Commodity Options in Indian Market Scenario

Currently in Indian market, the futures trade has been functioning successfully for the last 14 years. It has been increasingly supported by the participation of traders and merchants and few of the large and medium farmers. Involvement of small and marginal farmers, who comprises of about 78 per cent of the farming community, is still not so acclimatized with the futures trading. Still a lot of effort is needed in this direction. With every passage of time the commodity futures trade have evolved with increased strength and transparency.

The introduction of commodity options trade as a new instrument is likely to enhance the participation base as it requires lesser exposure capital thereby reducing the enormity of loss. In simple terms, in a futures contract, both participants in the contract are obliged to buy (or sell) the underlying asset at the specified price on settlement day. As a result, both buyers and sellers of futures contracts face the same amount of risk. On the other hand, the option contract buyer has the right but not the obligation to buy (or sell) the underlying asset. Hence the term "option" and this option come at a price in the form of a premium (more specifically, the time value of the premium). With this "option", the option buyer's risk is limited to the premium paid but his potential profit is unlimited. Sellers of options take on an additional volatility risk in exchange for the premium. However, their potential profit is then capped while their potential losses have no limit. Hence, this premium can be high if the underlying asset is perceived to be very volatile. The other major difference is that Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract. In futures, the performance of the contract is done only at the future specified date, but in the case of options, the performance of the contract can be done at any time before the expiry of the agreed date. Apart from the commission paid, futures do not require advance payment, but options require the payment of premium. In futures, a person can earn/incur an unlimited amount of profit or loss, whereas in options the profits are unlimited, but the losses are up to a certain level.

The very motive of starting the Commodity futures was to facilitate efficient price risk management and price discovery in a fair, transparent and orderly manner. The futures market was to help Indian farmers to hedge their produce against potential risks arising out of price movements in spot markets so that they can get guaranteed price for their produce in the future. But, in spite of 14 years of futures trading through Commodity Exchanges, majority of the farming community is till away from participating on the platform either due to lack of awareness or due to complexity of the trading process. Currently, the futures markets continue to be dominated by speculators and non-commercial players who frequently indulge in price rigging and other market abusive practices with impunity.

I feel that the desired penetration level has not been achieved owing to lack of liquidity and existence of fear factor in the minds of small and marginal farmers who are still depended on the whole sellers and local aggregators. According to market estimates, not even 2000 farmers in India are directly trading on commodity futures exchanges. Even the participation of farmers marketing cooperative bodies (such as NAFED, HAFED and Farmers Producers Group) is very limited due to lack of adequate knowledge of the functioning of futures market. Such bodies can act as aggregators and hedge positions in futures exchanges on the behalf of their farmers. Thus with such level of penetration in the market, we can apprehend that futures have failed to achieve their avowed objectives of price discovery and price risk management especially for small and marginal farmers (owning less than 2 hectares of land).     

In the Indian Scenario where an average Indian farmer lacks a basic understanding of what is involved in futures trading. The options trading are even more difficult to comprehend as it adds yet another layer of complexity on what is already a very complex trading instrument. In the same vein, small enterprises lack the resources and capacities to trade actively in derivatives contracts for hedging purposes. Even experienced traders struggle to understand the risks involved in trading both futures and options contracts. Moreover the bulk of trading in the Indian commodity futures market is carried out by speculators and non-commercial traders who attempt to profit from buying and selling futures contracts by anticipating future price movements but have no intention of actually owning the physical commodity, while the participation of hedgers is almost negligible. Time to time the commodity exchanges are conducting short duration training workshops for small stakeholders but such workshops are inadequate to impart information and insights on the complexities of derivatives trading.

Having said all about the complexity of the futures and options trade, the introduction of Option in the Commodities trade is still a very welcome step, but the quantum of challenges to implement it is enormous. The major challenges could be enlisted as:

·         Lack of awareness about the options

·         Majority of actual participants (Farmers, Producer’s Organization, Government entities & banks) are still not clear on the process of how it could be applied on the agricultural products.

·          Liquidity is still lacking in most of the agricultural products being traded on exchanges

·          Fragmented nature of spot market

·         Over-politicization of state agricultural produces marketing committees (APMCs) and state agricultural produces marketing boards (APMBs)

·         inadequate warehouses, storage and grading facilities

·         poor condition of roads and other infrastructure in the rural India

If these challenges are met, option trading in Commodity market for India is bound to make remarkable changes in the Indian Agriculture System. 

Copper Finding Sustained Support from Rising Strength in Global Economies

From the last couple of quarters, copper prices have been find increased support from the improving economic scenario in major economies and declining supplies from major producing countries. The US election results has infused strength in the global economies and provided further strength to dollar pushing the copper prices on the higher levels. The strength in the copper is coming from the continued reduction in supplies, improved demand from China, improving economic scenario in China and rising dollar strength. 

On the supply side the market continues to be in deficit. According to preliminary ICSG data, the refined copper market for September 2016 (excluding the adjustment for changes in China’s bonded stocks) showed an apparent production deficit of around 15,000 MT. World mine production is estimated to have increased by around 6% (820,000 MT) in the first nine months of 2016 compared with production in the same period of 2015. Concentrate production increased by 7.5 per cent while solvent extraction-electro-winning (SX-EW) declined by 0.5 per cent. The increase in world mine production was mainly due to a 44 per cent (+530,000 MT) rise in Peruvian output that is benefitting from new and expanded capacity brought on stream in the last two years. A recovery in production levels in Canada, Indonesia and the United States, and expanded capacity in Mexico, also contributed to world growth. However overall growth was partially offset by a 4 per cent decline in production in Chile, the world’s biggest copper mine producer, and a 7 per cent decline in DRC where output is being constrained by temporary production cuts. The average world mine capacity utilization rate for the first nine months of 2016 increased to 86 per cent from 85 per cent in the same period of 2015. World refined production is estimated to have increased by about 3 per cent (510,000 MT) in the first nine months of 2016 compared with refined production in the same period of 2015: primary production was up by 2.5 per cent and secondary production (from scrap) was up by 5.5 per cent. The main contributor to growth was China (+7 per cent), followed by the United States where production increased by 13 per cent and Mexico (+19 per cent) where expanded SX-EW capacity is contributing to refined production growth. Output in Chile and Japan the second and third leading refined copper producers increased by around 1 per cent and 3 per cent respectively. Refined production in the DRC and Zambia declined due to the impact of temporary production cuts. Based on the average of stock estimates provided by independent consultants, China’s bonded stocks increased by around 70,000 MT in the first nine months of 2016 from the year-end 2015 level. Stocks decreased by around 130,000 MT in the same period of 2015. In the first nine months of 2016. 

Mining disruption in major mines is supporting the copper prices. Workers at the giant Escondida copper mine in northern Chile, the world's largest, have rejected an opening pay offer as insufficient as the two sides prepare for the start of a new collective wage agreement. The BHP Billiton-controlled operation produced 1.153 million MT of copper in 2015; however, production fell by almost 20 per cent last year as the mine worked through lower grade ores. The company posted a 43 per cent drop in profits for the first nine months of 2016, reflecting the lower production and copper price in the period.

World apparent refined usage is estimated to have increased by around 3 per cent (565,000 MT) compared with that in the same period of 2015 mainly due to Chinese apparent demand as world usage excluding China remained essentially unchanged. Chinese apparent demand increased by around 7 per cent in the first nine months of 2016 based on a 2 per cent increase in net imports of refined copper and 7 per cent growth in refined production. However, net refined copper imports have been on a declining trend in 2016 with the monthly average in the third quarter 40 per cent below that of the 1st half. Monthly average Chinese apparent demand in the 3rd quarter 2016 is 5 per cent below that in the first half. In the first nine months of 2016 aggregated usage in the EU, Japan and the United States is down by 0.6 per cent. 

Nine large Chinese copper producers reduced production by close to 5 per cent more than 200K MT. Mining disruption in major mines is supporting the copper prices. Workers at the giant Escondida copper mine in northern Chile, the world's largest, have rejected an opening pay offer as insufficient as the two sides prepare for the start of a new collective wage agreement. The BHP Billiton-controlled operation produced 1.153 million MT of copper in 2015; however, production fell by almost 20 per cent last year as the mine worked through lower grade ores. The company posted a 43 per cent drop in profits for the first nine months of 2016, reflecting the lower production and copper price in the period. 

The development of China – US relationship is also going to have significant impact on the copper market. A huge amount of copper in China is believed to be tied to carry trades. In a typical carry trade, importers in China open an LC (letter of credit) with foreign banks by paying a portion of the total import costs. Chinese importers then sell the copper and get cash. The typical payment time for an LC is three to six months. In this way, Chinese importers get access to cheap US dollar funds. The basic premise behind these deals is the arbitrage between interest rates in China and the developed world. As the differential between US and Chinese interest rates is expected to narrow following the rate hike, we could see some unwinding in copper carry trades. This could impact copper’s financial demand. The rate hike could also have some impact on US real copper demand. Copper serves as a raw material for various industries. The construction and transportation sectors are among the major copper consumers. One of the factors driving higher car and home sales has been lower mortgage rates. Now, with the Federal Reserve embarking on a tightening path, the housing and automotive sectors could see some repercussions. To be sure, it’s not going to be an overnight impact. However, higher rates could certainly have some impact in the medium-to-long-term. 

The price trends for copper for the past two years have been bearish, but the rally in prices started in copper after winning of Donald Trump in the US presidential election. The rally has been partly based on speculation regarding the impact of the President-elect’s $500 billion infrastructure plans on demand for the metal. It has also been fuelled by a pick-up in Chinese imports, responsible for almost 50% of global copper demand, which is seen a good omen for the industry’s health. The copper concentrate imports into China have risen sharply as smelters there have taken advantage of an increase in the fees they charge to turn concentrates into metal. But as they've boosted production, the glut in concentrates has slowly fed through into the refined market, putting pressure on local premiums for copper cathode and causing imports of finished metal to get slower. The investment bank now believes that increased demand from China will leave the market tighter than previously expected, which will support a more "bullish" environment for the metal at least to mid-2017. Moreover, the slowing supply growth outlook primarily to production cuts in China, the world’s top consumer, and declining ore grades in Chile, the world’s largest producer of the red metal is also likely to provide more support to the copper market.