INTERNATIONAL COMMODITY DERIVATIVE MARKETS A 2-credit course for PGCPIBF Session 1 Course Coordinator: Dr. Niti Nandini Chatnani Professor Indian Institute of Foreign Trade, New Delhi Email: nitinandini@iift.edu Author- COMMODITY MARKETS AND DERIVATIVES 24 March 2024 PGCPIBF 1 Agenda: Overview of Commodity Markets and Risks 1. Understanding Commodities 2. Commodity Markets 3. Benchmark Price 4. Risks in Commodity Markets 24 March 2024 PGCPIBF 2 24 March 2024 PGCPIBF 3 24 March 2024 PGCPIBF 4 A commodity is: • any good that possesses a physical attribute and has a tangible form • a produce of the primary sector, in a relatively raw/unprocessed form • a thing of value, used as an input in the production of other goods and services • of relatively uniform quality, produced in large quantities by many different producers, so that it is effectively uniform across producers • a good that is demanded and supplied across markets without any product differentiation, interchangeable with another good of the same type • Types of Commodities: Agricultural, Energy, Metals (Industrial/Base), Precious Metals 24 March 2024 PGCPIBF 5 Types of Commodities: 1. Agricultural Products like Oil & Oil Seeds, Spices, Pulses, Cereals, Plantations, Fibers, Potato, Sugar, Livestock like lean hogs and live cattle, lumber etc. 2. Industrial (Base) Metals like Copper, Nickel, Zinc, Aluminium, Lead, Tin, Steel, Sponge Iron 3. Precious Metals like Gold, Silver, Platinum 4. Energy Products like Crude Oil, Natural Gas, Furnace Oil, Aviation Turbine Fuel (ATF), Power 24 March 2024 PGCPIBF 6 Mentha Oil Sugar Rubber Sheets Guar Gum 24 March 2024 PGCPIBF 7 Commodity Markets: • The marketplaces where all elements of commerce (buyers, sellers, asset to be traded) come together to settle a price at which a commodity gets traded • They serve as a platform for price discovery, prices being determined through an auction mechanism • Sellers represent the supply side and buyers represent the demand side, and each side may participate in the market through brokers • Conducted in physical as well as electronic marketplaces • Modern commodity markets have their roots in the trading of agricultural products 24 March 2024 PGCPIBF 8 How commodity prices are determined • Commodity prices are essentially an outcome of demand (consumption) and supply (production + inventory) • Current prices do not only factor in immediate supply and demand but also expectations of future supply and demand • However, accurate and transparent demand and supply data is not readily available • In general, the less information available, the greater price volatility will be • A large service industry has grown around researching, reporting and consulting on demand, supply and likely prices for all commodities • Price determination mechanisms range from basic cash exchanges between buyers and sellers (in spot/physical markets) to advanced spot and forward 24 March 2024 PGCPIBF contracts traded online on exchange platforms 9 Spot/ Physical Markets: - Traditional form of markets - Cash and Carry Markets a.k.a. Cash Markets - These are the real markets where buying and selling of commodities is done on Delivery-versus-Payment basis - Contracts called Spot Contracts and price is called Spot Price - Essentially bilateral, party-to-party contracts Advantages of spot contracts: - Can be tailored to requirements - Involve immediate settlement (T+10 or 11 days) Disadvantages of spot contracts: - No mechanism to lock-in future prices 24 March 2024 PGCPIBF 10 What is a benchmark price? • In the commodities markets, a benchmark is defined as a price reference acceptable to both buyer and seller to use as a basis for contract settlements. • Crucially, for a benchmark to be recognised, it needs to reflect actual prices being agreed/traded across the marketplace. • Benchmark prices are also derived by independent price reporting agencies who investigate ongoing market movements and make an expert assessment based on trades and price activity. Why benchmark is useful as a transparent and fair price guidance Using a trusted benchmark price to support contract negotiations offers numerous benefits: • Saves time: No need for detailed research to establish what market participants are paying for a particular commodity. • Enables trade with confidence: Contracts can be agreed quickly as both parties know that the price reflects current market value. • Builds trust: Negotiations remain positive and transparent as both buyer and seller March 2024 11 can24 trust the third party benchmark dataPGCPIBF implicitly. Price Reporting Agencies (PRAs) PRAs are privately owned publishers and information providers who report commodity prices transacted in physical and some derivative markets, and give an informed assessment of commodity price levels at distinct points in time. PRAs also report news stories relevant to the commodity/ sector/ market. There are several PRAs – Platts (a publisher owned by McGraw Hill Financial), Argus Media, and ICIS, that serve as providers of benchmark prices for a broad range of commodities in markets around the world, with their rigorous methodology and strict editorial policies. Price assessments are derived from data gathered from a wide cross-section of each market, including consumers, producers, traders and distributors. Price assessments are based on stringent editorial standards, agreed with regulatory bodies such as IOSCO, to ensure the price assessments are robust, 100% verified and free from conflicts of interest. 24 March 2024 PGCPIBF 12 World Spot Markets for Crude Oil: • Hundreds of crude oil streams are produced in the world. • Crude oils are naturally occurring minerals and no two crude oil streams are identical in their physical / chemical properties. • Pricing of various crude oils in the world is done with price linked to a few Marker crude oils like Brent Crude, NYMEX WTI, Dubai Crude, Tapis, Bonny Light etc. Marker crude oils are actively traded in the international markets. • The prices of daily trades are carried by publications specializing in the oil trade. Ready availability of the reported prices enhances price transparency and the ability of any market participant to assess the prevailing price level. • All crude oils are traded with linkage to the marker crude oils with premiums or discounts to reflect the quality variation, regional supply/ demand variations, etc. 24 March 2024 PGCPIBF 13 World Spot Markets for Iron Ore: • Iron ore is the world's most commonly used metal , used in steel, structural engineering applications and in maritime purposes, automobiles, and general industrial applications • Over the last 40 years, iron ore prices have been decided in closed-door negotiations between a small handful of miners and steelmakers - the first deal reached between these two groups sets a benchmark to be followed by the rest of the industry. • To answer increasing market demands for more transparent pricing, a number of financial exchanges and/or clearing houses around the world refer to prices based on The Steel Index's (TSI) iron ore transaction data • Platts IODEX is also serves as a benchmark to which prices of other grades of iron ore are linked 24 March 2024 PGCPIBF 14 Physical Markets for Gold: • Supply comes from new mine production, existing central bank holdings and recycling of scrap metal; while demand is from jewelry manufacturers, investors and industrial users • London is the centre of the world's physical bullion trading • The traditional practice of fixing gold prices was through the historic London Gold Fix. This has now made way for the new electronic London Bullion Market Association (LBMA) gold price, as of 20 March 2015 • In the LBMA price-discovery system, price is set twice daily - at 10:30 (AM Price and 15:00 (PM Price) London GMT. The new LBMA Gold Price is operated and administered by an independent third party provider, ICE Benchmark Administration (IBA) which provides the price platform, methodology as well as the overall administration and governance for the LBMA Gold Price. The IBA's new electronic platform provides an auction-based, tradeable, auditable method for fixing gold 15prices 24 March 2024 PGCPIBF World Physical Markets for Coal: • Because coal is a bulk commodity, mine supply and location, transportation costs, port fees and port access etc. are important aspects of its price and availability. • Since coal is now the largest single power generating fuel for most power utilities, the physical markets for coal have become volatile • Power producers can enter into long-term coal supply contracts, or opt for shortterm and more price-flexible contracts that rely more on spot market purchases as power producers try to reduce their inventory holding levels. • Since supply and demand are inelastic to price changes in the short run, inventory levels also play a role in pricing 24 March 2024 PGCPIBF 16 Natural Gas Pricing in India: The price of natural gas in India is not market-determined, but the weighted average price of four global benchmarks — the US-based Henry Hub, Canada-based Alberta gas, the UK-based NBP, and Russian gas. The domestic price is based on the benchmark prices in the prior year and kicks in with a quarter’s lag. Prices set using this formula are applicable for six months. The price for the period Oct 2017-March 2018 is based on an average of the four benchmark rates between July 2016 and June 2017. In order to promote E&P activities in the gas sector, the government has introduced a new pricing formula for gas produced from ultra deep-water and high pressurehigh temperature areas, the price being subject to a ceiling revised every six months. 24 March 2024 PGCPIBF 17 Commodity Risk: • Purchase, sale, possession and use of commodities entails a variety of risks • Risk arising from probable loss due to adverse price movements of commodities is “Commodity Price Risk”. • Price Risk can be transferred by the risk averse to the risk seekers through derivatives • Risk Management is the process of trying to control the effect of these risk exposures on firm value. Every business needs to: 1. Protect itself from adverse price movements and its impact on profit margins; and 2. Profit from favorable price movements (perhaps) http://www.indexmundi.com/commodities/?commodity=crude-oil&months=240 24 March 2024 PGCPIBF 18 What we learnt in Session 1: 1. What is a commodity? 2. Various types of commodities 3. What are commodity markets? 4. How commodity prices are set? 5. Benchmark Prices and Price Reporting Agencies 6. Functioning of various commodity markets 7. Risks in commodity markets 24 March 2024 PGCPIBF 19
