Fear not Commodity Investing!!-

For long, the investment universe for Indians consisted of stocks, jewellery, real-estate and bonds. Now, yet another avenue has opened up — commodity futures, thanks to the lifting of the three-decade ban on it.

Though it is four years since the government issued a notification allowing futures trading, commodities attract but lukewarm interest among retail investors.

A large number of brokerage firms are yet to open divisions for the commodities market. Common misgivings among investors are that ``commodities are risky'' and that ``they are difficult to understand'.

Equities versus commodities
Unlike equities, commodities touch every day life. For instance, sugar. Yet, investors keep away from commodities, unable to understand the market. But commodity markets are easier to understand than one imagines.

For one, there are relatively few factors at play, unlike in the case of the equity market where a wide spectrum of factors — earnings, free cash flows, interest rates and risk premiums — drives prices. Also unlike equities, commodities do not carry operational and management risks.

Though to a certain extent, commodity prices are driven by geopolitics and duty structures, they most often reflect the underlying demand-supply situation. A mismatch between them causes price changes.

The risk tag
Investment in any asset class — commodities, stocks, bonds or treasury bills — carries its own risk element. Commodities, in general, are tagged high-risk. This has been validated using statistical tools based on historical data.

Standard deviation is the common tool used to quantify risk, but it reflects volatility more. The risk element is the possibility of the actual varying, on the negative side, from the expected.

Proxies against inflation
Apart from being an asset class, commodities can also be used as instruments to hedge against inflation. In India, a key measure of inflation is the wholesale price index, which comprises both industrial and consumer goods. Though all the goods on the list are not traded in the commodity futures market, investors can use proxies to hedge against inflation. For instance, crude oil can serve as a proxy for diesel and petrol. It may be tempting for investors to invest in commodity stocks rather than in the commodity itself..

For example, the ONGC stock as a hedge against fuel price rise. But investors would need to consider the operational risk that comes with the ONGC stock. A drop in production or drying up of wells would impact the stock adversely limiting its hedging efficacy. But an investment in the commodity itself would not carry this operational risk.

Yet, proponents of the equity market would argue that an investment in a commodity stock is more rewarding than in the commodity itself. The leverage effect that an entity derives would come to the aid of these investors, they say. So how does a firm derive this effect? Take the case of a hypothetical company, Black Tea, which earns an operating profit of Rs 20 crore on a revenue base of Rs 100 crore.

A 10 per cent increase in unit realisation would push its operating profit up to about Rs 30 crore, that is, a 50 per cent growth (assuming the expenditure remains the same). Using the Enterprise Value/earnings befor interest, depreciation, tax and amortisation (EBIDTA) model, a fair value of the Black Tea stock would be 50 per cent higher.

A similar leverage effect is possible in the commodity market as well. For instance, while a barrel of crude oil trades at about Rs 3,900 on the MCX, investors need to pay only the margin, Rs 195 per barrel, to take exposure in a trading lot of 100 barrels.

A 10 per cent rise in crude oil prices would inflate the gains to Rs 390 or about double the investment. Of course, this can work the other way, just as well.

Element of subjectivity
Another argument that stock market proponents might throw is target prices, or the fair value of an asset for an investor. They would argue that arriving at target prices using fundamental analysis is difficult for commodities.

Though the target price — that help establish if an asset is over- or under-valued — approach to investing is thought to be scientific, there is a significant element of subjectivity attached. For, the various valuation models that generate the fair value are based on such subjective elements as growth rates.

Investors need to also understand that target prices do not guarantee returns. Though forecasting the direction of prices does not quantify the possible returns, it is the key to profiting from an investment.

With fewer factors in play in the commodities market, it is easier to forecast the direction of the prices.

Courtsey:The Hindu

Hedging with Steel Futures!! In LME Perspective

Lets start with the following scenario:

• Seller – HRC Steel Mill, with 100,000 tons per month to sell
• Buyer – Pipemaker, with capacity to produce 10,000 tons per month
• LME steel futures contracts are monthly contracts, expiring, say, on the 15th of the month before the month of delivery. What this means, for example, is
o All February delivery futures contracts will expire on the 15th of January.
o Any futures contract, issued at any time in the preceding 12 months, for August
delivery will expire on the 15th of July.

First week January

• The pipemaker is negotiating an order to supply 5,000 of base grade pipe to a pipeline project in Q4. He will require the tonnage in September, hence demands shipment from his supplier in August.
• The mill wants to produce the steel, and over the next few days negotiates with the pipemaker all the details of the specification – various widths & thicknesses, specific coils weights etc. They sign a forwards contract to this effect, committing the mill to deliver the 5,000 tons in August.

January 10th
Now lets look at the LME steel futures pricing table we looked at in our ‘Interpreting Futures Prices’ section, where we suggested, lets say its January 10th, and the LME steel futures screen for base grade HRC on our computer or in the Financial Times states:

Period Cash 3-month 6-month 12-month
Price $300 $310 $280 $255

For the steel mill, it does not know what the price of August delivery HRC will be. It may think it will be more than US$ 280 ton, or maybe it will be less. It’s a gamble, because at the end of the day the mill does not know what the price will be. No-one does. The mill can not determine its cashflows for Q4. It does not know whether it will make a profit or a loss. And an equity provider does not know whether the mill will be able to repay its loan on time, or even at all.

These are the risks associated with volatile pricing. These are the risks that hedging with futures can eliminate. Using LME steel futures, our mill can lock-in the price of US$ 280 ton.

Step 1

To match his price exposure relating to his contract for delivery of 5,000 tons in August, the mill needs to find the price for 50 futures contracts (1 futures contract = 100 tons of base grade HRC) for August delivery. August delivery contracts expire on the 15th of July, so on January 10th the mill goes to his broker and to secure the 6-month futures price of US$ 280 ton

• Note, for August delivery the mill would be quoted the 6 month price on all days from 16th December to 15th of January. If the mill went to his broker on 17th January for an August delivery contract, he would be quoted the 5-month price.

Step 2

The mill instructs his broker to sell 50 futures contracts (‘lots’) of 6-month futures @US$ 280 ton. The mill is now ‘short’ 5,000 tons in the futures market for August delivery

July 15th
This is the day the mills August delivery contract expires. Futures market now looks like this

Period Cash 3-month 6-month 12-month
Price $260 $240 $250 $295

The price the market is willing to pay for August delivery contracts – remember, that’s what the mill sold in January: 50 futures contracts of 100 tons for August delivery – is the cash price, US$ 260 ton. Remember too, that the cash price is the price that steel buyers in the physical market are willing to pay for August delivery also. So neither the mill nor the pipemaker is faced with the awkward situation where the steel can be bought more cheaply elsewhere. On July 15th US$ 260 ton is both the physical market and futures market price for August delivery.

Step 3

The action the producer takes is to buy back an equal number of identical futures contracts ie 50 lots of 100 tons for August delivery at the cash price of US$260 ton. This has two important consequences.

• First, by selling 50 futures contracts for August delivery in January, the mill was committing itself to deliver 5,000 tons of base grade steel via the exchange in August. However, by buying 50 futures contracts for August delivery on July 15th, the mill has cancelled its obligation to deliver steel via the exchange. 50 contracts sold, less 50 contracts bought, equals zero.
• o This is what is known as ‘closing out’. The ‘open’ position – the commitment to deliver 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August – has be ‘closed’ by taking an equal (50 lots) and offsetting (originally sold, now buying back) position, to take delivery of 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August. The two equal and offsetting positions have cancelled each other out. The mill no longer has any obligation to deliver or take delivery steel across the exchange.
  

• Second, the mill has made a US$ 30 ton profit on his futures contracts – the mill sold 50 lots at US$ 290 ton, and has bought back an identical quantity (50 lots) of identical contracts (August delivery steel futures) at US$ 260 ton. That’s a US$ 30 ton profit

August

But what about the physical steel – the API grade coils wanted by the pipemaker?

Remember, back in January the mill and the pipemaker agreed a forwards contract committing the mill to deliver 5,000 tons of HRC in the specific dimensions etc required. Since January the mill has had 6 months to program his rolling schedule, ensuring the coils are produced at the optimal point for maximum production efficiency.

And Remember last month, in July, August delivery coils were trading at US$ 260 ton. So that’s the base price the pipemaker is going to pay for his August delivery coils, no matter where he gets them from. US$ 260 was both the physical market and futures market price for August delivery.

Step 4
So the mill now makes delivery of the 5,000 tons. The price the pipemaker pays is the August delivery cash price – US$ 260 ton.

The Result

The mill has made a gain of US$30 on his futures transaction.

And the mill has produced and delivered the HRC to the pipemaker under their forwards contract. The pipemaker has paid US$ 260 ton.

The mill’s net income therefore is US$ 260 + $30 = $290, the price at which he hedged this 5,000 ton order back in January.

What if Prices had Risen, rather than Fallen ?

What if, between January 10th and July 15th, the Q1 price rise had continued, and prices on July 15th were actually higher, maybe something like this

Period Cash 3-month 6-month 12-month
Price $340 $340 $350 $315

Well, the mill would take exactly the same set of actions

Step 1 – January 15th
Get a quote from his broker for August delivery futures ie US$ 290 ton.

Step 2 – January 15th
Sell 50 lots of August delivery LME steel futures at US$ 290 ton.

Step 3 – July 15th
Buy 50 lots of August delivery LME steel futures at (the ‘cash’ price of) US$ 340 ton.

• Mill incurs a net loss of US$ 50 ton on the futures transaction.

Step 4 – August
The mill makes delivery of 5000 tons of steel as specified in the forwards contract, and gets paid US$ 340 ton.

The Result

US$ 340 ton from the physical sale, less US$ 50 ton loss on the futures transaction, realizes a net income of US$ 290 ton. Again, the level at which the original hedge was taken out, US$ 290 ton, has been achieved.

Thus, it can be seen, that by using futures, the mill has achieve the August delivery futures prices for his transaction. Even though, back on January 10th the price of US$ 290 was just the culmination of peoples opinions, it turns out that that is the price the mill achieved. It is irrelevent whether the actual August delivery price was higher or lower. The mill eliminated the risk of achieving less than US$ 290 ton, and rather achieved its objective of US$ 290 ton.

But wouldn’t it be good for the mill to have eliminated the downside risk, of achieving less than US$ 290 ton, but was able to participate in (at least some of) the favourable upside of pricing at US 340 ton ?

Yes, it would.

Interpreting Futures Prices!!- Steel

There are many myths and misunderstandings about futures prices

• What do they mean ?
• Where they come from ?
• And aren't they just gambling really ?

In the section below we get behind the myths and explain just what makes up futures prices, and what futures prices mean:

If you asked 3 executives from the steel industry, "what will be the FOB Antwerp price of base grade HRC from first class West European mills in 6 months time ?", you might get answers of US$ 300, US$ 330, and US$ 285. The average of their opinions would be US$ 305.

Now, you might ask them for prices based on 100 tons, and prices based on 1000 tons and 10,000 tons. The 3 executives are likely to adjust their estimates accordingly. For example, 100 ton lots might be priced slightly higher than 10,000 tons lots.

Now, if you asked them for prices for 7 months hence, the pricing of the preceding period - the 6-month prices just discussed - will have an influence on the executive's opinion on the 7-month price. The executives will be stating their 7 month opinion on the basis of

their own opinion of the 6-month and 7-month price

the opinions the 2 other executives expressed for the 6-moonth price

the average 6-moonth price of US$ 305

Essentially, what a Futures Exchange does is provide a forum for the expressions of such opinions about 'future' prices of the product underlying the futures contract, over a number of delivery periods in the future. Because every contract has exactly the same volume of exactly the same underlying, to be delivered to exactly the same place, its easy not to get caught up in technicalities of 'superior vs inferior' qualities, or 'expensive and inexpensive' shipment ports. All those elements are standardized in futures contracts. Everyone can purely focus on price.

In a futures market, rather than have an average of just three opinions, you've got many hundreds, even hundreds of thousands, of opinions of price expressed every day for every delivery period in the future.

Furthermore, those opinions of given credence because they are expressed through the buying and selling of futures contracts. These futures contracts actually commit the seller or buyer of such contracts to make or take delivery of the underlying. So we're not talking random, uneducated or even educated guesses of what prices may be. We're talking commitments to buy and sell very significant volumes of steel.

Set within the framework of appropriate regulatory and legal environments, futures markets are highly efficient mechanisms to centralize credible opinions about price to transparently discover future prices at which committed and knowledgeable market participants are prepared to buy and sell steel.