All About Commodities Market

By: Shipra Jha , NMIMS , MBA Capital Markets

WHAT ARE COMMODITIES?

Commodities are one of the most volatile asset classes available to investors .They are interchangeable products which, as a consequence, share a common price. Examples for commodities are goods such as grains, livestock, oil, cotton, or even financial products like currencies, bonds, and stock market indices.

ABOUT COMMODITIES MARKET:

The commodities market has emerged during the modern era as an important player in the way people invest and speculate. The two most-watched commodities by far are crude oil and gold: oil because it is the primary form of energy commodities market use to power international transportation and trade ,  and gold because it is viewed by financial markets as a hedge against rising inflation. Daily price swings in commodities of all kinds can be violent and due to the use of leverage, investors can lose more than their initial investment.

PROCESS :

Prices in the commodities market are determined by the motives of the buyers and sellers, who together make up the market.

TYPES OF COMMODITY MARKET :

A commodities market can be a : Cash market or futures market.

 In the case of a cash market, again it could be either a spot or forward market. In case of a spot market, you get immediate physical delivery of a commodity, whereas in the forward market, you tend to get your commodity delivered at a specific date in future. Both spot markets and forward markets are together known as actuals since actual delivery has to be made in either of the types.

A futures contract is a special type of forward contract. They are designed to reduce risks and increase flexibility of forward contracts. The contract, for instance, may specify delivery points and price variations for discrepancies in the quality of the commodity being shipped.

HOW  VULNERABLE ARE COMMODITY PRICES ?

The recent decline in commodity prices attests to the possibility that commodity prices are vulnerable to a deterioration of the global outlook.

HOW BENEFICIAL HAS QE3 BEEN TO COMMODITIES ?

As the Fed embarked on a third round of quantitative easing, risky assets are rallying hard. Commodities were among the biggest gainers of any asset class following the announcement of QE2.Are commodities poised for similar gains this time round?

Conditions in the macro economy are much less supportive, commodity prices are higher and the impact of successive waves of QE is reduced each time. China’s big build is maturing as capacity catches up with demand and that is beginning to backfire through parts of the global commodities supply chain that has fed China for the past decade. Markets are concerned that with business confidence low, growth faltering and export demand poor, weakness in China’s commodity imports will become more pervasive, especially with high inventories overhanging sectors such as copper and steel. With the dollar weakening and the debate over fiat currency debasement now likely to retake centre stage, QE3 is likely to unleash enough physical and futures market buying to bring to an end to gold’s position as one of the weakest commodity markets in 2012 so far. In terms of current market positioning, base metals look likely to benefit most from better sentiment in the short term, as hedge funds look severely underweight, especially in copper.

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Analysis of QE3 and its impact on india

Author:Ravi Srikant,NMIMS,MBA Capital Markets

After the recent announcement by the US Federal Reserve to buy US treasuries and mortgage bonds worth $40 billion a month, aka, Quantitative Easing - 3 (QE3), stock market indices around the world posted heavy gains. In India, the Sensex and Nifty jumped more than 2% each, with the Diesel price hike and expectations of FDI in retail and aviation also contributing to the increase. This is the third such initiative taken by the US Federal Reserve in the past 4 years to improve liquidity and get the US economy growing again by lowering interest rates. This money, which the banks by selling Mortgage Backed Securities (MBS) get at artificially low interest rates, finds its way into commodities and emerging market equities such as India where returns are much higher. Let us first analyse the impact of QE1 and QE2 to try to understand how QE3 may impact the country.

The US Fed bought around $1.45 trillion of mortgage-backed securities and other agency debt during the 14 months of QE1 and around $600 billion worth of securities during the 8 months of QE2.

QE1 came at an important time for the Indian markets as the Nifty hadstarted bottoming out around 2500 after which it began its climb. FII’s withdrew around Rs 54,000 crore from January 2008 to November 2008. After QE1 was announced there was a visible change in sentiment, which led to inflows of around Rs1,00,000 crores from December 2008 to March 2010. The Nifty doubled during this period.During QE2, there were inflows of around Rs 40,000 crores but the Nifty actually fell 6 % after reaching a peak of 6150, just before QE2 was announced. The markets responded positively to QE1 whereas the response to QE2 was muted. This could be attributed to the negative effect of higher commodity pricesespecially Oil and lack of reforms by the Indian government hurting investor sentiment.

The Indian basket of crude bottomed out around 40$/bblaround the time QE1 started after which it doubled to around 80 $/bbl by April 2010. By the end of QE2 in June 2011, the price had moved up to around $110/bbl. It can be seen that both QE1 and QE2 had a direct impact on the price of Oil. A higher price of Oil leads to inflation in the country and as India imports about 70% of its Oil requirement, it affects the balance of payments. Coupled with a higher subsidy bill, itaffects the fiscal deficit as wellThe current account deficit in turn put downward pressure on the Rupee, which inflated the Oil import bill even further.

The price of Gold has gained consistently ever since quantitative easing as a strategy was undertaken by central banks around the world. Gold is considered a hedge against inflation and also against fiat currencies, which are being devalued by loose monetary policies of the central banks. It went from just below $800/ounce to around $1200/ounce by the time QE1 ended. It further went up to around $1600/ounce by the time QE2 ended. Gold imports account for a major part of the current account deficit, so a higher price definitely worsens the current account. Gold imports reached a low of around 450 million tonnes in 2008 and reached around 958 million tonnes in 2010. Strong demand despite higher prices hasworsened the current account deficit even further.

On the whole it can be said that QE1 and QE2 were positive for the markets, whereas on the macro economic front, the current account deficit worsened from 1.3% of GDP at the beginning of 2008 to around 2.7% of GDP at the beginning of 2011 which further worsened to 3.7% of GDP at the beginning of 2012 on the back of higher Oil prices and a weak Rupee.

The Consumer Price Index (CPI) that measures inflation has consistently been above the 8 % mark from 2008 to 2012. It was below 6 % at the beginning of 2008 and reached a peak of 16 % in the beginning of 2010. Inflation has certainly worsened after quantitative easing began and is well above the RBI’s comfort level.

A high fiscal deficit and inflation have forced the RBI to keep interest rates high, which is definitely hurting the growth prospects of India.

QE3 involves a purchase of $40 billion worth of securities a month, i.e., $360 billion a year. Apart from this the ECB has an open-ended scheme to buy the bonds of the debtor European nations, which will act as a sentiment booster. It is difficult to estimate how much of the money will actually be invested in the Indian markets. But if past trends are any estimate, commodity prices are likely to increasewhich will further fuelinflation and due to our weak policies increase the subsidy burden as well as the fiscal deficit as the higher prices are not passed on to the consumers. It is safe to say that India is a net looser from the QE policy, which is popular with the central banks of the West.

Recent efforts taken by the government to reign in the deficit by raising diesel prices by Rs 5, going ahead with disinvestment in 4 PSU’s will have less of an impact if Oil prices begin increasing again. If recent trades are anything to go by, Oil and Gold both skyrocketed after the decision reaching 117$ and 1770$ respectively.

Also, the need for a third QE signifies that the earlier 2 QE’s failed to deliver according to the central bank’s objectives, mainly to get the banks lending again and get the US economy growing again. Unemployment rate in the US has stayed above 8% for a long time now.

As of now, there isn’t much of an inflation problem in the US, but there are worries that if such expansionary monetary policies continue inflation could rear its ugly head which would then force the Fed to raise rates before its stated year of 2015.

A rise in interest rates in the US would certainly be very bad for India, as investors will most likely withdraw money from India to cover up for losses at home which would not only affect the stock market but also the rupee.

Bernanke has exported his problems half way across the globe, when the rest of the world has enough on their plate.

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The Falling Rupee

Authors:  Bharat Mulchandani , NMIMS Capital Markets and Himanshu Bhutani , NMIMS Capital Markets

On the morning of 31^st May 2012, after reading the headlines “Rupee falls to a new low”, my father exclaimed, “I wish you were in the US right now, sending Dollars home”^{. [1]} Ironically, the “expensive” dollar was the reason my father refused to send me to the US to complete my post graduate education after I graduated in June 2010 (The exchange rate at that time was 1USD= Rs. 46.50). That was my first brush with the greenback and the affair has continued since.

Today, as a student of the capital markets, I wish to put my learning into practice and see how the economic theories I learnt in class apply to the current heartache caused by the dollar. Let us look at these theories in greater detail. 

The Demand Side

Current Account captures the difference between the imports and exports of goods and services in dollar terms. Here, we consider two commodities that account for most of our imports and drive the demand for the Dollar.

1. Oil

Let us analyze the consumption of oil, one of the most essential commodities and the chief driver for the demand of dollar in India. Even though the rupee depreciated from Rs 48 to Rs 56 in the blink of an eye and the price of crude stayed put close to a US$100 a barrel during the quarter ended 31^st December 2011, the demand for crude was not affected, as India imported nearly 3.45 million barrels of crude a day during FY 12. In value terms, crude imports rose 41% to US$141 billion. This, despite the volume imported remaining the same. 

Any undergraduate text book will explain that when currency weakens, imports become more expensive and people consume less. It's a way the currency and demand adjust themselves. In India, it doesn't work that way. Here, the currency slips, imports become more expensive but consumption does not fall.

What happens then? The currency further slides and slowly you find yourself in the midst of a vicious cycle. That's when a flexible exchange rate loses its significance. It's a point where economics ends and politics begins.The subsidy provided by the government artificially kept the demand high and also caused the government finances to take a severe hit. Moreover, the severe shortage of Dollars because of fund outflows by foreign investors resulted in the government hiking the price of fuel sharply. This further stoked inflation, already at dizzying levels because of supply side constraints, which affected the common man in the most extreme way possible. The prices of essential commodities such as food and milk went up drastically. The cost of travelling by public buses, once considered to be the most economical form of transport, increased by nearly 50%. The household budgets went for a toss. And coupled with a slowing economy ahead, it spelt difficult times for the man on the street.    

2. Gold

Let us consider the case of gold now. India’s been fascinated by gold since time immemorial and consider it to be the safest form of investment. This is reflected in the fact that India is the largest importer of gold in the world and accounts for one-third of the world’s demand. The gold import bill has risen from US$4.1 billion in 2001-02 to US$33.8 billion in 2010-11. As per the data released by ASSOCHAM India,gold’s share in the total import bill of the country has gone up from 8.1% in 2001-02 to 9.6% in 2010-2011. This accounts for the major outflow of the Dollars from the country and has a major impact on Fiscal Deficit. The table shown below gives us an overview of the demand for gold.

However due to the depreciation in local currency and rising fiscal deficit figures government has been taking some strict measures in order to curb the demand of gold. This is being done by imposing 1% excise duty on unbranded jewellery and doubling the customs duty on gold to 4%. The outcome of such measures is quite evident. India’s gold imports slowed to 200 tonnes (-30% YOY) in 1Q12. ^[3]

The Supply Side

Capital account records the flow of money in and out of the country. For a currency to be stable, the Dollar inflows in the capital account should match the deficit in the current account and vice versa. 

1.Capital Account Flows

In order to finance the gaps created in the current account by oil and gold, India needed to finance it by attracting Dollars for investment. And Dollars flowed in thick and fast due to the high returns on investment and the higher interest rate on offer. Using the interest rate parity theorem , we realize that the interest rates need to be high in order to ensure that there are sufficient capital inflows in order to finance the deficit, as is the case today, where the interest rates on offer in India are nearly 8% and near zero everywhere else around the world. So this should not be a problem right? But as it turned out, things have not quite been so smooth for India. Let us now look at the details. 

FII:

Foreign institutional investors have been a great source of dollar inflows for India. They invest in the India in order to capitalize on the higher interests on offer apart from trying to milk then security markets which features a number of high growth companies.

But, things have changed considerably. FII Inflows have dropped from US$30 billion in 2009-10 to US$18 billion in 20110-12. IN FY 13 also, FII have been net sellers, pulling out nearly US$327 million from the Indian Markets. 

This has caused severe shortage of Dollars and has led to a freefall in the rupee. And given that these flows move in and out of the country frequently, this has caused major volatility in the Rupee. This is demonstrated by the fact that the Rupee went from being the worst performing currency in Asia to the best performing and back to worst in a span of 6 months from December 2011- June 2012 as the FII inflows poured in at the start of the year and have been withdrawn after the budget session.

FDI:

Foreign Direct Investment was seen as critical to India’s development as the money was badly needed to build infrastructure in order to support economic growth. Thus the policies were liberalized and money came in.  But, due to unfavorable government policies such as GAAR and failure of government to take tough decisions rolling back its decision to allow FDI in multi brand retail due to pressure from coalition parties, FDIs inflows have dipped recently to US$1.32 billion in May 2012 compared to US$4.66 billion a year ago. And this has had a direct impact on the rupee.

NRI deposits:

In order to create newer avenues for dollar inflows, RI deregulated the interest rates for NRI deposits. As a result, Non-Resident Indian (NRI) fund inflow into Non-Resident External (NRE) deposits in the month of January 2012 touched US$1.6 billion, the highest in the last ten years. But this had little impact as this could not cover up the fall in inflows from FIIs and FDIs. 

 The Results

Balance of Payments is defined as a record of all transactions made between one particular country and all other countries during a specified period of time. One might argue that this fall must help exporters and reduce imports and that the situation will correct automatically. But what we fail to realize is that our imports are far greater than our exports and that the demand for oil is nearly inelastic due to the subsidies provided. It is precisely this imbalance between the current account and capital account in the current scenario has led to a Balance of Payments crisis. What it simply means is that we are using up our foreign reserves rather than adding to it and it is going to be very difficult expect the RBI to intervene directly to stem the fall. This can be illustrated by the fact that our forex reserves fell US$12.8 billion Dollars in Q3 and US$5.7 billion Dollars in Q4 of FY12 respectively.[3] RBI has used various measures such as limiting the banks open position in contracts and providing Dollars directly to the oil marketing companies. But this has simply helped in reducing volatility, and has not prevented the Rupee from falling. Moreover, even though there have been more remittances, they have not been able to compensate for the outflows on current account and reduced inflows on the capital account. RBI just does not have enough firepower in order to do anything due to limited forex reserves.

The onus is on the government now to put its act together and stop using monetary policy to correct structural problems in an economy. Strong measures have to be taken on the fiscal policy front such as removing fuel subsidies and reducing fiscal deficit. Government needs to come out of its slumber and take decisive political decisions such as FDI in retail to attract Dollars and help recover. I know that increasing fuel prices would harm the economy, but I sincerely believe that Indian must bear the pain through this correction as this will result in a far superior recovery and will ensure that we will reach a solution rather than postpone the problem.   

It is amazing the manner in which a common Indian household, which may have never seen the dollar, is being ruled by it.

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