Commodities are tangible assets that are relatively homogenous in nature. This attribute allows these assets to be standardized as contracts for purchase and sale in futures markets.
Increasingly in recent years, many investors have become involved in the ownership of or participation in commodities and natural resources. Commodities can be bought and sold easily in large quantities and held by investors directly in the form of physical assets or indirectly through the functioning of the futures markets.
There are two ways that an investor can access the markets: directly and indirectly. Investors can gain direct exposure to commodities by purchasing them in cash markets (eg, buying gold coins) or in the futures markets where the delivery of the asset is deferred.
Direct commodity investment involves the cash purchase of the asset and taking delivery of it. Space is required to store and insure the asset purchased. Exposure to futures and forwards in the same asset class does not involve taking delivery until the derivatives contracts expire. For example, an investor in oil can buy several thousand barrels of crude oil in the forward market for delivery in June 2018. The future price of the oil is set and the investor may close this contract and take a profit between now and June 2018 when the contract will expire. An increase in oil price will net the investor a return on the deal. Trading in this way is convenient because there is no need for an individual to take delivery of the product.
Alternatively, the investor may prefer indirect commodity investment via, for example, commodity-based collective funds, e.g. Commodity ETFs like Gold and Silver ETFs, or through the shares in commodity-related companies.
Categories of Commodities
These include metals (including gold, copper, platinum, lead, tin, nickel, and uranium) and diamonds. Hard commodities generally relate to metals, which require substantial capital expenditure to extract from the ground. These commodities are finite resources. The demand for some metals is dependent on specific industrial conditions.
Gold has traditionally been used as a hedge against inflation as well as a store of value when other investment markets have become weak or unstable.
Energy Commodities – Crude Oil and Natural Gas
Oil and other energy costs can rise due to various factors, such as economic growth and war or political unrest in key oil-producing areas such as the Middle East. In the summer of 2008 the price of a barrel of West Texas Intermediate Crude – the benchmark for trading on the New York Mercantile Exchange (NYMEX) future exchange in the US – reached $147 per barrel. As a result of the global recession prices fell back quite dramatically, with the price per barrel dropping below $40 in the first quarter of 2009. In 2012, the price per barrel had rebounded back to $110, by 2015 it dropped again to less than $40. By September 2016, the oil price had recovered slightly to around $46 per barrel. The price of oil is extremely volatile and plays a unique role in affecting the outlook for inflation and general economic conditions.
The availability of such supplies is obviously of great concern to a world that is still very much dependent on fossil fuels. There is a school of thought which suggests that the supply of oil has passed its ‘peak’ and that, going forward, the costs of extraction and availability are on a declining trajectory.
Soft Commodities
These are agricultural products including wool and cotton, and foodstuffs such as meats, cocoa, coffee, soya, and sugar. ‘Softs’ have the characteristic of being renewable, usually on an annual cycle. Crops can be grown season after season.
Additionally, many soft commodities are perishable. This can make their price highly volatile: if there is a surplus of coffee, relative to typical levels of demand, the price may fall significantly as producers seek to sell as much as they can.
The prices of soft commodities are, as for all assets, driven, among other factors, by supply and demand.
Supply can be significantly affected by factors such as:
- good/poor harvests
- diseases affecting livestock, such as pigs and cattle
- exceptionally good/bad weather
- political unrest in the producing country.
Investors need to bear in mind the short cyclical factors at work in agricultural commodities. A shortage one year leads to increased prices, which can in turn lead to much-increased production the following year and a subsequent collapse in prices.
Commodity Cash Market
An investor can buy and sell commodities directly through a commodity broker, or invest in a commodities fund. Dealing with physical commodities is not a practical proposition for most investors because of the minimum quantities that must be traded and the risk of deterioration in quality. The cash market is primarily for users of actual commodities rather than investors.
For non-deteriorating commodities such as metals, however, it is possible and practical to take a direct holding in the commodity, which can be stored in a commodity exchange (e.g. MCX in India, LME in the UK) approved warehouse. The investor should consider the storage and other costs involved with this option.
Trade on the cash market is for immediate delivery, known as trading physicals or actuals, with the price paid to be the spot price. Payment must be made immediately and charges are made for storage and insurance. There is a standard contract size, of different metals to facilitate the smooth running of the market.
Commodity Futures Market
The definition of a futures contract it as an agreement to buy or sell a standard quantity of a specified asset on a fixed future date, at a price agreed upon today, with buyers obligated to buy and sellers obligated to sell on a specified future date.
Exchange-traded futures are traded in standardized parcels known as contracts. For example, a futures contract on gold might be for 1 gm or 1 Kg. The purpose of this standardization is so that buyers and sellers are clear about the quantity that will be delivered. Futures contracts have the benefit that they are exchange-cleared, which removes the counterparty risk.
Homogenous and Specified Asset
All futures contracts are governed by their contract specifications, and legal documents set out in detail the size of each contract, when delivery is to take place, and what exactly is to be delivered. For example, in the crude oil futures market, the contract which is actively traded on the MCX calls for delivery of oil in terms of West Texas Intermediate Crude (WTI), whereas the contracts traded in the NSE call for delivery in terms of Brent Crude.
Fixed Future Date
The delivery of futures contracts takes place on a specified date known as the delivery day. This is when buyers exchange money for goods with sellers. Futures have finite life spans, once the last trading day is past, it is impossible to trade the futures for that date.
At any one time, a range of delivery months may be traded and, as one delivery day passes, a new date is introduced. Contracts may be ‘rolled over’ from one expiry date to another by selling the current contract and moving into a new futures contract with a later expiration.
Price Agreed Today
Many people, from farmers to fund managers, use futures because they provide certainty or a reduction of risk. Futures are tradeable, so although the contract obliges the buyer to buy and the seller to sell, these obligations can be offset by undertaking an equal and opposite trade in the market.
This offsetting is common in future markets, and very few contracts run through to delivery.
Example: Contract Offsetting (Squaring Off a Contract)
Suppose a gold trader has sold Sept 1st Gold Futures at Rs 55,000/- per 10 gms. If subsequently, the gold trader decides he does not wish to sell the gold, but would prefer to use it for some internal consumption like jewelry, he could simply buy Sept 1st, Futures at the then prevailing price. His original sold position is now offset by a bought position, leaving him with no outstanding delivery obligations.
Shares of Commodity Companies
One approach to indirect investment would be to acquire shares in a commodity-producing company, eg, miners, metal trading, or oil-producing companies. As commodity prices rise, we could anticipate that the company’s revenue, and correspondingly the share price, will rise.
Although all producers will face the same selling price, they will not all face the same cost pressures and hence, though we may expect share prices to move with the underlying commodity prices, the correlation will not be perfect.
There may not be a close correlation between the share prices of oil exploration and refining companies and the price of a barrel of crude oil. With the major oil companies, their profitability depends crucially on the margins they earn and they also make extensive use of hedging to limit their financial exposure to a volatile commodity price. However, they will have more flexibility in cutting costs in challenging times. For smaller oil exploration companies, the field is highly speculative and many exploration companies fail to make the oil finds they expect, while others may sometimes make extraordinary profits.
Mining companies’ shares may correlate relatively closely with the price of commodities being extracted if the company is at or near production. As with oil companies, share prices may be volatile and not closely linked with commodity prices, partly due to hedging.
Commodity Funds
Commodities funds could be of interest to an investor who is interested in real assets as a hedge against inflation and is also looking more toward capital growth than income. An investor would be able to gain commodities exposure through an Exchange Traded Fund that invests in commodities like Gold, Silver, or other metals. Such ETFs are commonly known as Gold / Silver ETFs.
They represent a relatively simple, easily understood, and low-charge option for the investor, both institutional and retail. It enables fund managers and individual investors to participate in a sector that is not closely correlated with certain other asset classes such as equity or bonds. In the case of most ETFs, there is a high degree of liquidity and they can be traded throughout the trading day.
Commodity Risk
Commodity risk is the risk that a business’s financial performance or position will be adversely affected by
fluctuations in the prices of commodities. Producers of commodities, for example in the minerals (gold, coal, etc.), agricultural (wheat, cotton, sugar, etc.), and energy sectors (oil, gas, and electricity), are primarily exposed to price falls, which means they will receive less revenue for the commodities they produce. Consumers of commodities, such as airlines, transport companies, clothing manufacturers, and food manufacturers, are primarily exposed to rising prices, which will increase the cost of the commodities they purchase.
A business should consider managing commodity risks where fluctuations in commodity pricing and/or supply may impact the business’s profitability.
Types of Commodity Risk
There are four types of commodity risk to which an organisation may be exposed:
- Price risk: arises from an adverse movement in the price of a commodity as determined by forces outside the control of the company.
- Quantity risk: arises from changes in the availability of commodities.
- Cost (input) risk: arises when adverse movements in the price of commodities impact business costs.
- Political risk: arises from compliance or regulation impacts on the price or supply of commodities.
Groups Exposed to Commodity Risk
- Producers can include farmers, other agricultural producers, and miners. They can be exposed to all of the types of risks noted above.
- Buyers: can include cooperatives, commercial traders, and manufacturers who consume commodities in their production processes. Such organisations can be exposed to commodity risk through the time lag between order and receipt of goods.
- Exporters: face risk from the time lag between order and receipt from sales, as well as a political risk where compliance, regulation, or availability can adversely impact sales price.
Commodity and Foreign Exchange Risk
Generally speaking, most commodities are priced and traded in US dollars (USD), and organizations that are exposed to commodity risk may also carry foreign exchange rate risk. Managing commodity risk in isolation from any exchange rate risk will leave the organization exposed to adverse movements in the currency in which the commodity is priced or traded. This may materially influence the organization’s profitability.
Therefore, when undertaking any strategy to manage commodity risk, due consideration should also be given to managing foreign exchange rate risk.
Effects of Commodity Price Fluctuations
Falling Commodity Prices
- Decrease sales revenue for producers, potentially decreasing the value of the organization, and/or leading to a change in business strategy.
- Reduce or eliminate the viability of production -mining and primary producers may alter production levels in response to lower prices.
- Decrease input costs for businesses consuming such commodities, thus potentially increasing profitability, which in turn can lead to an increase in the value of the business.
Rising Commodity Prices
- Increase sales revenue for producers if demand is not impacted by the price increase. This in turn can lead to an increase in the value of the business.
- Increase competition as producers increase supply to benefit from price increases and/or new entrants seek to take advantage of higher prices
- Reducing profitability for businesses consuming such commodities (if the business is unable to pass on the cost increases in full), potentially reducing the value of the organization.
Commodity Risk Management
Forward Contracts
Forward contracts are agreements to purchase or sell a specified amount of a commodity on a fixed future date at a predetermined price. Physical delivery is expected and actual payment occurs at maturity (the future date agreed to in the contract). These contracts enable the seller or purchaser to lock in a fixed price for future delivery and provide protection against adverse movements in the commodity price subsequent to the contract agreement.
Futures Contracts
Futures contracts are similar to forward contracts in that they are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. However, unlike forward contracts, the settlement of a futures contract does not necessarily require physical delivery. More commonly, futures contracts are traded on formal commodity exchanges and are settled by offsetting the contract on or before maturity (the closing date of the contract) by an equivalent reverse transaction that will cancel out the original contract. This is called ‘closing out’ the position. Futures contracts often carry a requirement to meet margin calls where there has been an adverse movement between the contract price and the current price — hence these contracts can impact cash flow.
Commodity Options
Commodity options enable an entity to purchase or sell the commodity under an agreement that allows for the right but not the obligation to undertake the transaction at an agreed future date. Essentially, a commodity option insures against adverse movements in the price of the commodity. A premium (which can be relatively expensive) to undertake this transaction is usually required. There are a number of different types of options that can be used to manage commodity price risk.
Participants in Commodity Derivative Market
Hedgers
They use derivatives markets to reduce or eliminate the risk associated with the price of a commodity. They trade in the futures market to transfer their risk of movement in prices of the commodity they are actually physically dealing with. Some of the hedgers are listed below and their objective from trading in this market:
- Exporters: People who need protection against higher prices of commodities contracted from a future delivery but not yet purchased.
- Importers: People who want to take advantage of lower prices against the commodities contracted for future delivery but not yet received.
- Farmers: People who need protection against declining prices of crops still in the field or against the rising prices of purchased inputs such as feed.
- Merchandisers: People who need protection against lower prices between the time of purchase or contract of purchase of commodities from the farmer and the time it is sold.
- Processors: People who need protection against the increasing raw material cost or against decreasing inventory values.
Speculators
Speculators are those who may not have an interest in the spot market but see an opportunity for price movement favorable to them. They provide depth and liquidity to the market. They provide a useful economic function and are an integral part of the market. It would not be wrong to say that in absence of speculators, the market will not be liquid and may at times collapse.
Arbitrageurs
Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, resulting in a riskless profit.
Benefits of Commodity Derivatives
Commodity derivatives have changed the way in which market participants manage the risk in their businesses. Hedging involves taking opposite positions in two different markets, with the primary objective of mitigating the loss in one market with a gain in another market. These two markets are usually the cash market on one hand, and the futures or forward markets on the other.
Let us analyze using practical examples, how different market participants use commodity derivatives to mitigate risk.
Example: Hedging by Exporter of Silver
Assume a hypothetical scenario of an exporter having an inventory of industrial-grade silver. If he is able to sell his existing inventory at the prevailing silver price of say, the trader would be at a gain or at break even. If the silver price decreases below the current price then the trader would incur a loss.
As the exporter cannot be sure of future price developments, he has an entirely speculative position in the physical commodity market. There is a threat of devaluation of his existing inventory of silver, for which he has not yet identified a customer. In order to protect against the devaluation of existing silver inventory at time ‘t’ the exporter can sell (short) Silver Futures contracts for a quantity equivalent to the inventory of unsold silver. Any decrease in silver price would lead to profit in the short futures position, compensating for the loss incurred in inventory devaluation. Thus, gains in the futures market would nullify the loss in the physical commodity market exposure.
At time t2, when the exporter sells the existing inventory of silver, he simultaneously closes out his short futures position by buying the same number of futures contracts as he had initially shorted.
In the above example, futures were used to protect the value of an inventory. In the same way, futures can serve to guarantee the price of a crop that has not yet been harvested, the price of metals that are likely to be produced in a year’s time, or the costs of importing fuel for the future period. Corporates, farmers, manufacturers, traders, distributors, and other market participants in the commodity ecosystem can buy or sell futures contracts, and thus more or less lock into the “net price” for either the procurement of raw material or the sale of finished goods.
Hedging by Farmer
A farmer plans to harvest a guar seed crop in the month of November. But in the harvesting season, the guar seed prices usually decline due to excess supply in the market. This usually forces the farmer, who requires income for the next harvesting season, to sell his harvest at a discount.
The farmer has two options to counter the risk he is exposed to, due to price fluctuations:
Option A
Store the guar seed for a few months and subsequently sell it when the guaranteed price increases (in the non-harvest season). But, this would not be possible if the farmer requires the proceeds from the sale of his harvest to finance the next crop season. Also, the farmer would require adequate storage space. Proper preservation techniques need to be followed to ensure that the stored harvest does not get destroyed due to infestation.
Option B
Alternatively, the farmer can hedge by selling the November guar seed futures contract, in September. Any decline in the cash price of guar seed in the month of November would result in a corresponding decrease in guar seed futures prices, which the farmer has already shorted (sold). Upon harvest, the farmer would offset his futures position by buying guar seed November futures contracts and simultaneously sell his guar seed crop harvest in the physical commodity marketplace (mandi). This ensures that the farmer is protected against any decline in the value of his harvested crop.
Rolling Over of the Hedged Position
If the time period required for a hedge position is later than the expiry date of the current futures contracts, the hedger can roll over the hedge position. Rollover of the hedge position means closing the existing position in one futures contract and simultaneously taking a new position in another futures contract with a later expiry date. If a person wants to reduce or limit the risk due to a fall in prices of the finished material to be sold after six months, and if futures contracts up to two months are liquid, then he can roll over the short hedge position three times till the date when the actual physical sale takes place. Every time the hedge position is rolled over, there is a possibility of basis risk and at the same time, the rolling hedge position limits or reduces the price risk.
Example: Roll Over of the Futures Contract
In April 20XY Raman, a Mumbai-based wholesale gold jewelry manufacturer buys 10 Kg of Gold in the spot market at a price of Rs. 55,000/- per 10 gm as raw material to make jewelry from it.
Raman wants to protect himself from the reduction in the price of raw gold till the jewelry is ready for sale in October 20XY. In April 20XY, Raman also sells June Gold Futures contracts (each of 1 Kg) at Rs. 55,500/-per 10 gm, which he closes out in June just before the expiration date at Rs. 55,300/-per 10 gm for a profit of Rs. 200 per 10 gm. In June 20XY, Raman sells August Gold Futures contracts at Rs. 55,500/-per 10 gm, which he closes out in August just before the expiration date at Rs. 55,600/- per 10 gm for a loss of Rs. 100/-per 10 gm. In August 20XY,
Raman sells October Gold Futures contracts at Rs. 55,000/-per 10 gm, which he closes out in October before the expiration date at Rs. 54,900/-per 10 gm for a profit of Rs.100/-per 10 gm. In the above futures transactions, Raman makes a total profit of Rs. 200 per 10 gm in the futures market whereas he sold jewelry for a spot price of Rs.54,900/-per 10 gm in October 20XY thus incurring a loss of Rs. 100/-per 10 gm.
So Raman managed to reduce the loss in the spot market by gaining in the futures market and realizing a net profit of Rs 100/- per gm by rolling over the hedge position for six months.
Risk Diversification through Commodities
Globally, commodity as an asset class is being recognized as an effective investment portfolio diversifier. Commodity derivatives markets in developed countries have matured to a large extent with turnover many times more than that of equity markets. It was only 6 years before that commodity futures trading was relaunched in India. Even in such a short span of time, the Indian Commodity derivatives markets have performed commendably in terms of growth in volume and turnover.
Commodity Futures is a contractual· agreement between two parties to buy or sell a commodity of a specified and standardized quantity and quality on a future date at a specific price through the Exchange. Commodity Derivatives Exchanges provide an efficient trading platform for buyers and sellers to hedge their risk exposure in physical commodity markets. They facilitate price discovery and price risk management for the entire value chain of participants in the Commodity EcoSystem. In India, commodity
derivatives are traded for bullion (gold, silver), energy (crude oil, natural gas), ferrous and non-ferrous metals (copper, aluminum, zinc, lead, steel), agricultural commodities (oils, oilseeds, pulses, fibers, spices, cereals, plantations) and other unique commodities such as petrochemicals.
Commodity Derivatives as an asset class offer an effective portfolio diversification avenue due to the low correlation of Commodity indices with equity indices. This aids in mitigating risk on the total investment portfolio. Hedge funds the world over have recognized this advantage and have started including commodities in their portfolio.
Following are some of the excerpts from a study conducted on identifying the extent to which commodities are an effective asset class for diversification of portfolio risk.
Commodity futures are strikingly different from stocks, bonds, and other conventional assets. Among these differences are:
- commodity futures are derivatives securities; they are not claims on long-lived
corporations; - they are short-maturity claims on real assets;
- unlike financial assets, many commodities have pronounced seasonality in price
- levels and volatilities.
Another reason that commodity futures are relatively unknown may be more prosaic, namely, there is a paucity of data. The economic function of corporate securities such as stocks and bonds, that is, liabilities of firms, is to raise external resources for the firm.
Investors are bearing the risk that the future cash flows of the firm may be low and may occur during bad times, like recessions. These claims represent the discounted value of cash flows over very long horizons. Their value depends on the decisions of management.
Investors are compensated for these risks. Commodity futures are quite different; they do not raise resources for firms to invest. Rather, commodity futures allow firms to obtain insurance for the future value of their outputs (or inputs). Investors in commodity futures receive compensation for bearing the risk of short-term commodity price fluctuations. Commodity futures do not represent direct exposures to actual commodities.
Futures prices represent bets on the expected future spot price. Inventory decisions link the current and future scarcity of the commodity and consequently provide a connection between the spot price and the expected future spot price. But commodities, and hence commodity futures, display many differences. Some commodities are storable and some are not; some are input goods and some are intermediate goods