The future of commodity market
and energy. In the short/medium-term,
G. Chandrashekhar
A strong and vibrant cash market is a pre-
condition for a successful and transparent
futures market.
As funds seamlessly flow from one market to
the other and the Indian commodity market
begins to integrate with the global market,
the risk perception is beginning to heighten.
Adoption of risk management or risk
mitigation tools is nowsine qua non for
success in businesses with exposure to
commodities. A serious look at futures trading
as a tool for price discovery and price risk
management is inevitable.
Before we examine commodities futures
trading — its principles and benefits — it may
be worthwhile to crystal gaze into the future
of this market. Some features of the emerging
scenario in India as far as the commodity
market is concerned:
Expansion of commodity trade: Very clearly,
trade volumes are set to expand rapidly.
Demand for a wide variety of commodities
covering food, fibre, metals and energy is
certain to expand. India is likely to produce
many of the aforesaid commodities, as
investment in production facility expands. If
demand growth outstrips domestic supply
growth, imports will become inevitable. The
possibility exporting certain commodities also
exists. In commodity production, consumption
and trade, India will become an important
player in the international market. This will
lead to a massive expansion in commodity
trade volumes over the next, say, 15-20 years.
Competition from imports: Whether or not
domestic producers like it, the competition
from imported commodities is inevitable. This
could be true in case of food crops, metals
indigenous output will trail consumption
demand because of the lagged effect of
investment. To fuel growth and rein in
inflation, the government and the business
houses will have to resort to imports. As
imports are unrestricted (Quantitative
Restrictions have been abolished), there will
be liberal inflow of goods from abroad. Often,
imports from developed countries are low-
priced and subsidised. Such competition will
result in inefficient domestic units falling by
the wayside, but will eventually lead to
greater efficiency among domestic producers.
Role of MNCs: Multinational corporations
cannot be wished away. They bring with them
a certain superior knowledge of operating in
developing or emerging economies. They also
have deep pockets and, often, are long-term
players. In the Indian commodities sector,
global companies will increasingly play a role
as producers, suppliers, traders and service
providers. Indian producers will have to learn
to face competition from MNCs.
Consolidation of fragmented capacities: It is
well-known that commodity producers and
industrial consumers in India suffer poor scale
economies because of their small size.
Fragmentation of business that is resulting in
scale-diseconomies and other infirmities is
likely to give way to consolidation.
Competition is now driving smaller players to
explore opportunities for merger. Bigger
companies with expansion plans follow the
acquisition route. Mergers and acquisitions
will lead to consolidation of fragmented
businesses, albeit slowly.
Dominance by a few large firms: In the
developed economies, a handful of companies
share a big slice of the business pie. Typically,
four-five companies would account for, say,
60-75 per cent of aggregate business and
several smaller players compete for the rest.
The commodity sector will inevitably move
towards such a situation. The process of
consolidation and dominance by a few large
firms is already visible, however incipient.
Take edible oil imports, for instance. Of the
total imports of 45-50 lakh tonnes a year
worth over Rs 10,000 crore, five companies
(of which two are MNCs) account for roughly
70 per cent of business; the rest being shared
by over 20 importers.
Waning role of government: As part of the
economic liberalisation process, the
Government has not only freed the
commodities market of controls and
restrictions but has also, by and large,
distanced itself from the market. The
interventionist role of the government is now
minimal. Of course, some restrictions still
remain, like those on the sugar industry.
The government's role is changing from
controller to facilitator. It must, however, be
mentioned that "liberalisation is not licence''.
Use of information technology: Very clearly,
IT will play a key role in bringing about greater
transparency in the commodities market. The
country's strengths in IT will increasingly be
leveraged to connect stakeholders and link
markets.
IT will be used for delivering price and market
information to primary producers (farmers).
E-commerce will be the modern way of doing
business. Several corporates have already
begun to employ IT to derive value, ITC's e-
chaupal being a remarkable initiative. The
agricultural produce markets (numbering
nearly 7,500 across the country) will soon be
networked so that growers can get to know
prices prevailing in various marketing yards
or mandis.
Strong cash market: These developments will
result in a stronger cash market for
commodities. Initiatives are already underway
to launch electronic spot trading in farm
commodities that will help growers and
others not only discover prices almost real
time, but also help capture value by taking
trading positions. A strong and vibrant cash
market is a pre-condition for a successful and
transparent futures market.
It is this emerging scenario that market
participants must gear themselves to face.
Investment in India has traditionally meant
property, gold and bank deposits.  The more
risk-taking investors choose equity trading. 
But commodity trading forms a part of
conventional investment instruments.  As a
matter of fact, future trading in commodities
was banned in India in mid-1960 due to
excessive speculation.  In February 2003, the
government revoked the ban and threw open
futures trading in 54 commodities in bullion
and agriculture.  It gave the go-ahead to four
exchanges (The National Commodity and
Derivative Exchange (NCDEX), The Multi
Commodity Exchange of India (MCX), The
National Multi Commodity Exchange of India
(NMCE) and The National Board of Trading in
Derivatives (NBOT)) to offer online trading in
commodity derivatives products.
What makes commodity trading attractive?
* A good low-risk portfolio diversifier
* A highly liquid asset class, acting as a
counterweight to stocks, bonds and real
estate.
* Less volatile, compared with, equities and
bonds.
* Investors can leverage their investments
and multiply potential earnings.
* Better risk-adjusted returns.
* A good hedge against any downturn in
equities or bonds as there is little correlation
with equity and bond markets.
* High co-relation with changes in inflation.
* No securities transaction tax levied.
Investors' choice:
The futures market in commodities offers
both cash and delivery-based settlement.  Energy: Crude Oil, Natural Gas, Gasoline etc.
Investors can choose between the two.  If the
buyer chooses to take delivery of the
commodity, a transferable receipt from the
warehouse where goods are stored is issued
in favour of the buyer.  On producing this
receipt, the buyer can claim the commodity
from the warehouse.  All open contracts not
intended for delivery are cash-settled.  While
speculators and arbitrageurs generally prefer
cash settlement, commodity stockists and
wholesalers go for delivery.  The option to
square off the deal or to take delivery can be
changed before the last day of contract
expiry.  In the case of delivery-based trades,
the margin rises to 0-25% of the contract
value and the seller is required to pay sales
tax on the transaction.
Trading in any contract month will open on
the twenty first day of the month, three
months prior to the contract month.  For
example, the December 2004 contracts open
on 21 September 2004 and the due date is the
20-day of the delivery month.  All contracts
settling in cash will be settled on the following
day after the contract expiry date.  patterns, government policies related to
Commodity trading follows a T+1 settlement
system, where the settlement date is the next
working day after expiry.  However, in case of
delivery-based traders, settlement takes place
five to seven days after the expiry.
Tradable Commodities:
World-over one will find that a market exits
for almost all the commodities.  These
commodities can be broadly classified into the
following:
Precious Metals: Gold, Silver, Platinum etc.
Other Metals: Nickel, Aluminum, Copper etc.
Agro-Based Commodities: Wheat, Corn,
Cotton, Oils, Oilseeds etc.
Soft Commodities: Coffee, Cocoa, Sugar etc.
Live Stock: Live Cattle, Pork Bellies etc.
Returns from Commodity trading:
Absolute returns from stocks and bonds are
definitely higher than pure commodities.  But
commodity trading carries a lower downside
risk than other asset classes, as pricing in
commodity future is less volatile compared to
equities and bonds.  While the average annual
volatility is 25-30% in benchmark equity
indices like the BSE Sensex or NSE's Nifty, it is
12-18% in gold, 15-25% in silver, 10-12% in
cotton and 5-10% in government securities.
According to study, if an investor had put his
money only in silver and bonds from 1997-
2003, his absolute returns would above been
24%.  Commodities are also good bets to
hedge against inflation.  Gold offers good
protection against exchange rate fluctuations,
and, in particular, against fluctuations in the
value of the US dollar against other leading
currencies.  However, unlike stocks,
commodity prices are dependent on their
demand-supply position, global weather
subsidies and taxation and international
trading norms as guided by the World Trade
Organisation (WTO).
Growth of commodity trading:
A soft interest rat regime and a weak US
dollar ahs increased the demand for the
commodities.  In a short span of over a year,
online commodity markets are witnessing
good growth in India.  The daily volume of
trading of Rs.2500 crore at NCDEX alone has
surpassed that of Rs.2000 crore on the
Bombay Stock Exchange (BSE).  It registered a
record daily traded volume of Rs.2617 crore
on 8 December 2004. Commodities like chana,
urad, soya bean oil, sugar, pepper, mustard
seeds and wheat contributed to the balance
trading volume.  MCX, on the other hand, has
achieved a peak daily turnover of Rs.1889
crore.  Though the most popular commodities
for trading in India are gold, silver, soya bean
and guar gum, the market is divided equally
between bullion and agricultural commodities
in terms of trading volumes.  is that of creating awareness and providing a
Expecting the turnover on the three online
commodity exchanges to spurt to Rs.10000
crore per day, banks are keen to tap the
commodity trade-financing front.  Commercial
banks are chasing the commodity industry
with attractive lending rates between 8% and
8.5% as against the normal lending rate
between 11% and 14%.
Problems galore:
The biggest danger to the galloping trading
business in commodities is poor supervision.  And, now, with daily global volumes in
Even though the commodity futures market is
regulated by Forward market Commission, a
proper regulatory system to supervise trades
needs to be implemented.  This is because
FMC, which functions under the
administrative control of the Ministry of Food
and Consumer Affairs, has no hands-on
experience in monitoring electronic trading
and detecting market manipulation.  For this
reason, it was caught unawares earlier this
year when a rubber dealer made several
shady deals.
In June 204, the rubber dealer, registered with
the Rubber Board, is understood to have
entered a series of shady circular transactions
with a sister firm on NMCE, creating a hefty
difference of Rs.10 per kg between cash and
futures prices.  FMC neither noticed the huge
gap between cash and future prices nor
bothered to investigate thereby signaling a
relaxed regulatory regime in the commodities
market, giving way to arbitrageurs and
speculators.
NCDEX is also understood to have pressed for
an amendment to the Banking Regulation Act
to allow several branches of banks to act as
intermediaries to enable farmers to insulate
fro price fluctuations through futures trading. 
Another herculean task in commodity trading
transparent and user-friendly trading platform
to investors.
Conclusion:
After almost two years that commodity
trading is finding favour with Indian investors
and is been seen as a separate asset class with
good growth opportunities.  For
diversification of portfolio beyond shares,
fixed deposits and mutual funds, commodity
trading offers a good option for long-term
investors and arbitrageurs and speculators. 
commodity trading touching three times that
of equities, trading in commodities cannot be
ignored by Indian investors.
Online commodity exchanges need to revamp
certain laws governing futures in commodities
to make the markets more attractive.  The
national multi-commodity exchanges have
unitedly proposed to the government that in
view of the growth of the commodities
market, foreign institutional investors, too,
should be given the go-ahead to invest in
commodity futures in India.  Their entry will
deepen and broad base the commodity
futures market.  As a matter of fact, derivative
instruments, such as futures, can help India
become a global trading hub for select
commodities.

Commodity trading in India is poised for a big

take-off in India on the back of factors like
global economic recovery and increasing
demand from China for commodities. 
Considering the huge volatility witnessed in
the equity markets recently with the Sensex
touching 6900 level commodities could add
the required zing to investors' portfolio. 
Therefore, it won't be long before the market
sees the emergence of a completely redefined
set of retail investors.