Issue Report 6-9 Emerging Commodity Markets: Current Status and Utilization

Transcription

1 Issue Report 6-9 Emerging Commodity Markets: Current Status and Utilization PARK Hwan-Il June 2011

2 Abstract The continued uptrend in the prices of crude oil, gold, corn, raw cotton, etc. has rekindled interest in commodities as an investment asset. Spot and future prices of commodities have been on the rise since the first half of 2010, either breaking new records or coming close. The Commodity Research Bureau (CRB) spot price index posted on April 11, the highest since the index began in 1940 (average CRB was in April). As rising commodity prices and inflation hedging investment in commodities gain more attention, demand for commodities is growing accordingly. A total of 646 Korean funds are dedicated to commodities, 23% of the total funds. The total value of the commodity funds amounts to 5.2 trillion won (12% of the entire funds) and these funds have seen a net inflow of investment for four consecutive months since January of this year. Growth in commodity prices leads to rising inflation and increased production costs which dent profits. Companies who failed to manage the risks stemming from growth in the prices of raw materials are susceptible to pullbacks in operating profit. Futures prices of West Texas Intermediate (WTI) crude oil, corns and raw cotton rose 27%, 86%, 147% from a year ago respectively. Rising producer and consumer prices are highly likely to lift inflation, shrinking the economy and stunting economic growth. Continued growth in commodity prices and the resulting uptick in inflation are expected to increase the importance of the functions and value of the commodity market. As the commodity market is anticipated to have a bigger impact on the Korean economy and asset portfolios, it is urgent to form a consensus and lay the foundation for the development of Korea s commodity market. As of now, the Korean commodity market mainly trades in gold and pork futures, thus it has great potential for further growth. Although gold and pork futures were first listed in 1999 and 2008 respectively, trade volume is too low for the market to perform as a full-blown futures market. As the importance of the commodity market in the real economy and financial market grows, the characteristics of the commodity market such as high risks and high returns should be well understood and utilized. Investors and companies who try to manage risks from growth

3 in spot prices have to clearly set the level of bearable risks. The entire process of investment and risk management should be transparent, and whether the level of tolerable risks is maintained should be closely monitored. The inclusion of investment in commodities in asset portfolios can help make higher expected profit. Since the commodity market is rarely correlated to the financial market, investment in commodities can lower the risk of portfolios. Hedging strategies should be drawn up under a specific goal and a good understanding of hedging mechanisms would prevent hedgers from turning into speculators. The objective of hedging is to hedge against the risk of a spot market position a company is currently taking, so taking a bigger futures market position than the current spot market position can translate into a risky speculative trade.

4 1. Commodity Markets 1 Draw Renewed Attention and Concern The continued uptrend in the prices of crude oil, gold, corn, raw cotton, etc. has rekindled interest in commodities as an investment asset. Spot and future prices of commodities have been on the rise since the first half of 2010, either breaking new records or coming close. The CRB spot price index posted on April 11, the highest since the index began in 1940 (average CRB was in April). Figure1. Average Monthly Indices of Spot and Future Prices of Commodities Note: The CRB spot price index is an average price of 22 commodities including energy, grains, food, metals, etc. The IMF commodity price index is a weighted average of 56 commodities spot and future prices Source: Korea Price Data System (PDS). As rising commodity prices and inflation hedging investment in commodities gain more attention, demand for commodities is growing accordingly. A total of 646 Korean funds are dedicated to commodities, 23% of the total funds. The total value of the commodity funds 1 Broadly speaking, the commodity market includes both commodity spot and futures markets. But it generally refers to commodity futures markets. Thus, commodity markets in this paper refer to commodity futures markets.

5 amounts to 5.2 trillion won (12% of the entire funds) and these funds have seen a net inflow of investment for four consecutive months since January of this year. 2 Growth in commodity prices leads to rising inflation and increased production costs which dent profits. Companies who failed to manage the risks stemming from growth in the prices of raw materials are susceptible to pullbacks in operating profit. Futures prices of WTI crude oil, corns and raw cotton rose 27%, 86%, 147% from a year ago respectively. Rising producer and consumer prices are highly likely to lift inflation, 3 shrinking the economy and stunting economic growth. In March, the producer price index (PPI) and the CPI climbed 7.3% and 4.7%, exceeding the government s target range for the third consecutive month. Table1. Change in the Futures Prices of Major Commodities WTI Crude Oil ($/barrel) Average Growth from Growth from Mar. Sept All-time low All-time high (Mar. 2011) (%) (%) ( ) ( ) Corn (cent/bushel) ( ) ( ) Raw Cotton (cent/pound) ( ) ( ) Source: Korea PDS (as of April 15) 2 The data was as of April 19, The number of commodity-related funds and the total value grew 26% and 33% compared with 514 funds and 3.9 trillion won at the end of (FnSpectrum.) 3 There are growing fears over an economic recession caused by cost-push inflation (growth in production costs such as raw materials and wages), not by demand-pull inflation.

6 Korea s Weak Commodity Market Continued growth in commodity prices and the resulting uptick in inflation are expected to increase the importance of the functions and value of the commodity market. A weak US dollar, growing demand for raw materials from developing nations and unstable supplies of agricultural goods due to climate change have all contributed to the rise of the commodity market. Influxes of speculative capital into the market have also worked to drive up prices. In addition, the commodity market is now regarded as an alternative investment in an era of high inflation and as a hedge against the risks involved in rising prices. As the commodity market is anticipated to have a bigger impact on the Korean economy and asset portfolios, it is urgent to form a consensus and lay the foundation for the development of Korea s commodity market. As of now, the Korean commodity market mainly trades in gold and pork futures, thus it has great potential for further growth. Although gold and pork futures were first listed in 1999 and 2008 respectively, trade volume is too low for the market to perform as a full-blown futures market. 4 With the growth in commodity prices, the need for spot and futures trading of commodities like produce and crude oil has been increasing. 5 To that end, the government plans to set up a gold spot trading market within Korea Exchange (KRX) in January 2012, which will cover crude oil, oil products and agricultural goods by A total of two gold futures contracts traded at Korea Exchange (KRX) till April The daily average trade volume was two in 2007, five in 2008, seven in 2009, 0.1 in 2010 and zero in As mini gold futures started to be listed in Sept. 2010, the gold futures market has almost closed its business. The daily average trade volume of pork futures was 144 in 2008, 55 in 2009, 56 in 2010 and 46 in 2011, while the volume of futures contracts accounts for only 1.6% of daily spot pork production (KRX). 5 The volume of domestic investment in overseas commodity markets was 8 million in 2010, up 7.4% a year ago. In particular, investment in commodities like crude oil, corns and copper surged 48.4% (The Korea Financial Investment Association).

7 2. Overseas Commodity Markets US-Led International Commodity Market Sees Rapid Growth in China The US, led by the Chicago Mercantile Exchange (CME), has reigned supreme in the global commodity market. The CME Group was created by absorbing the 250-year-old Chicago Board of Trade (CBOT) in 2007 and buying stakes in the New York Mercantile Exchange (NYMEX) in It trades in commodities like agriculture, energy and metals and financial derivatives including stocks, interest rates and foreign exchange. And during the period from January to March of this year, commodity-related trade volume took up 22.9% 6 of the total trade volume (about 13.8 million contracts a day) at the CME. The total daily trade volume of commodities was 3.1 million during the same period, up 10.7% from 2.8 million in The share of energy products in the CME commodity trade volume was more than half. Figure 2. CME s Daily Trade Volume by Commodity Source: CME 6 The share of commodity-related trade was 23.2% in 2010 (CME.).

8 Japan and China have long ago established commodity exchange markets and are actively engaging in the markets. The Tokyo Commodity Exchange (TOCOM), which originated from the Tokyo Textile Exchange established in 1951, now trades mainly in energy and metals while the Tokyo Grain Exchange, which was created in 1952, trades in corn, soybeans, non-gmo soybeans and coffee. China, which first started commodity trading in 1993 through the Shanghai Commodity Exchange, the Dalian Commodity Exchange (DCE), and the Zhengzhou Commodity Exchange (ZCE), has emerged as the world s No.2 commodity market, mainly dealing in commodities such as reinforcing bars, soybean meal, sugar, soybean oils, natural rubber, copper, etc. The global commodity market is rapidly growing - especially in China which accounts for 51% 7 of the global commodity market s total trade volume. In 2010, the total trade volume of the derivatives (futures and options) of financial and commodity products was 22.3 billion contracts, of which commodity-related trade volume equaled 3 billion contracts or 13.4%. The total trade volume jumped 25.9% from 2009 and the commodity trade volume ascended 29.2%. Among commodities, agricultural goods accounted for 40.4%, metals 33.4% and energy 10.2%. In 2010, white sugar contracts at the Zhengzhou Commodity Exchange (ZCE) took up 10.8% of the total global trade volume while crude oil futures at the New York Mercantile Exchange (NYMEX) accounted for 6%. 7 Futures Industry Association.

9 Figure3. Trade Volume of Derivatives and Share of Commodity-Related Derivatives Source: Futures Industry Association. 3. Characteristics of the Commodity Market and Ways to Exploit Them Various Items and Unique Price-Determining Structure Items traded in the commodity markets are largely divided into agricultural products, energy and metals, each of which has unique characteristics. 8 Production of agricultural goods is seasonal and a certain level of consumption is maintained while energy production is continuous and its consumption is seasonal. And high costs and large spaces are required to store agricultural products and energy, while metals can be easily kept. Recently, weatherrelated derivatives, designed to help companies reduce risks associated with adverse or unexpected weather conditions such as temperature, rainfall and hurricanes, and carbon credits are also on the market. 8 The initial barter system evolved into forward contracts between suppliers and demanders. The emergence of standardized futures markets and clearing houses has eased fears over credit risks among traders.

10 Table 2. Major Items at Commodity Market Items Agriculture Energy Metals Grain, fat and oil: corn, wheat, soybean, rice. etc. Livestock: cattle, hogs, pork, etc. Dairy: milk, butter, Cheese, etc. Soft: cocoa, coffee, cotton, sugar, etc. Crude oil, ethanol, natural gas, gasoline, heating oil, diesel, coal, electricity, etc. Gold, silver, platinum, steel, copper Stocks and bonds are priced at the current value of expected future cash flows, but commodity prices are decided by demand, supply and inventory levels. Commodity markets are sensitive to the global economic situation, population, changes in income, policy changes in major economies and weather conditions. The prices of energy products fluctuate in accordance with demand while agricultural goods are greatly affected by supply-side changes and jewelry by economic forecasts. Major Functions: Price Discovery and Risk Management The function of the commodity market is to predict future prices, which is what society and economies demand of commodity market. The most important function of the commodity markets is to provide information on future commodity prices. And the information is open to everyone. Information on prices can help make a decision on the sale of a commodity, whether to retain a commodity, and when to buy a commodity. In the commodity market, risks involved with spot prices of commodities are controlled by the risk transfer between hedgers and speculators. Hedgers buy or sell futures contracts to speculators thereby transferring risks. Speculators tend to accept risks from changes in futures prices so as to make a profit. Active participation by speculators adds ample liquidity to the commodity markets and enables risk management. However, excessive speculative activity can also trigger herd behavior of futures prices and high volatility, thus distorting prices.

11 Basis and Spread Relationship between spot and futures prices offer information that is needed in making a decision on investment and buying or selling products. -Basis: the difference between the price of a futures contract and the underlying commodity's spot (or cash) price. It changes according to region, season and economic situation. Contango refers to the market condition wherein the price of futures contract is trading above the present spot price Backwardation refers to the market condition wherein the price of futures contract is trading below the present spot price. This occurs before harvesting season or in winter when energy demand is high. Spread: the relationship between two different futures prices. It tends to exhibit particular patterns depending on the commodity and time. -A vertical spread is the price difference between two futures contracts for the same underlying commodity whose delivery months are apart. -A horizontal spread is the price difference of two futures contracts for the different but related underlying commodities whose delivery months are same The Commodity Market as an Investment Alternative Investment in commodities has recently produced the highest ROI among investment portfolios including stocks and bonds. If a dollar invested in stock (the KOSPI), bonds (threeyear treasury bonds) and the commodity market (GSCI 9 ) separately is held till now, the ROI on commodity investment would be the highest. The dollar in the commodities market, invested in January 2009, would grow to 2.16 dollars as of March 2011 while those in stocks and interest rates would increase to 1.81 dollars and 1.08 dollars respectively Goldman Sachs Commodity Index 10 One dollar invested in commodities, made in Jan. 2011, was 1.11 as of Mar while that in stocks and interest rates grew to 1.02 and 1.01 dollars respectively (the Korea Center for International Finance.; Korea PDS.).

12 When converted into the average annual ROI, the ROI for commodities exceeded that for stocks. In particular, with growing inflation, the ROI gap between the commodity market and the stock market has widened with the ROI for commodities being on average 16 percentage points higher than that for stocks. When the CPI topped 3% in September of last year, the gap between the ROI for commodities and stocks swelled to 40 percentage points. Though the commodity market is basking in attention due to rising inflation, its price-determining structure, which is different from the financial market, and high vagaries in prices need to be carefully watched. Figure 4. Average Annual ROI for Stocks and Commodities Source: Korea Center for International Finance (KCIF); Korea PDS.; Bank of Korea Economic Statistics System (ECOS). The Commodity Market as a Corporate Risk Management Tool Companies need to conduct an analysis of the commodity market to make a decision on buying or selling raw materials and better manage price risks. When the CRB spot price

13 index goes up 10%, the producer price index (PPI) was found to gain 1.55% three months later. 11 Figure 5. CRB Spot Index and PPI Source: Bank of Korea s Economic Statistics System (ECOS); Korea PDS. Companies that purchase raw materials have to take heed of the movement of spreads and margins in the commodity market because the movement of spreads and margins is a deciding factor when raw materials processing companies are making a decision on material purchases and production. 11 A regression analysis, in which the PPI was assumed to be affected only by the CRB spot price index, showed that the CRB spot price index influenced the PPI the most three months later.

14 Crush Margin and Crack Spread Soybean meals are produced from the process of making soybean oils out of soybean and are used as animal feed. - Crush margin refers to the price relationship among soybean, soybean oils and soybean meals. Soybean processors make a decision on production and investment once a certain level of a crush margin is secured. And they adjust schedules for purchasing soybeans and selling soybean oils and soybean meals. - If margins go up, they purchase more soybeans and increase their production capacity and if the margins go down, production output decreases. When crude oil is processed, a variety of products such as gasoline, kerosene and propane gas are produced. Crack spread is the differential between the price of crude oil and petroleum products extracted from it. - In accordance with changes in crack spreads, oil companies make a decision on investment and hedging to secure a certain level of profit and adjust schedules for crude oil purchases and selling products. It is desirable for companies to use a hedging strategy that avoids price risks at a lower cost. Hedging refers to offsetting risks from spot prices with futures by taking the opposite position in the futures market to what a company would take in the spot market. 12 Yet most companies are often defenselessly exposed to price risks due to either their ignorance of hedging strategies or fears of additional costs. A 10% increase in raw material prices leads to a 1.2% rise 13 in production costs while hedging can help companies avoid risks arising from 12 There are basis risks: if the basis changes abnormally during the hedging period, the perfect protection of spot market positions is difficult. 13 A 10% increase in international raw materials prices leads to a 1.2% rise in production cost (LEE Jin-Myun (2011). " The Impact of Rising International Raw Materials Prices on Industries and Responses." The Korea Institute for Industrial Economics and Trade (KIET).)

15 rising prices at a much lower cost. The cost of hedging in importing crude oil and corn is estimated at a mere 0.1% of their prices. Hedging Costs The cost of hedging corn purchases is 0.12% or US$ 0.36 per ton. -For fear of a rise in the price of the 10,000 tons of corn that a company is scheduled to buy three months later, the company buys corn futures to hedge against growth in spot prices. -10,000 tons of corn is equal to 79 corn futures contracts. The company buys 79 futures contracts in the futures market and liquidates them three months later. The cost of hedging WTI crude oil is 0.08% or US$ 0.08 per barrel. -In preparation of a rise in the price of aviation fuel which is needed three months later, an airline buys 100 futures contracts (or 100,000 barrels of crude oil) to hedge against an increase in fuel prices. 10,000 ton of corns 100,000 barrels of crude oil Commodity Prices US$295 x 10,000 ton = US$ 2.95 million Us$108 x 100,000 barrels- US$10.8 million Commission (US$ 20 per contract) Margin Deposit Opportunity Cost of Margin Deposit (5% annually, three months) The Total Hedging Cost (as a share of commodity prices) US$20 x79 contracts = Us$1,580 US$ 2,025 x 79 contracts= US$159,975 US$2,000 US$3,576 (0.12%) 20 x 100 contracts= US$2,000 5,063 x 100 contracts= US$506,300 US$6,329 US$8,329 (0.08%) The government needs to take advantage of the commodity market to control prices. Monitoring of international commodity markets should be reinforced and immediate responses must be taken should the indices such as futures prices, basis and spreads start to indicate unfavorable market conditions. Support for SMEs that import raw materials and a

16 temporary easing of import tariffs on major raw materials should be considered to rein in inflation. In addition, development of varied financial and insurance products and institutional support are required to manage risks from commodity prices through a market mechanism. 4. Suggestions Utilization of the Commodity Market in Response to Risks including Inflation As the importance of the commodity market in the real economy and financial market grows, the characteristics of the commodity market such as high risks and high returns should be well understood and utilized. Investors and companies who try to manage risks from growth in spot prices have to clearly set the level of bearable risks. The entire process of investment and risk management should be transparent, and whether the level of tolerable risks is maintained should be closely monitored. The inclusion of investment in commodities in asset portfolios can help make higher expected profit. 14 Since the commodity market is rarely correlated to the financial market, investment in commodities can lower the risk of portfolios. Hedging strategies should be drawn up under a specific goal and a good understanding of hedging mechanisms would prevent hedgers from turning into speculators. The objective of hedging is to hedge against the risk of a spot market position a company is currently taking, so taking a bigger futures market position than the current spot market position can translate into a risky speculative trade. In 2008, VeraSun Energy, then US No. 2 producer of ethanol, placed risky bets on rising corn prices via derivatives in the futures market to hedge corn spot 14 Geman, H. (2005). Commodities and Commodity derivatives: Modelling and Pricing for Agriculturals, Metals and Energy. Wiley.

17 prices. During the 2008 financial crisis, however, when commodities prices fell and the value of corn dropped by half, the company was left illiquid, and forced to declare bankruptcy. Efforts to Lay the Foundations for the Commodity Market Now is the time to discuss specific ways to effectively run the commodity market in line with growing demand for utilizing commodity products. It is urgent to deliberate ways to lay the groundwork for the commodity market such as opening markets, trading in spot and futures contracts, listed commodity items, rules about specifications and trade regulations. Korea needs to take its cues from overseas commodity markets that have successfully paved the way for further growth based on the competition systems of many established commodity exchange markets. Trade knowhow and settlement-related technologies that have been accumulated in Korea s financial derivatives market should be employed to build stable, efficient infrastructures for the commodity market. Korea s advanced IT should be capitalized on and nurturing of finance-, market-savvy human resources dedicated to product development is essential. To that end, industry-academia collaboration is required. For a commodity market to be successful, support for the supply of ample liquidity is needed and commodity exchange markets for spot contracts should be revitalized. Sweeteners should be prepared to lure in real demanders of commodities, institutional investors, investment banks and speculators like hedge funds. Trading gold and pork futures at Korea Exchange (KRX) has been lackluster owing to the issue of liquidity creators and regulations on margins. Spot markets for oil, produce, etc. should get transparent and adopt a competitive structure in order to breathe new life to futures markets.