Commodities -- How to Approach Them-VRK100-07062006

Commodities

How to Approach Them?

AUTHOR: Rama Krishna Vadlamudi

MUMBAI

June 7th, 2006

INTRODUCTION TO COMMODITIES:

            The investment universe has, for long, consisted of stocks, bonds, fixed deposits, mutual funds, jewellery, real estate and art. Sophisticated investors deal in currencies or timber also. The lifting of the 30-year ban on commodity futures trading in India has opened yet another avenue for investors. Many analysts feel that we cannot ignore a whole asset class, that is, commodities. An analysis of worldwide flow of capital, new materials, goods and information helps one in understanding financial markets in a better manner. Internationally, commodity market is many times bigger than stock market. Commodities market is the largest non-financial market in the world. The twentieth century has seen three periods of commodity bull markets; the periods are 1906-23, 1933-53 and 1968-82. The present bull market had started in 1999. Commodity pundits are of the opinion the present bull market will last for another 10 to 15 years.

DEFINITION: Commodities are alternatively called as “raw materials”, “natural resources”, “hard assets”, “real things”, and “essentials”. World-renowned commodities guru, Jim Rogers, in his famous book “Hot Commodities” writes: “Commodities are so pervasive that, in my view, you really cannot be a successful investor in stocks, bonds, or currencies without understanding them. Commodities belong in every truly diversified portfolio. Investing in commodities can be a hedge against a bear market in stocks, rampant inflation, even in major downturn in the economy. Investing in commodities will present an enormous opportunity for the next decade or so.”

SUPPLY AND DEMAND: Commodity prices are dictated by supply-demand mismatch. Commodities provide good investment opportunity. China is a big guzzler of commodities, like, steel, aluminum, oil, agri commodities, etc. and the country is a big importer of commodities. Commodities are liquid assets. Some economists argue that when stocks are down, commodities are up and vice versa. Like all financial markets, the prices of commodities swing between extremes. For example, the price of gold was USD 35 per ounce in 1960s, USD 200 in 1975, USD 100 in 1976 and USD 870 in January 1980. Now, it is hovering around USD 630.

            In the 1960s commodity futures were banned in our country. In 1998, the Government started liberalizing futures trading in commodities. In April 2003, the Government permitted futures trading in all the commodities. In a follow-up move it said it would allow new commodity exchanges to come up and let them deal in all commodities, on an electronic trading platform. The major commodity exchanges in India are National Commodity and Derivatives Exchange Ltd (NCDEX), Multi Commodity Exchange of India Ltd (MCX), National Multi Commodity Exchange of India Ltd and National Board of Trade (NBOT). Forward Markets Commission (FMC) is the regulatory body for the commodities trading. FMC is an arm of the Ministry of Consumer Affairs, Food & Public Distribution. FMC is thinking of introducing commodity options also.

PRICE DISCOVERY: By definition forwards/futures perform the important functions of price discovery and price risk management. It is useful to all segments in the economy. A reasonable cost of carry must determine the relationship between spot and futures prices, thereby removing arbitrariness and bringing in greater transparency. Cost of carry in commodity markets means interest on investment, loss on account of loss of weight or deterioration in quality, etc.

CORPORATE EXPOSURE TO COMMODITIES:  May corporates that have exposures on metals like copper, aluminum, cotton, oilseeds, etc., will be benefit immensely by hedging their positions on the exchanges. The Banking Regulation Act does not permit banks to deal in commodities, though they are allowed to trade in bullion. Institutions and banks use the commodity derivative market for their risk management and hedging requirements. Many banks in India are now dealing in gold. They are holding gold and selling gold coins to general public through their branches.

State Bank of India has sought the approval of the Reserve Bank of India to get into exchange traded commodity futures. SBI feels a commodity future trading is a good investment opportunity. In August 2004, SBI had taken a 10% stake in the equity capital of MCX. Our Bank also holds a small stake in the exchange.

AGRI COMMODITIES: Farmers are also expected to profit from the futures market in agri commodities. If farmers expect a good crop in a particular season, they can sell part of their expected crop forward on exchanges. This will enable the farmers to lock into a price irrespective of the price on the day the crop is harvested. Some of the exchanges have networked major ‘mandis’ and provide prices of agri commodities on a real time basis. Some exchanges are working with banks to fund farmers against commodities stored in accredited warehouses. Government is also mulling introduction of a Warehouse Receipts Act to provide legal validity to such warehouse receipts.

COMMODITY BROKING: Various stockbrokers, including Geojit, Motilal Oswal, ICICI Web Trade and India Infoline provide commodity-trading services also. Commodity future contracts are tradeable standardized contracts, the terms and conditions of which are set in advance by the exchanges regulating the trade. Each contract has a lot size and a delivery size. A settlement takes place either through squaring off one’s position or by cash settlement or physical delivery. Delivery is at the option of the seller. Commodity derivative is construed as a financial instrument and not a commodity instrument. More than 95-98 per cent of contracts expire/get squared off on the commodity exchanges without any physical delivery. Unlike stock markets, some commodity exchanges open up to 11.00 pm. However, crude and metals are traded in the night sessions.

Commodity futures are easier to understand compared to equity futures, as one has to just keep track of demand and supply and not the several financial metrics that the latter calls for.

The major traded commodities in India are: gold, silver, oil, guar, soya bean, cotton, mustard seed, RBD palmolein, soya oil, castor seed, wheat, rice, sugar, coffee, tea, pepper and rubber.

 

Source: Newspapers, Magazines, Investment books, web sites, etc.