract prices (usually with a discount or a premium) without significantly affecting these prices. But when the spot market serves a marginal role, it becomes an indicator of overall market conditions as decisions are determined by marginal results. STAGE 3: Turning into a major market Despite the significance of spot transactions to the industry’s planning and pricing policies, their volume remained small during the second stage of market development. It was only after 1983 that spot trading began to grow appreciably and spot related transactions grew to account for 80-90% of internationally traded oil. Factors which contributed to the rapid development of the spot market are: Excess capacity in the refining industry forced refiners to fight for their survival. Refiners were forced to use the most economical way of procuring crude oil. They increased their refinery throughput to the point where the price of a marginal barrel of product covered the marginal operating cost. This brought about a shift from term contract arrangement to spot purchasing of crude to take advantage of flexible spot prices over rigid contract prices. “Refining for the spot market” also became common practice means excess capacity forced many refiners to refine and sell on the spot markets as long as they could cover operating costs.

36

As the member countries of the Organization of Petroleum Exporting Countries (OPEC) began to lose their market share, they began to engage in so-called spotrelated sales to recapture lost sales. These spot-related sales included variable price contracts, barter trade etc. The main problem with spot trading is that neither the producer no the consumer can predict the price and quantity and thus are unable to plan their business. The extent of this problem is, of course, different for various commodities depending on the volatility of the market and the lead time needed for investment decisions. The most difficult trading situations of the oil industry is that in which: The supply of the commodity ,and its price is subject to manipulation; and There is a long investment lead time for both producers and consumers, who may, use this commodity to produce other good Due to these problems in the spot market, parties search for the contractual arrangements that provide predictability in price and quantity over a specified period of time. Successful

market

needs

standardized

trading

instruments

in

order

to generate liquidity and improve price transparency and oil is no exception. But since oil is inherently non-standard commodity, the industry has chosen a small number of ‘reference’ or ‘marker’ grades of crude oil and refined products to provide the physical basis for a much larger “paper” market which trades derivatives instruments such as forward and futures contracts. Although the choice is often arbitrary and problems can arise due to unforeseen changes in the underlying physical market, the industry has invariably found ways of adapting the contracts, since rest of the market now depends on their continued existence.

37

The most important derivative trading instrument is the New York Mercantile Exchange’s Light sweet crude oil contracts. It is usually known as “WTI” since West Texas Intermediate crude still effectively underpins the market despite the introduction of alternative delivery grades in recent years. NYMEX WTI is the most actively traded oil market in the world and not only provides a key marker for the industry as a whole, but also supports a wide range of others sophisticated derivative instruments such as options and swaps. So to be more effective spot market functions simultaneously with the future markets.

STAGE 4: Parallel function with futures markets Markets in petroleum futures developed in response to instability of spot prices. The first generation of petroleum, including a crude oil contract on the New York Cotton Exchange and a Bunker and gasoil contract on the New York Mercantile Exchange (NYMEX), was introduced in 1974. None of the first generation contracts were successful because petroleum prices did not fluctuate as expected. The international spot prices of the crude oil stayed between $10.30 and $10.40 per barrel during the period from October 1974 to December 1975. Price stability was further reinforced in the United States by the Energy Policy and Conservation Act (1975), which by limiting the annual increase in the crude oil price, led to reasonable predictability in petroleum prices. The second generation of petroleum futures began with the introduction of a heating oil and heavy fuel contract on NYMEX in November 1978. The success of the heating oil contract encouraged NYMEX and other exchanges (Chicago

38

Board of trade, Chicago Mercantile Exchange, and International Petroleum Exchange of London) to introduce other petroleum futures. Among them, NYMEX

crude oil contract introduced in March 1983was the most significant;

it expanded the potential for trading petroleum futures and substantially intensified the interaction between the futures and spot markets. The significance of this contract was in: Its “cash market”, i.e. the crude oil spot market , being one of the largest commodity markets in the world; The complementary role of this contract in providing the industry’s requirement of a crude/product mix of contracts before effectively utilizing petroleum futures or hedging purposes; and The fact that it soon developed into a price signaling channel for crude oil traders, especially in the United States. Indeed, it was after the introduction of this contract that the petroleum industry began to take futures trading seriously. At this stage both the spot and future market expanded and increased their role in the decision making activity of the industry and at the same time, the two markets interact, compete and complement each other. The co-existence of spot and future trading is the sign of maturing market.

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FUTURES MARKET EVOLUTION OF FUTURE MARKET Futures markets have evolved from the so-called forward trading, which dates back at least to the seventeenth century. A forward trading contract is an agreement the sale (or purchase) of a commodity at a specified time in the future at a certain price. It differs from a future contract as forward contracts are not standardized with respect to quantity, quality and location. Rather each contract is designed as per the special need of the buyer and seller. The formal emergence of futures market occurred in the 19th century when futures trading started in United States, the United Kingdom, Germany and elsewhere. The oldest commodity exchange in US is the Chicago Board of Trade, which was founded in 1848 and futures trading in 1865 and other exchanges began trading in the second half of 19th century. Futures market exist for a wide array of real and financial assets, including grains and feeds, livestock, industrial raw materials(crude oil etc), precious metals, financial instruments and foreign currencies. By 1990, futures trading in various commodities expanded in many European and Asian countries. Futures market in various countries developed in response to Economic forces in the spot market. If situations in the spot market are suitable then futures market will emerge. After its development, the future market will facilitate the operation of spot market. Thus futures market have evolved out of

40

the need to have functions performed that the existing marketing system is not performing effectively. Futures’ trading was introduced in response to the seasonal fluctuations in the supply of commodities. A logical extension of the future market was the development of forward contracts. With the passage of time some new characteristics were incorporated in these forward contracts, which finally lead to the formal introduction of futures trading. These are: For the purpose of promoting the commerce of Chicago, the city’s Board of Trade was designated as the official agency for the measurement, weighing and inspection of grains. This led to the development of quality standards that facilitated the trade even for those who did not much about the grains. An organized exchange (CBOT) was introduced as the marketplace for those who wanted to but or sell forward contracts. Contracts became increasingly transferable, allowing a buyer of contract to sell his contracts before the time of delivery. The trading of forward contracts was expanded to cover a new group of peoplespeculator- who were not actually involved in the production, storage, processing or consumption of the commodity but who viewed the forward contract deals as “a paper market” which was very suitable for making a fast profits. MEANING The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The

41

futures contract will state the price that will be paid and the date of delivery. But, almost all futures contracts end without the physical delivery of the commodity. Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies and stock indexes. Trading has also been initiated in options on futures contracts, enabling option buyers to participate in futures markets with known risks. Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half, to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts--contracts that establish a price level now for items to be delivered later--individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging. Volume has increased from 14 million futures contracts traded in 1970 to 179 million futures and options on futures contracts traded in 1985. Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity but, rather, seek to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators helps to provide active, liquid and competitive markets. Speculative participation in futures trading has become increasingly attractive with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions--such as what to buy and sell and when to buy and sell--others choose to utilize the services of a professional trading advisor, or to avoid day-to-day trading responsibilities by establishing a fully

42

managed trading account or participating in a commodity pool which is similar in concept to a mutual fund. For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds and other investments. Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time. The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading are a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value. What Exactly Is a Futures Contract? Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with

the cable company to receive a specific

number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices. That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how

43

much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market. So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel Profit And Loss - Cash Settlement The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

44

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides

to

sell

the

stock

or

cover

his

or

her

short

position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract. But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is

45

referred to as hedging. Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires. Economic Importance of the Futures Market Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators. Price Discovery – Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrows estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. Risk Reduction – Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the

46

retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market. MERITS & DEMERITS OF FUTURES MARKET • •

MERITS

To avoid the effect of fluctuations in prices for producers who, because of their limited production volume or seasonal factors are not able to spread out their sales over the year, or for consumers who, because of their limited size, cannot spread out their purchases.

•

To protect the value of inventories, or partly finance the cost of storage.

•

To secure a processing margin.

•

To “lock-in” future price at an attractive level.

•

To improve marketing policies and financial planning and forecasting. DEMERITS

One of the most important demerit of futures trading is that ; they freeze up working capital due to margin requirements and mark to market on a real time basis with daily settlement. MECHANICS OF FUTURE TRADING HEDGING The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures market to protect their business from adverse price changes. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of hedge).

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Long Hedge A situation where an investor has to take a long position in futures contracts in order to hedge against future price volatility. A long hedge is beneficial for a company that knows it has to purchase an asset in the future and wants to lock in the purchase price. A long hedge can also be used to hedge against a short position that has already been taken by the investor. For example, assume it is January and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $1.50 per pound, but the May futures price is $1.40 per pound. In January the aluminum manufacturer would take a long position in 1 May futures contract on copper. This lock in the price the manufacturer will pay. If in May the spot price of copper is $1.45 per pound the manufacturer has benefited from taking the long position, because the hedger is actually paying $0.05/pound of copper compared to the current market price. However if the price of copper was anywhere below $1.40 per pound the manufacturer would be in a worse position than where they would have been if they did not enter into futures contract. Uses of long (buying) hedge •

To protect increase in the cost of raw material

•

To replace inventory at a lower prevailing cost

•

To protect uncovered forward sale of finished goods

Buying hedge is done with the purpose of protecting against price increase in the spot market of a commodity that has been already sold at a specific price but not yet purchased. It is very common among exporters and importers to sell commodities at an agreed price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered. Long hedgers are

48

traders and processors who have made formal commitments to deliver a specified quantity of raw material or processed goods at a later date at a price currently agreed upon and who do not have the stocks of the raw material necessary to fulfill their forward commitment.

BUYING HEDGE SPOT AND FUTURES PRICES INCREASE LONG FUTURES PAYOFF

PROFIT

PROFIT PRICE

LOSS

SHORT PHYSICAL PAYOFF LOSS

Payoff for buying hedge when spot and futures prices increases

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BUYING HEDGE (spot and futures price decrease)

PROFIT

SHORT PHYSICAL PAYOFF

PROFIT

PRICE

LOSS

LONG FUTURES PAYOFF LOSS

Payoff for buying hedge when spot and futures prices decrease

Short Hedge An investment strategy that is focused on mitigating a risk has already been taken. The "short" portion of the term refers to the act of shorting a security, usually a derivatives contract and those hedges against potential losses in an investment that is held long (i.e., the risk that was already taken).

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If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position, and vice versa A common risk in short hedging is basis risk, or the risk of price levels not changing much over the period the hedge is in place; in this scenario, the asset held in the long position would not gain any value, and the short hedge would lose value. Short hedging is often seen in the agriculture business, as producers are often willing to pay a small premium to lock in a preferred rate of sale in the future. Also, short hedges involving interest rates are common among institutional money managers that hold large amounts of fixed income securities and are concerned in the reinvestment risk in the future. E.g. in April 2006, Mr. A, the gasoline manufacturer buys 10,000 barrels of crude in a spot market at a price of Rs 9700 per barrel as a raw material to make gasoline from it. Mr. A wants to protect the reduction in the price of crude till the gasoline is ready for sale in may 2006. For the above purpose Mr. a sells 100 contracts (100 barrels each) of crude June futures at prices of Rs 9800 per barrels. In May 2006 Mr. A sells 10,000 barrels of gasoline at the reduced spot prices of Rs 9600 per barrel and squares off his crude June futures open short position at Rs 9700 per barrel.. The above transaction have resulted in a profit of Rs 100 per barrel in crude June futures contract and a loss of Rs 100 per barrel in the spot transaction, thereby protecting the price of the finished material i.e. gasoline at Rs 9700 per barrel.

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SELLING HEDGE (spot and futures price decrease)

LONG PHYSICAL PROFT

PAYOFF

PROFIT PRICE LOSS

SHORT FUTURES LOSS

PAYOFF

Payoff for selling hedge when spot and futures price i

52

SELLING HEDGE (spot and futures prices decrease)

PROFIT

SHORT FUTURES PAYOFF

PROFIT

PRICE

LOSS

LONG PHYSICAL PAYOFF LOSS

SS

Payoff for selling hedge when spot and future price decrease

Only hedge strategies operations made to provide protection to the participants who have exposure in the physical commodities markets will be explored here. For all practical purposes, hedgers efficiently transfer risks (to which they are exposed in the physical commodity market) to speculators and arbitragers (who are wiling to take risks). In short, the principle of hedging is that loss in one

53

market should be offset by an “equivalent” gain the other market. With such a strategy, one locks in price to be paid or receive for future deliveries. Two basic strategies of hedging can be summarized here: Firstly, hedges can be undertaken in order to offset price risk that has arisen in a physical contract; this is known as “offsetting hedge”. The fundamental principle is to maintain the balanced book, each physical transaction must be balanced by an opposite futures operation. Hedges can serve to lock-in an attractive price level, by securitizing profits on anticipated business. This last strategy may seem to be speculative one but it is the opposite: locking-in a good price removes the speculative part from a transaction by fixing the sales price at a level above known costs (in case of seller) or fixing a purchasing price at a lower level. Different people can use future to hedge their position. A producer can sell forward in a future market in order to hedge sales of physical to clients, whether these sales are based on a long-term contract or spot. Exporters, merchants, manufacturers, and on the other side importers and customers ma also benefit from futures hedging when they have to buy, sell or both. Some commodity producers use commodity futures as an instrument to ensure their physical delivery commitments can be realized. Factors like: Temporary technical breakdowns , Upgrading of the refinery process to comply with environmental legislation, Strikes at ports, Transportation problems or Electricity cuts etc may leave the producers with shortages preventing him from delivering his clients the forward committed quantity of commodity. The producer will have to buy the lacking quantity on the spot market. The risk is that by the time these kinds of production shortages occur, spot price may rise, entailing large costs to the

54

producer. In practice, some commodity traders buy futures contracts covering part of their projected deliveries in anticipation of supply problems. If, unforeseen sales commitments surpass possible deliveries, the trader lets his future contracts expire and takes delivery of the commodity. HYPOTHETICAL EXAMPLE: A crude oil producer enters into the contract to sell 100 barrels of crude to refiner four months from now. The price is agreed upon today though the crude will only be delivered after four months. The producer is worried about the rise in price of crude during the course of next four months. Rise in the price of crude will result in losses in contract with the producer. To safeguard against the risk of increasing prices of crude, the producer buys crude oil future contract that call for the delivery of crude in four months time. The producer then purchases the crude in the spot market at a higher price. However since he has hedged in the futures market, he can now sell his contract in the futures market at a gain since there is an increase in the futures price also. He does offsets his purchase of crude at a higher cost by selling the futures contract thereby protecting his profit on the sale of the crude. Thus the crude oil producer hedges against exposure to price risk. ADVANTAGES AND LIMITATIONS OF HEDGING ADVANTAGES •

Hedging reduces or limits the price risk associated with the physical commodity.

•

It is used to protect the price risk of a commodity for long periods by rolling over contracts.

•

It makes business planning more flexible without interfering with routine business operations.

•

Facilitates low cost financing.

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LIMITATIONS •

It cannot eliminate the price risk associated with the physical commodity in totality due to the standardized nature of futures contracts.

•

Because of basis risk, hedging may not provide full protection against adverse price changes.

•

Hedging involves transaction costs.

•

It may require closing out a futures position before it enters into the delivery period.

SPECULATION Speculation means anticipating futures price movements to make profits from it. The main objective of speculation in a commodity futures market is to take risks and profit from anticipated price changes in the futures price of an asset. A speculator will buy futures contract (long position) if he anticipates an increase in the price of the commodity in future and he will sell futures contract (short position) if he anticipates a fall in the price of commodity in future. Long Position in Futures Long position in commodity futures contract without any exposure in the cash market is called a speculative transaction. Long position in futures for speculative purpose means buying a futures contract in anticipation of increase in the price before expiry of the contract. If the price of the future contract increases before the expiry of the contract then the trader makes profit on squaring off the position and if the prices of the futures contract decrease then the trader makes losses. Short Position in Futures Short position in commodity futures contract without any exposure in the cash market is called a speculative transaction. Short position in futures for speculative purpose means selling a futures contract in anticipation of decrease in the price

56

before expiry of the contract. If the price of the future contract decreases before the expiry of the contract then the trader makes profit on squaring off the position and if the price of the futures contract increases then the trader makes losses. EXAMPLE In April 2005, Mr. Black, a stockbroker sees that there will be sudden increase in the prices of crude oil by end of the year. He is not interested to buy oil barrels in the physical market because he is not interested to take physical delivery due to storage and other issues. He buys 10 contracts (100 barrels each) of Crude Oil Dec 05 contract on MCX platform at Rs.2000 per barrel. In the process he can enjoy a leverage of 20 times as he will deposit (margin) suppose only 5 % (Rs.100,000) with the exchange and be free from quality and storage requirements. The Crude Oil futures prices actually move according to his anticipation and rule at Rs. 2050 in December 2005, which gives him a profit of Rs. 50,000 on his 10 contracts of 100 barrels each buy position in futures, which he squares off by selling in MCX. The Role of Speculation on Futures market One of the prominent concerns about the functioning of the commodity futures markets and effect on the distribution of manpower is speculation. Speculation provides the depth and flow that is the key to the functioning of the futures market. There will be very high illiquidity in the futures market if firms after entering a trade to buy or sell have to wait till a suitable bid or offer arose since the availability of commodities in physical may not always necessarily match with the firm’s decision to buy and sell commodities. The intention of speculators is to profit by taking risks that is already prevalent in the market and as a result plays an economically important role. A proper and

57

accurate assessment and interpretation of the fundamental factors that drive the market forces determines the extent of success in speculating in the futures markets. In fact, the important function of price discovery in the futures markets is a direct outcome of the exercise of the information gathering in the underlying in commodities being done by the speculators. They forecast the movement in price and this effort would eventually bring the prices closer to the market equilibrium. If the futures market does not adhere to the relevant risk management requirements of growers, manufacturers, traders and processors, they would not survive since their correlation with the underlying physical market would be nonexistent. ARBITRAGE Arbitrage means locking in a profit by simultaneously entering into transactions into or more markets. If the relationship between spot prices and futures prices in terms of basis or between prices of two futures contracts in terms of spread changes, it give rise to arbitrage opportunities. Difference in equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage. The futures price must be equal to he spot prices plus cost of carrying the commodity to the futures delivery date else arbitrage opportunity arises. Mathematically, it can be expressed as F (o, n) = So (1+c) F(o,n) = futures price of the commodity at t=0 for expiry at t=n So= spot prices of the commodity at t=0, c= cost of carry from t=0(present) to t=n (expiry date of futures) expressed as percentage of the spot pices. Cost of carry relationship also applies to price relationship that should exist between futures contracts of same commodity with different expiry dates. The farmonth futures price must be equal to the near-month futures price plus cost of

58

carrying the commodity from the near month to the far month expiry date else arbitrage opportunities arise. Mathematically it can be expressed as F (o, f) = F (o,n) (1+c) where f>n F (o, f) = futures price of the commodity at t=0 for expiry at t=f (far-month), F (o, n) = futures price of the commodity at t=0 for expiry at t=n (near-month), c= cost of carry from t=n (near-month) to t=f(far-month) expressed as percentage. Arbitrage provides market efficiency in commodity futures and hence prices are quoted at their fair value most of the time. Cash And Carry Arbitrage Between spot and future prices means buying physical commodity with borrowed funds and simultaneously selling in the futures contract in the first transaction and closing the futures contract by delivering the physical commodity on maturity in the second transaction. This opportunity arises when the futures prices of the asset is more than the spot price of the asset plus cost of carrying the asset to the futures expiry date, ie F (o,n) > (1+c) Between two futures contracts means buying the near-month futures contract with borrowed funds with the intention of taking delivery and selling the far-month futures contract with the intention of giving delivery. This opportunity arises when futures price of the far-month contract is more than near-month futures price plus cost of carrying the commodity from the near-month to the far-month expiry date, F (o,f)> F(o,n) (1+c) where f>n . Reverse Cash And Carry Arbitrage Between spot and futures prices means lending, funds realized from selling the physical commodity and simultaneously buying the futures contract in the first transaction and closing out futures contract by taking delivery of the physical commodity on maturity in the second transaction. ssThis arbitrage opportunity arises when the futures price of the asset is less than the spot price of the asset plus cost of carrying the asset to the futures expiry date,ie F (o,n) < So (1+c)

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Between two futures contracts means selling the near-month futures contract with the intention of giving delivery from the available physical stock of the commodity and buying the far-month futures contract with the intention of taking delivery. This opportunity arises when far-month futures price is less than the near-month futures price plus cost of carrying the commodity from the nearmonth to the far-month expiry date,ie F (o,f) < F(o,n) (1+c) where f>n.

FUTURES TRADING IN THE PETROLEUM MARKET Although a future trading in the petroleum market is a recent phenomenon, forward trading has existed in this market for a long time. Contract sales with fixed prices have served the industry as a form of forward trade for several decades. At present, however, revisions, discounts, and premiums to the posted price are becoming the rule rather than the exception. Many contract prices are now related to the spot market price. Thus, contract sales have lost their forward trading characteristics, creating an opportunity for futures trading to provide price insurance to petroleum traders. Petroleum futures developed in response to instability in petroleum prices. “First generation” petroleum futures, which were introduced in 1974, came about as a reaction to the 1973-74 fluctuations in the price of oil. It started with the introduction of a crude oil contract on the New York Cotton Exchange in 1974. The contract called for the delivery of crude at Rotterdam. These futures failed for various reasons, the most important of which was the relatively stable prices that prevailed in the market in 1975. All the first generation contracts failed to attract the petroleum industry and faded into obscurity due to several reasons. The most important of which was that petroleum prices did not fluctuate as expected, the international spot prices of

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crude oil stayed between $10.30 and $10.46 per barrel during the period of October 1974 to December 1975. The second reason for the failure of these futures was the lack of participation of petroleum industries in trading these futures. The industry’s lack of participation was related to two discouraging factors. First, the requirement for Rotterdam delivery was a technical inconvience for US refiners, jobbers, distributors and consumers. Although the oil industry has been told that futures contracts provided financial protection and there was no reason to worry about delivery, the industry could not see the rationale of buying or selling a contract that specified the delivery point far away from domestic market. Second, futures markets were unknown to the oil industry, and there were serious concerns about their impact on the petroleum business. “Second generation” petroleum futures started with the introduction of heating oil contract in 1978 on NYMEX, it then expanded to include several futures in crude oil and petroleum products. During 1978 in November two contracts was introduced on NYMEX, the first contract called for the delivery of no.2 heating oil with gravity of 30 deg API and a maximum sulphur content of 0.2 percent. and the second contract called for the delivery of no.6 fuel oil with gravity of 10-30 deg API and a maximum sulphur content of 0.3 percent . The No.2 heating oil future contract was successful after a few months slow trading. Its trading volume reached 34 million barrels in 1979, followed by 238 million,995 million, and 1.754 billion barrels in 1980, 1981,1982, respectively. The volume of trade reached 25 million b/d in 1990.The success of this future was due to several factors, they were: First, gasoil was exempted from price controls in more than forty states in 1976. The international prices of oil had been very volatile since late 1978.

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The complete deregulation of U.S. oil prices by the Reagan administration in February 1981 forged a stronger link between domestic prices and volatile international prices. NYMEX has consistently attempted to communicate the uses of its futures contracts to the petroleum industry. The success of the heating oil contract encouraged NYMEX and other exchanges to introduce other petroleum futures. Probably the most important event in the energy futures market was the introduction on March 30, 1983, of crude oil future contract at NYMEX. This contract called for the delivery of 1000 barrels of sweet crude at Cushing Storage, Oklahoma. So other types of crude (U.K. Brent Blend, Nigerian brass blend, and bonny light, Norwegian Efofisk, Tunisian Zarzaitine, Algerian Saharan Blend, Mid Continent Sweet, New Mexican Sweet, and South Texas Sweet) were, all acceptable for delivery at certain premiums and discounts. Cushing was chosen as the delivery center because it was common for companies to trade crude oil there. Benefiting from NYMEX experience, a petroleum futures market was established in London. This market came to be known as the International Petroleum Exchange (IPE), introduced its first contract in April 1981.It introduced its crude oil contract in November 1983.Each contract specified 100 barrels of Brent blend. CRUDE OIL FUTURE CONTRACT A futures contract, in contrast to a spot transaction, concerns the future purchase or sale of crude oil or petroleum products.*specifically, it is a contract that carries the obligation for delivery of a given quantity of crude in the future. The contract specifies the volume, type or grade of crude oil, the price, the future time in which the crude is bought or sold, and the particular location to which it is to be delivered. The buying and selling of futures contracts occurs on organized exchanges. Since the vast majority of traders “close out” their positions (i.e., cancel out a contract prior to the time it would require the trader to actually

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deliver or take delivery of the crude oil), futures transactions rarely entail the actual delivery. As a result, the futures market is often referred to as the “financial market.” The crudes underlying futures contracts are often called “marker” or “benchmark” crudes. A common example of marker crude is West Texas Intermediate, which is the principal crude underlying the futures contract traded on the New York Mercantile Exchange, or NYMEX. These organized exchanges allow for the competitive interaction of thousands of independent traders, including both commercial as well as financial institutions. These interactions, in turn, give rise to publicly reported futures prices that reflect the market’s best estimate today of what future supply and demand conditions and, hence, prices will be. Prices of futures contracts are connected to prices in the physical market because futures positions that are not closed out will lead to either delivery or receipt. Thus, the closing “futures” price for any given month must equal the “physical” price at the time trading in the futures contract ends. With delivery, the futures price effectively becomes a physical price at the time the futures contract matures. So, for example, the closing “futures” price for delivery in June must equal the “spot” price for oil in June. If the prices differed, a trader would buy in the market in which the price is lower and immediately sell it into the market where the price is higher and earn a profit. No one wants to leave such profit opportunities on the table. The prices in the spot market transactions described above are often tied to prices for crude oil on organized exchanges (e.g., NYMEX) with, for example, price adjustments to account for differences in the quality of the crude oil being traded and the location of the spot market transaction. In fact, even OPEC countries often base their prices on the prices determined on organized exchanges, with appropriate quality and other differentials. The benefit of these arrangements is

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that the price of the physical crude oil will be set at the market level at the time of delivery. This protects buyers from dramatic price fluctuations that could occur while crude oil was in transit to its final markets. Today it is from the spot and futures markets that the global oil market – producers, refiners, marketers, traders, consumers, investment banks, hedge funds, and so forth – receives competitively determined market signals that inform buyers and sellers on current and future supply and demand conditions. In sum, the interactions of well-informed traders on spot and futures markets assure that the global price of crude properly reflects its market value. CHARACTERISTICS •

A future contract is standardized with respect to four elements:

•

The quantity to be delivered(for instance 1000 barrels of oil)

•

The quality or qualities to be delivered

•

The time interval within which delivery is to be made

•

The location or locations where delivery can be made (for e.g. Cushing storage, Oklahoma)

•

The method of delivery

•

They may include

•

Specific premiums or discounts for variations in quality

•

Specific premiums or discounts for different delivery points

•

They normally contain limits on

•

The minimum price fluctuations

•

The maximum permissible price fluctuations

•

The contracts on U.S. exchanger impose

•

A limit on the number of contracts that each person can hold Benefits of CRUDE OIL Futures Markets Futures markets bring a number of benefits to the global oil market.

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First, crude oil futures markets provide information about future expectations regarding supply and demand conditions. Second, these expectations are made transparent, i.e., known to the market, in the form of a series of futures prices for crude to be delivered at different dates in the future. Finally, crude oil producers, marketers, refiners, and others are able to use the financial contracts on the exchanges to manage risk, facilitated, in part, by the increasing participation of the number of investors without a commercial interest in the petroleum industry (i.e., no capacity to produce, refine, store, or sell physical volumes of crude or petroleum products). Of course, actual prices for crude in the future may be different than those implied by today’s future prices. Because it is the market’s best estimation today that oil will be $65 per barrel in three months does not necessarily imply that oil will, in three months, be $65 per barrel. As expectations about future supply and demand conditions change, e.g., due to colder than expected weather or unforeseen political events that could cause temporary supply disruptions, so too will current and future expected prices. This trading process, i.e., the competition between various market players in the futures markets, is beneficial because it provides transparent price information to those who can respond to this information by, for example, putting additional oil in storage or taking steps to reduce their consumption in the future. To illustrate, when prices of futures contracts with early delivery dates exceed those with later delivery dates, the market consensus is for prices to fall in the future. This futures market is commonly said to be “backwardated” under these conditions. This provides an economic incentive to draw down inventory today – thereby softening prices today. On the other hand, when prices of futures contracts with early delivery dates are lower than those with later delivery dates, the market consensus is for prices to

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rise in the future. This futures market, under these conditions, is commonly termed “in contango”. This provides the economic incentive to build inventories if the higher futures prices will cover the cost of storage. This saves supply for the future when prices say it is most needed. In short, futures market prices provide information about expected future supply and demand conditions that producers and consumers can act on today. The effect of these actions is to shift the supply of crude oil from periods of relatively lower prices to periods where crude oil prices are expected to be higher. These actions, in turn, tend to ameliorate price swings. Finally, futures markets permit industry participants to manage the significant risks they bear in the production, refining, and transacting in crude oil and petroleum products.

• They do so by making it possible, for example, for an oil producer to lock in prices for its future production on the futures market or to use other instruments to limit the price fluctuations it will realize. The fact that these financial markets are highly liquid, with thousands of traders, allows users to shed risk at the least possible cost and at prices that reflect all of the information brought to the market by those trading. •

Consumers benefit because holding down producers’ risks encourages investment in future supplies.

• these risks include market risk, i.e., risk due to the change in oil prices; • Credit default risk, i.e., the counter-party may fail to meet the financial terms of the contract;

• Liquidity risk; i.e., risk arising from the inability to sell an asset; • Basis risk, i.e., prices for the types of crudes or products owned by the participant do not perfectly track changes in the benchmark product; operational risk; and political risk, e.g., expropriation.

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As described above, futures markets bring together valuable information about the market’s expectations about future supply and demand conditions in the physical market – conditions that will ultimately determine the price for oil. If, for example, the price today of an oil futures contract for the delivery of oil three months from now is $65 per barrel, that “futures” price represents thousands of buyers’ and sellers’ best estimate of what the price of oil will be for physical delivery three months hence. And, if in this hypothetical situation, the current (spot) price were $60 per barrel, the futures market would then be revealing the fact that it is the market’s current expectation that prices are expected to increase over the near future. That is, based on the information of thousands of commercial participants and sophisticated financial institutions, futures prices are telling producers and consumers alike that the crude oil market is likely to remain tight for the foreseeable future. SUCCESSFUL AND UNSUCCESSFUL CONTRACTS In order to be successful, a future contract must be based on a commodity that has: Price volatility- volatile prices are essential because without them there is no need for people to use futures markets. The prime function of a futures market is to provide a hedging mechanism for the related industry. It is easy to plan and budget for a commodity which has a stale prices or even one with regular seasonal fluctuations and there is therefore no reason to hedge. Standard quality specification- it is not easy to come up with a standard quality specification which will attract the whole of one sector of the industry and although an contract can be used as a reference for other similar products, it is vitally important in the early days of a contract that the specification is acceptable to the user.

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Range of participants- a wide range of participants on both sides of the market is also essential in order to ensure that there is enough interest in the price movements in both directions and enough liquidity on the market. A product for which there are only one or two suppliers will not have an active free market. Future market, like any other, can only trade when buyer and seller agree a price; the more players there are on both sides, the more likely traded such an agreement. Market participants Selling Hedger is a producer, or a stock holder who possesses (or will possess) the commodity and wants to protect himself against a fall and its price; he will sell a futures contract to hedge against a price fall. He will take a “short position” in the futures market and a “long position” in the actual or spot market. Buying hedger is again a user or stockpiler of a commodity. He will need the commodity for sometime in the future; he does not intend to buy it now. He buys a future contract to hedge against a possible price rise. He will take a “short position” in the spot market and a “long position” in the futures market. It is important to note that a buying hedger (refiner for example) does not normally use the futures market as a source of supply. It is true that the refiner can plan on taking delivery; in such a case, the seller of the contract is obligated to make the delivery. The usual practice is to close the futures contract before its maturity date. That is, futures transaction do not really required a physical delivery or even physical existence of oil being traded. Participants simply sell an “obligation to take or make delivery” and buy back his obligation before it reaches maturity. Thus refiner buys his crude on the spot market at the same time he sells his futures contract. His gain or loss on a futures contract will compensate for the change in the spot value of the crude.

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Speculators they trade futures with the objective of making a profit by being on the right side of a price move. Since the prices of commodities and financial instruments tend to change frequently, at least in certain markets, trading opportunities can be numerous. Speculators can be categorized into several broad groups: scalpers, day traders, position traders, arbitragers, and people seeking exposure to certain markets. Scalpers typically trade for a small profit on any single trade and therefore often trade continuously, seeking to make as many small gains as possible. In so doing, they create liquidity – the presence of enough people in the market so that market participants, notably hedgers, can buy and sell quickly and in large volume without substantially impacting prices. Scalpers’ frequent trades increase the trading possibilities available to others, and help provide the liquidity that is essential to the existence of futures markets. Other speculators include day traders, who typically make one or two trades per day, and position traders, who tend to hold contracts for days, weeks or months, depending on market factors. And finally, arbitragers are speculators who watch the relative value of multiple markets closely and step in to trade whenever momentary price discrepancies appear. By keeping prices in line for the same product trading on different exchanges, arbitragers lend stability to the price negotiation process. INTERACTION BETWEEN FUTURES TRADING AND THE SPOT MARKET PRICES Futures markets are sometimes believed to destabilize the spot market in order to provide speculative opportunities. This perception is not correct; rather futures trading can actually help the spot market work more efficiently. In the absence of futures market, the spot market provides guidelines for the producers to organize and distribute their supplies. It also serves as a means of

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sharing risks among some producing and consuming agents. If a trader wants to avoid the risks on the value if his inventory, he will sell part of his inventory in the spot market. Consequently, some other agents in the industry will assume the risks through spot market mechanisms. The spot market will then have a dual function to serve ie the provision of supply and demand guidelines and the sharing of risks. However, it cannot serve either function in most effective manner, because no organ can satisfy a dual objective as efficiently as it can a single one. If a futures market is introduced and can play its role effectively, then the second function of the spot market- risks sharing- is transferred to the futures market. Therefore, the spot market can play its primary function – facilitating the interaction of supply and demand forces-more efficiently. When futures trading exist in a market, speculators find it more convenient to deal in futures contracts than to buy a quantity of commodity at the current spot price and hold it with the hope that there will be a rise in the spot price. In the same manner, traders who want to avoid the risks of a price decline can do so more conveniently by selling futures contracts than by selling the commodity in the spot market. Thus, the risk sharing function of the spot market is transferred to the futures market. Although, the futures and the spot market will serve, two distinct functions, the interaction between the two markets constitutes the most important aspect of futures trading. This interaction is studied by exploring the relationship between spot and futures. There are two important factors to consider in this relationship: The relationship between the futures prices and the forthcoming spot market price (the spot price that will prevail in the delivery month) The relationship between futures contract prices and the current spot market price (the cash market price)

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With regard to first factor, most studies have concluded that there is no significant correlation between the two prices. The empirical evidence has shown that the correlation between futures price and the spot price in the delivery period is very weak. The lack of strong correlation has explained by the idea that any information about the future supply and demand conditions that becomes available gets incorporated in the current spot market price. Thus, there is no reason for futures contract prices to contain more information about futures market conditions than the current spot price. With regard to second factor – the relationship between futures contract prices and current spot prices- most studies have found a very strong correlation between the two. This correlation can be clearly understood with the help of theory of normal backwardation and theory of storage. In short relationship between is cash and futures price explained below: Cash prices are the prices for which the commodity is sold at the various market locations. The futures price represents the current market opinion of what the commodity will be worth at some time in the future. Under normal circumstances of adequate supply, the price of the physical commodity for future delivery will be approximately equal to the present cash price, plus the amount it costs to carry or store the commodity from the present to the month of delivery. These costs, known as carrying charges, determine the normal premium of futures over cash. As a result, one would ordinarily expect to see an upward trend to the prices of distant contract months. Such a market condition is known as contango and is typical of many futures markets. In most physical markets, the crucial determinant of the price differential between two contract months is the cost of storing the commodity over that particular length of time. As a result, markets which

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compensate an individual fully for carry charges –interest rates, insurance, and storage – are known as full contango markets, or full carrying charge markets. Under normal market conditions, when supplies are adequate, the price of a commodity for future delivery should be equal to the present spot price plus carrying charges. The contango structure of the futures market is kept intact by the ability of dealers and financial institutions to bring carrying charges back into line through arbitrage. Futures markets are typically contango markets, although seasonal factors in energy markets play an important role in market relationships. For example, during the summer, heating oil futures are often in contango as the industry begins to build inventory for the approaching cold weather. On any given day, prices in the forward contract months are progressively higher through the fall, reflecting the costs of storage, interest rates, and the assumption of increased demand. The opposite of contango is backwardation, a market condition where the nearby month trades at a higher price relative to the outer months. Such a price relationship usually indicates a tightness of supply; a market can also be in backwardation when seasonal factors predominate. Convergence As a futures contract approaches its last day of trading, there is little difference between it and the cash price. The futures and cash prices will get closer and closer, a process known as convergence, as any premium the futures have had disappears over time. A futures contract nearing expiration becomes, in effect, a spot contract . WHEN TO HEDGE? The effectiveness of a hedge depends on the premium and discount at which futures contracts are traded over the spot market price. In dealing with the futures

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contracts traded at a full carrying charge premium, the selling hedge will be effective whether the spot price advances or declines. The hedger will sell the futures contract at a high premium over the spot price. At the same time, the spot and futures price tend to come together as maturity date for futures approaches. This means the hedger will be able to buy back the futures contracts at a lower premium over the spot price i.e. the hedger’s gain (loss) in the futures market will be greater (smaller) than his loss (gain) in the spot price. The advantage of a selling hedge depends on the extent to which the premium is closer to the full carrying cost. The lower his premium, the less will the advantage of selling hedge. In this sense, the carrying cost establishes a benchmark (a ceiling to the premium) that can be utilized to appraise the desirability of the conditions for a selling hedge. The situation for buying hedge is opposite to that of selling hedge. More specifically, when futures contracts are traded at a full carrying cost premium over the spot prices, the buying hedge is not likely to be very successful. In fact, the buying hedge may, in such a case, led to losses greater than if no hedge were utilized. This may happen if the basis risk is greater than the commodity’s cash market price variations. The futures contract should be sold when its premium over the spot price is high and bought when the premium is low (this is again due to the fact that as the maturity of a futures contract approaches, the spot price and the futures price tend to come together.) Hedging in “inverted market” conditions (a market is inverted when futures prices are lower than the spot price) is totally different matter. Under such market conditions, a future contract is sold at a discount to spot price. The extent of this discount does not have a limit. So there is no benchmark for comparison or basis to judge the desirability of the hedge. Under such circumstances, the advantage of hedge should be evaluated based on the analysis of the market prospects.

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In an inverted market, futures prices are normally stronger and more stable than the spot market price, this is due to the fact that futures prices are already lower than the spot market price. When the futures contract approaches its maturity, its price has to come close to the spot price. By that time, the hedger may find himself in one of the following three situations: The spot price has remained constant, in which case the future price should rise to approach the spot market price The spot market price has increased, in which case the futures price has to increase faster to reach the spot price The spot market has declined, in which case the futures price will decline by a smaller amount to equal the spot price at the maturity date Thus in an inverted market, the buying hedge is likely to be effective, whereas a selling hedge may only be partially effective or even ineffective as a means of price protection. Hence, the relationship between the spot price and the future price is the principal determinant of the advantages and disadvantages of hedging. GLOBAL TRADING PATTERN Existing global trading patterns, i.e. movement of crude from one country to another or from one continent to another, primarily reflect the result of buyers and sellers responding to market forces to get each type of crude oil from where it is produced to where it is most valued, accounting for the cost of transportation. That is, trade flows at any point in time are largely a result of the relative advantages in transportation costs and buyers’ preferences for different qualities of crude oils. However, because buyers and sellers can and do substitute one type of oil for another, specific trading patterns are not crucial to evaluating supply and demand or pricing. For example, if the supply of crude oil from a source were cut off –

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regardless of whether that oil flowed to the United States – competition from buyers for the world’s remaining supplies would drive up all oil prices. Alternatively, if a country decided to cut off shipments of oil to the United States but maintained its production, there would be relatively little long-term impact on price. (This is, of course, holding aside any price changes due to an increase in geopolitical risk or smaller influences, such as shifting transportation and refining patterns.) Those supplies previously flowing to the United States would find new buyers who, in turn, would release their existing purchases to the market. U.S. buyers would then seek those newly released supplies. In sum, what is of most concern is the global supply and demand for crude oil. In the longer term, trade flows are of significantly less important. These facts have direct implications for the United States, which stands as the international crude oil market’s largest consuming nation. As shown in table, the United States consumes approximately one-quarter of the world’s daily supply of crude oil. In order to meet the nation’s demand for petroleum products, U.S. refiners must import about ten million barrels of crude oil per day, representing nearly two thirds of their refinery throughput. These imports come from scores of different countries, including, for example, Canada, Mexico, Saudi Arabia, Venezuela, and Nigeria, which in 2005 represented the top five sources of foreign supply. This pattern of trade demonstrates the degree to which the United States is interconnected to the world oil market. 2004 Crude Oil Consumption by Region Regions Asia Pacific United states Western Europe (OECD)

Percentage of consumption 30 25 19

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Middle East South-Central America Eastern Europe, Russia &Eurasia Rest of N. America Africa

7 6 5 5 3

Source: BP Statistical Review of World Energy, June 2005

MCX Crude oil

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Crude oil is a naturally-occurring substance found trapped in certain rocks below the earth's crust. It is a dark, sticky liquid which, scientifically speaking, is classed as a hydrocarbon. This means, it is a compound containing mainly hydrogen and carbon. Crude oil is highly flammable and can be burned to create energy. Along with its sister hydrocarbon, natural gas, crude oil is one source for most of the fuel. Crude oil is a natural resource that is actually "mined" from the earth. Crude oil is valued for the products that are derived from the oil (Gasoline, LPG, Naphtha, Diesel fuel oil etc) and is therefore considered a commodity complex. It is often helpful, when learning about a commodity complex to first get a good understanding of how the products are produced from the basic commodity. The process used to derive the products from the crude oil is called refining. Crude oil is used to meet majority of the global energy needs today. Almost all industries are dependent either directly or otherwise on crude oil and its refined products which include petrol, diesel, lubricants, heating oil, aviation gasoline, asphalts, lubricating oil etc. most of the world’s crude oil reserves are found in the Middle east, Africa, Eastern Europe and Central America. Middle East has around 65% of the world’s crude oil reserves. Different oilproducing Areas yield significantly different varieties of crude oil.

Crude oil prices have always been highly volatile due to various factors such as

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•

OPEC output and supply

•

Terrorism, Weather/storms, War and any other unforeseen geopolitical factors that causes supply disruptions

•

Global demand particularly from emerging nations

•

Dollar fluctuations

•

DOE / API imports and stocks

•

Refinery fires & funds buying

Organization of Petroleum Exporting Countries (OPEC) ,an organization of eleven developing countries that are heavily dependent on oil revenues for their income, controls almost 40% of the world’s crude oil. It is the energy source that dominated the 20th Century and will continue to be pivotal for the foreseeable part of the 21st Century. It is the most versatile energy source available today. It is the most political of energy sources - the resource that makes countries go to war, the resource that countries must have to wage war. And yet, it is also a commodity - like sugar or wheat. It is the single largest commodity in international trade and has been one of the most volatile. India is the sixth largest consumer of oil. Current consumption of oil amounts to 2.43 million bbl/day and only around 30 % of this demand is met by indigenous production. The remaining 70% crude oil is being imported. Crude oil imports to India comes from various sources like opec countries –Iran, UAE, Iraq, Kuwait, Saudi Arabia which are sour crude. West Africa & Far East grades from Malaysia are also import and are sweet crude. Crude oil unique characteristic. •

Over- shadows any other physical commodity.

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•

Volatile prices which are continuously transforming every day.

•

Each grade is unique – means different value to different refiners.

•

Price volatility is hall mark of present day crude market.

Importance of Crude oil •

It is the energy source that dominated the 20th Century and will continue to be pivotal for the foreseeable part of the 21st Century.

•

It is the most versatile energy source available today.

•

It is the most political of energy sources - the resource that makes countries go to war, the resource that countries must have to wage war. And yet, it is also a commodity - like sugar or wheat.

•

It is the single largest commodity in international trade and has been one of the most volatile.

•

We can say that crude oil is Black Gold.

. Crude Oil Units (average gravity) •

1 US barrel = 42 US gallons

•

1 US barrel = 158.98 litres

•

1 tonne = 7.33 barrels

•

1 short ton = 6.65 barrels

•

Note: barrels per tonne vary from origin to origin.

Global Scenario Oil accounts for 40 per cent of the world’s total energy demand. The world consumes about 84 million bbl/day of oil.

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United States (20 million bbl/d), followed by China (5.6

million bbl/d) and

Japan (5.4 million bbl/d) are the top oil consuming countries. Balance recoverable reserve was estimated at about 142.7 billion (in 2002), of which OPEC was 112 billion tones. OPEC Fact Sheet OPEC

stands

for

‘Organization

of

Petroleum

Exporting

Countries’(www.opec.org). It is an organization of eleven developing countries that are heavily dependent on oil revenues as their main source of income. The current Members are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. •

OPEC controls almost 40 percent of the world’s crude oil.

•

It accounts for about 75 per cent of the world’s proven oil reserves.

•

Its exports represent 55 per cent of the oil traded internationally.

Indian Scenario India is the sixth largest consumer of oil. Crude and related products account for 30% of India’s total energy consumption. •

Current consumption of oil amounts to 2.43 million bbl/day and only around 30% of this demand is met by indigenous production. The remaining 70% of crude oil is being imported.

•

Crude oil imports to India comprise of the Oman-Dubai sour grade crude, Brent dated sweet crude and also large quantities of Bonny light crude.

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The Indian import crude basket consists of the Oman-Dubai sour grade crude and Brent dated sweet crude in the ratio 57:42.. •

India had a total of 2.5 million barrels per day in refining capacity.

•

Under NELP series government is encouraging active participation by private and international parties in exploration of Oil & Natural Gas

•

Indian government in 2002 officially ended the Administered Pricing Mechanism (APM).

•

Disinvestment/Restructuring of public sector units and complete deregulation of Indian retail petroleum products sector is under way.

•

Production, Imports & Exports of Crude Oil

•

India faces a large supply deficit, as domestic oil production is unlikely to keep pace with demand. India’s rough production was only 0.8 million barrels per day.

•

India imports more than 70 per cent of its total oil consumption and it makes no exports.

•

The oil reserves of the country (about 5.4 billion barrels) are located primarily in Mumbai High, Upper Assam, Cambay, and Krishna-Godavari and Cauvery basins.

•

Balance recoverable reserve was about 733 million tones (in 2003) of which offshore was 394 million tones and on shore was 339 million tones.

Duties & Levies on Crude Oil

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The industry is requesting the Govt. to reduce the customs duty on crude petroleum from 10 per cent to 5 per cent, ahead of the union budget 2005-06 announcement Prevailing rates Particulars

Rate

Basic Customs Duty

5%

NCCD*

Rs. 50 per metric tonne

Education Cess

2%

Octroi (Mumbai Consumption)

3%

Wharfage

Rs. 57 per metric tonne

Note: The quoted price on MCX is excluding all taxes and levies; hence the reference price would be just equal to prevailing international crude oil prices multiplied by prevailing Indian exchange rate. Price variation Unlike previous years, which were under the APM and protected with Oil Pool account, now crude price is having a high correlation with the international

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market price. As on date, even the prices of crude bi-products are allowed to vary +/- 10% keeping in line with international crude price, subject to certain government laid down norms/ formulae. All these necessitate futures trading in crude. International oil price variation

Particulars

Frequency 0 to3.1%

Of %variation 3.2 to 6.2%

6.3 to 9.3%

>than 9.3%

Refiner

8

16

4

8

acquisition cost for Crude oil (composite) – Average monthly price from Apr 01 to Mar 04

Maximum price variation Period considered

Percentage

(Based on data from Apr 94 to Mar 04)

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Monthly

23.25

Yearly

28.73

(Note: 1. Prices of Refiner Acquisition cost (composite) in US – Low sulphur grade considered; 2. Yearly price variation is Simple AM of monthly averages MCX CRUDE OIL CONTRACTS In MCX twelve contracts are traded in a year with 3 contracts run concurrently. Here time period for one contract is three months i.e. one contract of crude is traded or listed on exchange for a period of three months. Varieties of crude oil traded WESTERN TEXAS INTERMEDIATE (WTI) – a high quality crude oil explored and physically traded in the US is one of the largest traded commodities in the world. WTI’s API gravity is between 37 and 42 degrees and has 0.24% sulphur content. NYMEX is the primary exchange facilitating futures trade in light sweet crude oil.

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BRENT CRUDE OIL – a grade from the North Sea, UK, and Brent is a pricing benchmark for crude from Europe and Africa. With API 39 degrees and 0.4% or less sulphur content by weight Brent is the second most traded variety of crude in the world. MIDDLE EAST CRUDE OIL- generally taken as the arithmetic average of Dubai and Oman crude grades, API gravity between 31and 37 degrees and 2.05%or less sulphur content by weight, makes ME crude oil a heavy and sour crude. It is a variety with a very large physical market in the Gulf region. Most of the Indian refineries use crude benchmarked against Middle East Sour Crude Oil. TOCOM is a prominent futures trading platform to trade in this grade. CRUDE OIL CONTRACT SPECIFICATION PARTICULARS

WTI

Trading Period Trading Session

Mon through Sat Mon through Sat Mon through Sat Mon to Fri: 10.00 Mon to Fri: 10.00 Mon to Fri: 10.00 a.m to 11.30 p.m

BRENT

MIDDLE EAST

a.m to 11.30 p.m

a.m to 11.30 p.m

Sat : 10.00a.m to Sat : 10.00a.m to Sat : 10.00a.m to 2.00p.m Trading Unit 100 barrels Base Value Rs/barrel Maximum order 10,000 barrels

2.00p.m 100 barrels Rs/barrel 10,000 barrels

2.00p.m 100 barrels Rs/barrel 10,000 barrels

size Tick size Price quote

Rs 1 Ex-Mumbai

50p Ex-Mumbai

Rs 1 Ex-Mumbai (excluding

all (excluding

all (excluding

all

taxes, levies and taxes, levies and taxes, levies and

85

freight)

freight)

freight)

Basis price

Simple arithmetic average of Dubai

Daily price limits Initial margin Special margin

and Oman 4% 4% 4% 5% 5% 5% Imposed in case of Imposed in case of Imposed in case additional

additional

volatility,

as

immediately

% volatility,

of as

on immediately

additional

% volatility, as % on immediately

on

both buy and sale both buy and sale both buy and sale side in respect of side in respect of side in respect of all

outstanding all

outstanding all

outstanding

Maximum

position position position For individual For individual For individual

allowable

clients:

400000b clients:

150000b clients: 100000b

positions

For

member For

member For

member

collectively for all collectively for all collectively clients:1200000b or

15%of

clients:600000b or all

clients:

the 20%of the market- 25%of the open

market-wide open wide position, whichever

for

open market position,

position, is whichever

is

Delivery unit

higher higher 50,000b with +/- 50,000b with +/-

Delivery margin

2% tolerance limit 25%

2% tolerance limit 25%

86

Delivery center

Port installation at Port installation at Port Mumbai/JNPT

Mumbai/JNPT

Quality

port port Sulphur 0.42% by Sulphur-

specification

wt or less API between

wt or less gravity: API

installation

at Mumbai/JNPT

port 0.4%by Sulphur-

2.05%

by wt or less gravity- API

gravity-

37deg- between 38deg – between 31deg –

42deg

39 deg

37 deg

All volumes are defined at 60deg Fahrenheit DELIVERY AND SETTLEMENT PROCEDURE OF ALL VARITIES OF CRUDE OIL CONTRACT

87

Delivery logic Both Option Tender day 1st working day after expiry of contract by 6.00 p.m. Tender and delivery 1st to 3rd working days after expiry of the contract. period Buyer’s and Seller’s On the contract expiry day by 6.00 p.m. Intention

Seller will submit copies of relevant documents as evidence that he is holding stock at the time of giving his

Mode

intention. of Fax / Courier

communication Matching of Buyer’s On the basis of intention received from the buyers and and Seller’s intention

sellers, the Exchange will match the total quantity offered by the buyers and sellers and with respect to the matched quantity, the allocation of delivery between the buyers and sellers will be done. The unmatched quantity of open position will be closed out as per DDR and actual delivery will be affected only to the extent of matched

quantity. Dissemination of the On the contract expiry day by 7.00 p.m. information

on

delivery intention on TWS Delivery margin Exemption delivery margin

period 25% margin will be imposed during tender and delivery period on both buyers and sellers on matched quantity. from Delivery period margin is exempted if the Seller provides period with documentary evidence of the delivery at the Exchange’s designated delivery center.

88

Delivery

On expiry date of the Contract

allocation

At due date rate (DDR)

- Date - Rate Delivery pay-in Delivery pay-out Pay-in of funds Pay-out of funds

On tender days E+3 working day by 11.00 a.m. ( E – Expiry Date ) E+2 working day by 11.00 a.m. E+3 working day by 11.00 a.m. In case the buyer opts for second sampling, he has to inform the Exchange on E+ 2 working days by 6.00p.m and in such case the pay-out of funds will be released only after

Penal provisions

completion of sampling procedure. After getting intentions from the buyer and seller to take or give delivery, if any of the party fails to honour his obligations, a penalty of 1% of the DDR will be imposed on him, out on which 90% will be passed on to the other party

Delivery center Deliverable

and 10% will be appropriated by the Exchange. Mumbai The selling members tendering delivery will have the option of

grade

delivering such grades as per the contract specifications. The buyer has no option to select a particular grade and the delivery offered by the seller and allocation by the Exchange shall be binding on buyer. lot Delivery will be affected only on delivery lot basis. In case

Odd treatment

there is any mismatch in the position of seller and buyer then delivery will not be matched and accordingly the position will be closed out at DDR. The freight, insurance, storage and all other expenses will be

Storage, Insurance

and on account of the buyer.

Freight charges Taxes, duties, All other charges, levies or Cess, import or export duties cess and levies

applicable at the delivery center will be on account of buyer. In case of Inter-State movement, the buyer has to submit requisite forms or pay CST as applicable. Post lifting delivery

all charges are borne by the buyer. Endorsement of The buyer member can endorse delivery order to a client or delivery order

any third party with full disclosure given to MCX. Responsibility for contractual liability would be with the

Extension

89 original assignee. of As per the Exchange decision due to a force majeure or

delivery period

otherwise.

90

Legal obligation

The member will provide appropriate tax forms wherever required as per law and as customary and neither of the

Penal provisions

parties will unreasonably refuse to do so. Delivery will be affected in case both seller and buyer agree. After giving intention, if any party fails to honour for the delivery marked quantity then a penalty of 1% shall be imposed, out of which 90% shall be passed on to the other

Intention

party and 10% will be retailed by the Exchange. of On the expiry day of the contract by 6.00 p.m.

delivery by buyers Seller will submit copies of documentary evidence such as and sellers

Letter of Credit or any other appropriate receipt and Quality Certificate along with the intention to give delivery to the effect that he is holding stock at the time of giving his

Matching

intention. of On the basis of intention received from the buyers and

intention of buyers sellers, the Exchange will match the total quantity offered and sellers

by the buyers and sellers and with respect to the matched quantity, the allocation of delivery between the buyers and sellers will be done. The unmatched quantity will be closed out as per the due date rate and actual delivery will be

Dissemination

effected only to the extent of matched quantity. of On each tender days by 7.00 p.m. onwards on trading

information

on workstation

tendered delivery Evidence of stock At the time of issuing the delivery order, the Member must in possession

satisfy MCX that he holds stocks of the quantity and quality specified in the Delivery Order at the declared delivery center by producing bank documents/ LC/ appropriate receipt.

91

delivery has not been received and such positions where expression of intentions have been received but have not found the counter party for honoring the intentions, shall be closed out at due date rate and respective pay-in and pay-out of funds of such close out positions shall be effected on the following day of last day of trading by 11.00 a.m. Applicability Byelaws,

of The general provisions of Byelaws, rules and Business Rules of Rules, the Exchange and decisions taken by Forward Markets

Business Rules of the Commission, Board of Directors and Executive Committee of the Exchange.

Exchange in respect of matters specified above will form and integral part of this contract. The Exchange or FMC as the case may be further prescribe additional measures relating to delivery procedures, warehousing, quality certification, margining, risk management from time to time. (The interpretation or clarification given by the Exchange on any terms of this contract shall be final and binding on the members and others.)

92

Crude Oil futures contract hold immense potential for India India has more than 1,000 companies directly or indirectly affected by crude oil price risk of which only few can hedge outside as actual users. India has more than 5,000 commodity and stock brokers, who would trade in crude, which is one single commodity representing energy cost, inflation, geopolitical situation, etc. India has many FII’s and Mutual Funds who are expected to be permitted by the regulator shortly to trade in commodities. Banks would do business on behalf of their clients, which they currently do not do at international exchange due to large contract size and low accessibility from India. Indian shipping companies, power producers, fertilizer companies, refineries and energy traders do not access international exchanges to hedge crude oil price risk. Reserve Bank of India and the Government regulation permits only actual user to hedge in the international exchanges and this is a restricted clause due to foreign exchange risk exposure and possible foreign exchange outgo due to incorrect trading for profit transfer. Crude is the mother product in the hydrocarbon hierarchy. Prices of all distillates of Crude are highly correlated. So MCX Crude future can be used as a proxy for all derivatives of Crude, like Naphtha, ATF & LDO.

Benefits of trading MCX crude oil contracts India’s importance in world markets as one of the largest importers of crude oil and responsiveness to world events make MCX an important risk management platform for commercial interests as well as an exciting potential Opportunity for those investors who seek to profit by correctly anticipating price changes. The contracts are standardized by quality and quantity, widely accepted and therefore are liquid financial instruments. MCX offers cost efficient trading and risk management opportunities. Contracts are traded online on a real time trading platform of MCX, representing a confluence of opinions on future values and resulting in price transparency and best price discovery. MCX crude oil futures prices are widely and instantaneously disseminated, serving as a ready reference price for different sections in the industry. MCX allow hedgers and investors to trade anonymously through futures brokers, who act as independent agents for traders. The depth of the market allows the contracts to be easily liquidated prior to required receipt or delivery of the underlying commodity. While futures contracts are seldom used for delivery, if delivery is required, performance is guaranteed. Counter party risk is absent from transactions executed on the Exchange. Contract performance in the crude oil futures is supported by a strong financial system, backed by MCX clearing members.

MCX offers safe, fair and orderly markets protected by its rigorous financial standards and surveillance procedures.

MCX Clearing and Settlement The clearinghouse of the MCX through the MCX’s clearing member firms guarantees the performance for each futures contract. Daily Settlement (Pay-in and Pay-out) MCX has daily settlement of all transaction conducted on the Exchange. This process begins with the daily settlement price, which is calculated for each futures contract. Once established, the settlement price is used for all new and open (un-liquidated) positions to compute the pay-in and payout. Every account holding futures positions is adjusted in cash daily when it is marked-to market. Delivery / Cash Settlement Traditionally contracts are fulfilled by taking an offsetting position. (thereby avoiding giving or taking delivery). But when open contracts run into the delivery period then contracts are initiated for delivery. It is a both option contract. When either the seller or the buyer has not intended to give or take delivery, then those open contracts on the expiry day of the contract are cash settled at the due-date rate of the contract. Due date rate will be calculated on the last trading day (i.e. 15th of the month preceding the contract month) by taking Bloomberg fixings i.e. international spot price of light sweet Crude Oil as reported by Bloomberg, multiplied by Rupee - US Dollar rate as notified by the Reserve Bank of India on that day.

Delivery in Crude Oil will take place at the due date rate notified by the exchange. The buyer has to pay freight cost, import duty and all other taxes and levies applicable on that day in addition to the due date rate. MCX trading Multi Commodity Exchange of India Ltd., established in 2003 and already the largest commodity futures exchange in India, provides the premier forum for managing the price risk associated with oil market. MCX is a dominant center for gold and silver futures trading. MCX is the first exchange to launch Crude Oil futures in India. MCX’s liquidity, price transparency and financial integrity will make it a benchmark for crude oil markets in India and perhaps for Asia per se . Orders are entered through MCX Trader Work Station terminals. A credit–controlled module verifies credit worthiness based on clearing–member predetermined parameters. Orders are matched on price and time priority. Matched orders are confirmed at each originating terminal. Meanwhile, all unmatched orders remain in the system until matched or withdrawn. The instant a trade is executed, all participating quote vendors receive last sale price and quantity data, as well as updated information on best bid, offer and size of each order. As each trade is confirmed, it is routed to the MCX clearing system for settlement. Clearing member firms adjust buyers and sellers accounts for positions and margins. MCX’s dominance in energy futures trading in India

Multi Commodity Exchange of India (MCX), the pioneer in launching energy futures trading in India, has not only successfully established itself as the ‘Exchange of Choice’ for energy futures trading in India, but has also made strong footprints at the global level. The energy basket offered includes Crude Oil, Brent Crude Oil, Middle East Crude Oil, Furnace Oil and Natural Gas of which Crude Oil and Natural Gas are highly successful. The strategic tie-up with NYMEX (the global benchmark for energy commodities) has led to an efficient price discovery mechanism for the participants from India. The MCX crude oil prices enjoy a high correlation of more then 96% with NYMEX crude oil prices. The exchange’s energy markets also operate in the same timeframe as the global markets. Extended timing ensures that the Indian industry and traders are able to effectively manage their price risk and participate in the global price discovery process. The utility of these contracts can be gauged by their immense success within two years of launch. The entire energy basket registered a volume of more than Rs. 168319 crores in 2006, a growth of more then 19% on YoY basis. Understandably MCX enjoys more then 97.5% domestic market share for energy futures trading in 2006. MCX-NYMEX CRUDE OIL CORRELATION

Source: www.mcxindia.com

At the same time, globally MCX has climbed up the ladder of success fast enough to capture the position of third largest exchange for futures trading in crude oil in terms of number of contracts traded. The ranking only gets better for MCX with the second position globally for futures trading in Natural Gas. The key differentiators of MCX for success are that It operates in a cohesive manner with commodity industry participants and bodies; global positioning of the exchange through tie-ups and knowledge & product sharing; extensive domain knowledge and exchange management experience and emphasis on training, research and awareness creation.

NYMEX The Exchange is the world’s largest physical commodity futures exchange. Trading is conducted through two divisions: the NYMEX Division offers futures and options contracts for light, sweet crude oil; heating oil; New York Harbor gasoline; natural gas; electricity; and platinum; futures for propane, palladium, sour crude oil, Gulf Coast unleaded gasoline; and options contracts on the price differentials between heating oil and crude oil, and New York Harbor gasoline and crude oil, which are known as crack spread options. The Exchange performs trades through two divisionsthe COMEX Division lists futures and options on gold, silver, copper, aluminum, and the FTSE Eurotop 100® European stock index; and futures for the FTSE Eurotop 300® Stock index. The NYMEX Division heating oil futures contract, the world’s first successful energy futures contact, was introduced in 1978. The light, sweet crude oil contact, launched in 1983, is the most actively traded futures contract based on a physical commodity in the world. These contracts and the others that make up the Exchange’s energy complex have been adopted as pricing benchmarks in energy markets worldwide. NYMEX ACCESS®

The Exchange’s electronic trading system, NYMEX ACCESS®, allows trading in energy futures and options, platinum futures and options, and other metals futures after the trading floor has closed for the day. The NYMEX ACCESS® trading session for light, sweet crude oil; heating oil; New York Harbor unleaded gasoline; and the metals contracts begins at 4 P.M. and concludes at 8 A.M. the following morning, Mondays through Thursdays. A Sunday evening session commences at 7 P.M. When combined with the daily open outcry session, NYMEX ACCESS® extends the trading day to approximately 22 hours. Natural gas and propane are offered in abbreviated evening sessions. Electricity contracts trade exclusively on NYMEX ACCESS® for approximately 23 hours a day. Terminals are in use in major cities in the United States and in London, Sydney, Hong Kong, and Singapore. Efficient Markets Require Diverse Participants To be efficient and effective risk management instruments, futures markets require a mix of commercial hedgers and private speculators. The New York Mercantile Exchange’s energy markets have attracted private and institutional investors who seek to profit by assuming the risks that the underlying industries seek to avoid, in exchange for the possibility of rewards. These investors, in combination with hedgers, have brought a diversified balance of participants to the Exchange’s markets.

Floor Trader 6.6%

Investors 7.4%

Funds 3.6%

Financial 10.1% Marketers 7.1%

Refiners 11.1% Oil Traders 42.4%

Integrated Producers 11.5% 0.2%

Nymex Crude Oil Futures Market Participation by occupation Open Interest

Nymex market participants 1. Producers: Firms primarily engaged in oil exploration and production 2. Integrated: Firms with oil production interests, refining, marketing and distribution operations 3. Refiners: Firms primarily engaged in refining and marketing 4. Marketers: Firms primarily engaged in wholesale / retail marketing and Distribution 5. End-users: Ultimate consumers hedging their oil product demand 6. Traders: Firms actively trading physical oil in addition to paper barrels 7. Financial Institutions: Financial firms engaged in funding, underwriting, and trading futures and/ or options 8. Funds: CTA's and managed-money accounts 9. Floor Market- Makers: Firms which have a physical presence in the trading ring and provide short term liquidity to the market place by taking the opposite side of competitive trades 10. Speculators (Investors): Individual and retail investors How a Transaction Works? The execution of a transaction on the trading floor is a finely honed process that can be completed in seconds. The open outcry auction process on the floor assures that transactions are completed at the best bid or offer. The process starts when a customer calls a licensed commodities broker with an order to buy or sell futures or options contracts. The broker sends the order to his firm’s

representative on the trading floor via telephone or computer link. An order slip is immediately prepared, time stamped, and given to a floor broker who is an exchange member standing in the appropriate trading ring. All buy and sell transactions are executed by open outcry between floor brokers in the same trading ring. Buyers compete with each other by bidding prices up. Sellers compete with each other by offering prices down. The difference between the two is known as the bid-ask spread. The trade is executed when the highest bid and lowest offer meet. When this trade is executed, each broker must record each transaction on a card about the size of an index card which shows the commodity, quantity, delivery month, price, broker’s badge name, and that of the buyer. The seller must toss the card into the center of the trading ring within one minute of the completion of a transaction. If the last line on the card is a “buy,” the buyer also submits the card to the center of the ring; the card is retained by the Exchange as part of the audit trail process. The cards are time-stamped and rushed to the data entry room where operators key the data into the Exchange central computer. Meanwhile, ring reporters listen to the brokers for changes in prices and enter the changes via hand-held computers, immediately disseminating prices to the commercial price reporting services as they simultaneously appear on the trading floor wallboards Confirmation of each completed trade is immediately made by the floor broker’s clerk to the originating broker who then notifies his customer.

Why Use New York Mercantile Exchange Contracts? The contracts are standardized, accepted, and therefore liquid financial instruments. The Exchange offers cost-efficient trading and risk management opportunities.

Futures and options contracts are traded competitively on the Exchange in an anonymous auction, representing a confluence of opinions on their values. Exchange futures and options prices are widely and instantaneously disseminated. Futures prices serve as world reference prices of actual transactions between market participants. The Exchange’s markets allow hedgers and investors to trade anonymously through futures brokers, who act as independent agents for traders. The liquidity of the market allows futures contracts to be easily liquidated prior to required receipt or delivery of the underlying commodity. While futures contracts are seldom used for delivery, if delivery is required, financial performance is guaranteed, as it is for options that are exercised. Unlike principal toprincipal transactions which must be continually examined for unexpected financial performance, counterparty credit risk is absent from transactions executed on the Exchange. Futures and options contract performance is supported by a strong financial system, backed by the Exchange’s clearing members, including some of the strongest names in the brokerage and banking industries. The Exchange offers safe, fair, and orderly markets protected by its rigorous financial standards and surveillance procedures.

Commercial Applications of the Exchange’s Energy Futures and Options Contracts The Exchange provides buyers and sellers with price insurance and arbitrage opportunities that can be integrated into cash market operations. Trading Exchange contracts can improve the credit worthiness and add to the borrowing capacity of

natural resource companies, thus augmenting the companies’ financial management and performance capabilities.

CONTRACT SPECIFICATION OF LIGHT, SWEET CRUDE Crude oil began futures trading on the NYMEX in 1983 and is the most heavily traded commodity. Trading unit: Crude Oil Futures trade in units of 1,000 U.S. barrels (42,000 gallons). Options: One NYMEX Division light, sweet crude oil futures contract Trading Months: Crude Oil Futures trade 30 consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Additionally, trading can be executed at an average differential to the previous day’s settlement prices for periods of two to 30 consecutive months in a single transaction. These calendar strips are executed during open outcry trading hours. Options: 12 consecutive months, plus three long-dated options at 18, 24, and 36 months out on a June/December cycle. Price Quotation Crude Oil Futures are quoted in dollars and cents per barrel. Minimum Price Fluctuation $0.01 (1¢) per barrel ($10 per contract). Maximum Daily Price Fluctuation Futures: Initial limits of $3.00 per barrel are in place in all but the first two months and rise to $6.00 per barrel if the previous day's settlement price in any back month is at the $3.00 limit. In the event of a $7.50 per barrel move in either of the first two contract

months, limits on all months become $7.50 per barrel from the limit in place in the direction of the move following a one-hour trading halt. Options: No price limits. Last Trading Day Crude Oil Futures: Trading terminates at the close of business on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non-business day, trading shall cease on the third business day prior to the last business day preceding the 25th calendar day. Options: Trading ends three business days before the underlying futures contract. Delivery F.O.B. seller's facility, Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or inter-facility transfer (pumpover). Delivery Period All deliveries are rateable over the course of the month and must be initiated on or after the first calendar day and completed by the last calendar day of the delivery month. Alternate Delivery Procedure (ADP) An Alternate Delivery Procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange. Exchange

of

Futures

for,

or

in

Connection

with,

Physicals

(EFP)

The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position. Deliverable Grades

Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37° API gravity nor more than 42° API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, and South Texas Sweet. Specific foreign crudes of not less than 34° API nor more than 42° API. The following foreign streams are deliverable: U.K. Brent and Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 30¢-per-barrel discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana, are delivered at 15¢ premiums; and Nigerian Qua Iboe is delivered at a 5¢ premium. Inspection Inspection shall be conducted in accordance with pipeline practices. A buyer or seller may appoint an inspector to inspect the quality of oil delivered. However, the buyer or seller who requests the inspection will bear its costs and will notify the other party of the transaction that the inspection will occur. Position Limits Any one month/all months: 20,000 net futures, but not to exceed 1,000 in the last three days of trading in the spot month. Margin Requirements Margins are required for open futures or short options positions. The margin requirement for an options purchaser will never exceed the premium. Trading Symbol Futures:CL Options: LO Delivery procedure A Responsibilities of clearing members having open long positions (buyers) Notice of intention to accept

Exchange clearing members having open long positions shall give the Clearing House a Notice of Intention to Accept delivery by 3:00 PM on the first business day after the final day of trading. Delivery instruction On the business day following Notice Day, the buyer shall give to the seller, with a copy to the Exchange, properly completed and signed Delivery Instructions in the form prescribed by the exchange, which shall include the following information: •

name of seller,

•

tender number,

•

Name of seller’s designated crude stream ( either a specific foreign crude oil streams(s) or domestic crude oil) specified in the Notice of Intention to Deliver,

•

Name of incoming pipeline or storage facility specified in the notice of intention to deliver

•

Number of contracts,

•

Method of delivery (which must confirm to the normal capabilities of the facility named in the notice of intention to deliver with respect to the manner of delivery and the quantity to be delivered)

•

Name of the outgoing pipeline or storage facility with access to the incoming pipeline or storage facility designated in the notice of intention to deliver

•

For inter-facility transfers, name of receiving facility with access to the facility designated in the notice and

•

Such additional information as may be required by the exchange.

B Responsibilities of clearing members having open short positions (sellers) Notice of Intention to deliver

Exchange clearing members having open short positions shall give the Clearing House a Notice of Intention to deliver by 3:00 PM the first business day after the final day of trading. Scheduling Notice Seller shall give the buyer a Scheduling Notice in the form prescribed by the Exchange stating delivery time, with a copy to the exchange , as soon as possible following determination of scheduling, but not later than the last business day of the month preceding the delivery month. C Amendment of Delivery Instruction The buyer and the seller may, by mutual agreement, elect to change the delivery terms, at any time prior to the last business day of the month, with respect to: (a) Method of delivery, (b)Timing of delivery, (c)type and/or quality of crude oil to be delivered (d)Designation of buyer’s and/or seller’s facility Any such changes must be made on the form prescribed by the Exchange. Any changes made with respect to the foregoing must be made in conformance with all contracts requirements and specifications. D Settling Price The last settling price shall be the basis for delivery E Notice Day The Clearing House shall allocate Delivery Notices and Notices of Intention to accept by matching size of positions and considering the type of light ‘sweet’ crude oil by origin to the extent possible. The clearing House shall pass copies of the notices to the respective Clearing Members on the morning of the next business day. The day the notices are passed to the Clearing Members shall be referred to as the Notice day. The Notice day shall be the second business day after the final day of trading. F Non-transferable

The Clearing Member who receives the Delivery Notice or Notice of Intention to Accept from the clearing house shall be deemed to have agreed to accept or deliver product. Delivery Notices or Notices of Intention to Accept are not transferable G Allocation of Foreign Crude Oil Shorts and longs in foreign crude oil deliveries will be matched as follows: Foreign crude oil will be assigned first to the longs indicating a preference for foreign crude oil. For such longs, foreign crude oil shall be allocated in order beginning with the largest preferences If there is more foreign crude oil than the quality requested by the preferences, the balance after preferences are filled will be assigned to buyers with a minimum lot size of 60 contracts on a proportional basis, to the extent applicable. Exchange staff, working with the pipelines, will retain authority to modify the above procedures to respond to practical and logistical issues as they arise. Timing of Delivery Delivery shall take place no earlier than the first calendar day of the delivery month and no later than the last calendar day of the delivery month. It is the short’s obligation to ensure that its crude oil receipts, including each specific foreign crude oil stream, if applicable, are available to begin flowing ratably in Cushing, Oklahoma by the fist day of the delivery month, in accord with generally accepted pipeline scheduling practices Transfer of title- the seller shall give the buyer pipeline ticket, any other quantitative certificates and all appropriate document upon receipt of payment. The seller shall provide preliminary confirmation of title transfer at the time of delivery by telex or other appropriate form of documentation. Delivery Margins and Payment

On the third business day following the last day of trading, the long clearing member shall obtain from the long, if any, margin equal to the full value of the product to e delivered, not including any adjustment for discounts and premiums. Such margin shall consist of cash, securities issued by the US Treasury Department maturing within ten years from the date of deposit and guaranteed as to principal and interest by the US Government or a letter of credit. The short clearing member shall obtain from the short, if any, margin in an amount fixed, from time to time, by the board. The long clearing member and the short clearing member shall deposit with the Clearing House margins in such amounts and in such form as required by the Exchange. Such margins which shall not be greater than the margins charged to the longs and the shorts, shall be returned on the business day following notification to the Exchange that delivery and payment have been complete News Releases — 2006 Title: NYMEX and Multi Commodity Exchange of India Sign Licensing Agreement Global Energy Contracts Now Available on Indian Platform NEW YORK, N.Y. and MUMBAI, INDIA, June 6, 2006 —The New York Mercantile Exchange, Inc. (NYMEX), and the Multi Commodity Exchange of India Limited (MCX) announced today that they have signed a five–year licensing agreement for the use of NYMEX energy futures settlement prices. In addition to the current MCX rupee–denominated, financially settled light sweet crude oil futures contract, which is one–tenth of the size of the NYMEX light sweet crude oil futures contract, the new licensing agreement includes rupee– denominated natural gas, heating oil, and gasoline futures contracts that MCX plans to launch. These new contracts will be financially settled by MCX based on the settlement prices for the corresponding physically settled NYMEX futures

contracts and one–tenth of the size of the NYMEX contracts. The agreement also anticipates the launch of additional rupee–denominated contracts in RBOB gasoline and propane futures. Celebrating the agreement, India's Union Minister of Agriculture, Consumer Affairs, Food & Public Distribution, Sharad Pawar, marked the commencement of trading with the traditional ringing of the opening bell at NYMEX in New York. In October 2005, NYMEX and MCX signed a memorandum of understanding that allows MCX to use NYMEX settlement prices for its light sweet crude futures contract. James E. Newsome, NYMEX President and Chief Executive Officer, said, "Our agreement with MCX will provide a benchmark price reference for risk management to the Indian energy sector, a significant user of such products from the global standpoint, while also optimizing the cost of such risk management." Venkat Chary, Chairman of the MCX, added, "Producers, users and investors in India can take benefit from access to globally aligned prices and trading practices in such energy products. We proudly bring these products to the Indian industry." Jignesh Shah, Managing Director and Chief Executive Officer of MCX said, "MCX will leverage its pan-India presence, and its member and client network spread across the country, to offer mini–NYMEX energy contracts to a range of stakeholders in the industry. It will also facilitate the price discovery of these products in the Indian time zone based on local fundamentals." Forward Looking and Cautionary Statements

This press release may contain forward–looking statements within the meaning of the Private Securities Litigation Reform Act, with respect to our future performance, operating results, strategy, and other future events. Such statements generally include words such as could, can, anticipate, believe, expect, seek, pursue, and similar words and terms, in connection with any discussion of future results. Forward–looking statements involve a number of assumptions, risks, and uncertainties, any of which may cause actual results to differ materially from the anticipated, estimated, or projected results referenced in forward–looking statements. In particular, the forward–looking statements of NYMEX Holdings, Inc., and its subsidiaries are subject to the following risks and uncertainties: the success and timing of new futures contracts and products; changes in political, economic, or industry conditions; the unfavorable resolution of material legal proceedings; the impact and timing of technological changes and the adequacy of intellectual property protection; the impact of legislative and regulatory actions, including without limitation, actions by the Commodity Futures Trading Commission; and terrorist activities and international hostilities, which may affect the general economy as well as oil and other commodity markets. We assume no obligation to update or supplement our forward–looking statements.

Chapter7: ASSESSMENT OF MCX CRUDE OIL CONTRACTS On studying the crude oil futures contract of MCX some of differences could be studied on comparison with Nymex’s Light Sweet Crude futures contract. Some of these are:

Time period-: for which crude oil contract is listed or traded on MCX is just for three months as compared to Nymex’s, because here there is nil physical delivery and also here only those players participate who wants to earn profits from market due to the fluctuations in the prices. But it has been proposed by both the Exchanges i.e. MCX and NCDEX to allow bi-annual contracts in crude oil, as given the news below: THE National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX) are planning to approach the Forward Market Commission (FMC) to launch long-term contracts for attracting serious risk hedgers in the market. The FMC currently allows only quarterly contracts in crude oil. The development coincides with recent stabilization in crude prices at a lower level leading to a drop in daily turnover in the future markets on both the exchanges. The drop is reportedly attributed to the speculators or day-traders, generally attracted during the volatile price situations.

Sources in both the exchanges confirmed that they were considering launch of biannual contracts in the near future to attract serious players. While NCDEX, the latest entrant in crude futures, is planning to move the FMC with its plea to launch bi-annual contracts, MCX feels that the market demand for such derivatives is yet to attain the requisite critical mass and the exchange may have to wait for some time before introducing such contracts. "The long-term stability of crude futures will depend on participation of users of crude oil and other associated industries which have a strong price co-relation with crude oil for hedging the risks. Compared to the day-traders who are only interested in profit booking taking advantage of price volatility, the risk-hedgers take a greater interest in futures market in all seasons," said a senior NCDEX official.

miNY futures-: contract cannot be traded on MCX. These miNY futures contract of crude are traded on NYMEX which provides lot of advantage. About miNY futures Investment opportunities in the energy and metals markets are offered by NYMEX and COMEX miNY™ futures, fractional versions of the Exchange's highly liquid crude oil, natural gas, heating oil, gasoline, gold, copper, and silver futures contracts. The NYMEX miNY™ crude oil, heating oil, and gasoline contracts are 50% of the size of their respective standard-sized contracts; NYMEX miNY™ natural gas contracts are 25% of the size of their respective standard-sized natural gas contracts; and COMEX miNY™ gold, copper, and silver are 50% of the size of their respective standard-sized metals contracts. All are financially settled at the settlement price of their corresponding standard-sized contracts, the world's most actively traded physical commodity futures contracts. The contracts trade virtually around the clock on the CME Globex® electronic trading platform and clear through the New York Mercantile Exchange clearinghouse

NYMEX miNY™ Advantages Energy is a global market, and political or economic events in any part of the world can affect market fundamentals elsewhere at any time. The volatility of the energy markets can be as much as twice as high as the Standard & Poor's 500 index, and are considerably higher than either the Eurodollar and relatively stable U.S. Treasury bond markets

Volatility of Investment Compared

Source:www.nymex.com The high liquidity of energy futures contracts and relatively low holding costs, make them an important alternative investment vehicle for the serious investor's portfolio. The NYMEX miNY™ energy futures combine the New York Mercantile Exchange's world reputation for energy price discovery,

market transparency,

and financial

innovation with the liquidity of the NYMEX Clear Port® electronic trading platform.

NYMEX miNY™ energy futures are 50% of the size of the Exchange's standard NYMEX Division energy futures contracts with two NYMEX miNY™ energy futures equal to one standard futures contract. NYMEX miNY™ energy futures offer advantage to investors seeking affordable instruments that provide portfolio diversification and trading opportunities.

The financial integrity of all trades in the NYMEX miNY™ energy futures are assured by the New York Mercantile Exchange clearinghouse, backed by the strongest names in the financial services and energy industries. Margin requirements on positions in the NYMEX miNY™ energy futures can be granted a spread credit against economically related positions on the New York Mercantile Exchange NYMEX Division, and NYMEX Europe. A single margin requirement will be determined for the portfolio resulting in improved cash flow, more efficient use of capital, and reduced costs On MCX OPTIONS trading in commodities are not allowed. Presently options trading on commodities are prohibited under sec19 of the FC(R) Act, 1952. No Exchange or person can organise or enter into or make or perform options in commodities. However, the market expects the government to permit.

options trading in

Commodities soon. Options on futures offer additional flexibility in managing price risk. There are two types of options, calls and puts. A call gives the holder, or buyer, of the option the right, but not the obligation to buy the underlying futures contract at a specific price up to a certain time. A put gives the holder the right, but not the obligation to sell the underlying futures Contract at a specific price up to a certain time. A call is purchased when the expectation is for rising prices; a put is bought when the expectation is for neutral or falling prices. The target price at which a buyer or seller purchases the right to buy or sell the options contract is the exercise price or strike price. The buyer pays a premium, or the price of the option, to the seller for the right to hold the option at that strike.

An options seller, or writer, incurs an obligation to perform should the option be exercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract and the writer of a put has an obligation to buy a futures contract. An option is a wasting asset. The premium declines as time passes. Depending upon the movement of an option’s price, the buyer will choose one of three alternatives to terminate an options position: Exercise the option; liquidate it by selling, or buying, it back on the Exchange; or let it expire without value. Options give hedgers the ability to protect themselves from adverse price moves while participating in favourable price moves. If the options contract expires worthless, the only cost is the premium. Many people think of buying options like buying insurance. By using options alone, or in combination with futures contracts, strategies can be devised to cover virtually any risk profile, time horizon, or cost consideration. Options Rights and Obligations Call buyer

Has the right to buy a futures contract at a predetermined price on or before a defined date. Expectation: Rising prices

Seller

Grants right to buyer, so has obligation to sell futures at predetermined price at buyer’s discretion. Expectation: Neutral or falling prices

Put buyer

Has right to sell futures contract at a Predetermined price on or before a defined date. Expectation: Falling prices

Seller

Grants right to buyer, so has obligation to buy Future Predetermined price at buyer’s discretion. Expectation: Neutral or rising prices

Determinants of an Options Premium In return for the rights they are granted, options buyers pay options sellers a premium. The four major factors affecting the price are: •

Futures price relative to options strike price

•

Time remaining before options expiration

•

Volatility of underlying futures price

•

Interest rates

As in the futures market, options trading takes place in an open outcry auction market on the floor of the Exchange or after-hours on NYMEX ACCESS®. While the value of futures is tied to the underlying cash commodity through the delivery process, the value of an option is related to the underlying futures contract through the ability to exercise the option. EXCHANGE OF FUTURES FOR PHYSICALS This option is not exercised on MCX as there is no physical delivery on the exchange whereas in NYMEX this is exercised very effectively, the concept is explained below:

The Exchange estimates that more than 95% of all energy futures contracts do not directly result in physical delivery. Companies who do choose to deliver, however, have several options. They can choose standard delivery, attempt to arrange an Alternative Delivery Procedure (ADP) or effect an Exchange of Futures for Physicals (EFPs). (Figure) The NYMEX Division energy futures contracts explicitly set forth delivery locations and other terms. With an ADP, however, buyer and seller are matched for delivery by the Exchange following the termination of Exchange and their clearing members from all liabilities related to the delivery negotiated between parties. Companies using energy futures contracts for hedging purposes locations. In many cases, they are not interested in being matched toa trading partner by the Exchange. More often than not, a hedger using futures finds it economically desirable to make or take delivery elsewhere, under terms that differ from those of the futures contract. EFPs provide the mechanism for such transactions and, based on frequency, is the preferred method of delivery because it provides greater flexibility. EFPs allow companies to choose their trading partners, delivery site, the grade of product to be delivered, and the timing of delivery. The EFP mechanism allows buyers and sellers to effect their cash market transaction on the basis of negotiated price. However, the quantity of the cash commodity involved in an EFP must be approximately equal to the quantity specified by the number of futures contracts involved in the EFP. After both parties to an EFP agree to such a transaction, the price at which the EFP is to be cleared is submitted to the Exchange. This is the nominal price of the EFP. The EFP parties can then affect the actual physical exchange at a price they negotiate between themselves.

n Natural Gas n NY Harbor Unleaded Gasoline n Heating Oil n Crude Oil

Mechanics of an EFP EFPs can be affected between two futures market participants – a long and a short hedger – provided there is a physical market transaction between the parties. For example, a futures market long (a buyer) would take delivery of crude oil from a futures market short (the seller) with whom the EFP is conducted. In this transaction, the buyer’s hedge is liquidated, as is the seller’s, and the actual transfer of crude oil occurs between the parties.

Chapter8: CONCLUSION While preparing the project on crude oil contracts of MCX it was necessary to understand the basics of crude oil market spot and futures market, their development, players and participants in the market, mechanics and their role etc. After having the overview of market the working of both MCX and NYMEX is studied and also the comparison of the crude oil contracts has been done. As a result which have been sought out such as differences have been sought out such as difference in time period of the contracts, futures miny contracts are not yet introduced, even the options trading futures is not allowed by the Government, the EFP option is not or cannot be exercised because there is no physical delivery on the exchange etc are many other differences which should be implemented so that the liquidity and the volatility of the contracts can be increased. Specifications Trading unit Trading Months Minimum fluctuations Delivery Period

ADP miNY futures contracr Options Contract

MCX 100 barrel Contract is

traded

3months price Rs1 per barrel

NYMEX 1000barrels (42000gallons) for Contract is traded for a period of 9years $0.01(1cent)per barrel ($10

per barrel) 1st to 3 rd working day All deliveries are rateable after expiry of contract

over the course of the

NA NA Not yet allowed

month Applicable traded traded

BIBLIOGRAPHY •

Reference material of MCX

•

BP Manual Trading Booklet

•

HossienRazavi& Fereidun Fesharaki, Fundamentals of petroleum trading

•

www.mcxindia.co

• www.nymex.com • www.eia.com • www.investopedia.com •

Glossary