International Business Environment Group Assignment

International Business Environment Group AssignmentIndustry Analysis: Commodity Futures

Submitted by:Gautam Jain(Pgp30076)Priyanshu Jain(Pgp30095)Sonali Gupta(Pgp30107)Submitted to:Prof. K. G. SahadevanIIM LucknowFebruary 2015The report entitled Industry Analysis: Commodity Futures is the original work carried out by Gautam, Priyanshu and Sonali and no part of report is copied from other published/unpublished sources

Table of ContentsExecutive Summary2Introduction3Reforms in commodity futures industry post liberalization4Porter five forces Model4Bargaining power of Suppliers4Threat of new entrants5Threat of Substitutes7Bargaining Power of buyers8Intensity of Rivalry9Infrastructure9Technology9Brokers Community9Current Market Scenario:10References11

TABLE OF FIGURESFigure 1Market Share Distribution amongst various Indian Commodity Exchanges6Figure 2: Regional distribution of commodity futures exchanges10Figure 3: Market share split10

Executive Summary

India is the worlds leading producer of numerous commodities, which has holds an important role in defining a balance in the economy. The commodity futures trading in India has witnessed exponential growth of around 50-60% since the inception of electronic-trading in 2003. Still, the industry faces numerous challenges and with the imposition of new tax rules (Commodity Transaction Tax) as well the 5600 crores payment crisis (NSEL Scam) can act as a setback in the future growth of the industry.The report is a vivid description about the fundamentals of the commodity futures industry with a detailed description about the stakeholders involved in it. The major reforms brought in by the government to regulate fair and transparent trading practices. The primary objective for the trading is price discovery as well as use hedging and speculation practices to provide liquidity to the market. Currently, the market has an oligopolistic structure with MCX having captured more than 80% of the market share. The differentiation achieved by this exchange is through trading of global commodities in large volumes.The later part of the report deals with the detailed industry analysis though analyzing the value chain that includes buyers and suppliers. The competitive nature of the market is observed gaining insights about the impediments to entrance in the industry. Similarly, the current threats faced by the industry from new exchanges establishments and competitive firms that supply substitute products are analyzed in detail. The major challenge still faced is to get higher participation of farmers in the industry and bring about innovative designs in the development of the market.

Keywords: Commodity, Exchanges, Price-Discovery, Reforms, Bullions, Agri-commodities, Spot, Futures

Introduction The commodity futures are the contracts between the two parties to buy/sell a particular quantity of commodity on a future date at a predetermined price. The party buying the future contract is said to have long position in the future contract and the party selling the contract is said to have short position in the future contract. The contracts are made generally for standardised quantities and standardised quality commodities. These are traded in commodity future exchanges.The buyers are generally of following types:Hedgers: These are the businesses which will use the commodities for their businesses and their main objective is to lock the favourable prices for the commodities so as to avoid loss due to price fluctuations because of bad weather, political disturbances, government intervention etc. They only try to reduce the risk involved with the adverse price change.Speculators: These trade for making profits and with no intention of using these commodities for any business activity. These closely watch the market so as to use the small fluctuations for their benefits by buying and selling at low and high price respectively. In theory, the main objective of the speculators is to bring the liquidity into the market so as to make it function smoothly.Arbitrageur: These trade in the risk free contracts. When markets are imperfect, they buy from one market at lower price and sell in the market with higher price, earning risk free profitsThe futures buyers do not pay the entire amount at the time of contract but they only pay a part of the amount known as the margin payment. The eventual settlement does not include actual delivery but includes the payment of difference between the amount of current spot price and the contracted price on the date of expiry.The commodities which are suitable for the future trading are as follows: The commodity should have a suitable demand and supply condition. Prices should be volatile enough to have a significant demand for future to hedge the risk of price fluctuation in spot market. The government regulations should be minimum which can restrict the price thus supply and demand. The commodities should have a measurable quality which can be compared against some standard because the commodities traded with the future contract should have some quality The commodity should be storable otherwise the hedging of risk between the future and spot market will not be possible. The trading of futures has been an integral part of Indian derivative market and the first derivative market was setup in Mumbai in 1875 to trade cotton futures. This was followed by future markets of edible oil seeds, raw jute, jute goods and bullion. In the early independence era, the scarcity of food forced the Indian government to restrict the commodity trading. After adoption of the constitution of republic, a central legislation was passed known as Forward Contract act in 1952, which crushed the commodity market prohibiting the cash settlement of the commodities future. Under this act, trading of the contracts was allowed through the recognised exchanges and more regulations were imposed by forming the Forward Markets Commission. The commodities were notified for prohibition under this act which left only a handful of insignificant commodities available for trade. For almost four decades, the futures market remained dormant in spite of few attempts to revive the commodity futures market but in 1993 a committee was setup to examine the scope of commodity trading. Reforms in commodity futures industry post liberalization 1994: As per the recommendation of kabra committee, commodity futures market went open for 17 commodities but did not favour the same for other commodities like pulses, tea, maize, coffee, sugar and others due to their unstable market. These were termed as sensitive items and their trading was banned. 2001: The Guru Committee expressed the role of futures markets as a medium for marketing agriculture products as well as for price risk management. The medium will be supportive for farmers to make an informed, rational decisions to get appropriate price and participate directly in the market to prevent price risks 2003: The market got a boost with the opening of future markets for 54 commodities including sensitive items and platforms were established for electronic trading giving organized structure to the industry 2007: Irregular rise in prices of agriculture commodities like urad, wheat, rice and tur developed suspicion among government officials causing their delisting from the market. This was done to curb the rise in inflation caused due to price increase in essential commodities. 2008-09: Almost all the bans were uplifted for agricultural commodities with a count of 95 commodities trading in future markets 2013: Government levied a Commodity Transaction Tax (CTT) of 0.01% on trade of some commodity futures and all non-commodity futures. This has increased the trading cost significantly with an impact of decline in volume for two consecutive years. In value terms it is a decline from Rs 170.46 lakh crore to Rs 101.44 lakh crore

Porter five forces ModelThe assessment of any business requires the analysis of the various components of the internal and external environment. To understand this in detail, the most influential and widely used framework is five forces model proposed by porter. It examines the attractiveness of the industry from the perspective of suppliers, buyers, ease of entry for new players, substitutability of the products and the competition among the existing players. The detailed discussion of the five forces is given below:Bargaining power of SuppliersThe commodities market is a highly volatile market with the following categories of commodities being traded. Energy: The supplier companies of crude oil, heating oil, natural gas and gasoline generally do not have strong bargaining power. However in case of events such as recession or OPEC meet to decide on the oil supply for the coming months, the prices fluctuate widely. In case of supply shocks, the demand of oil increases, which in turn increases the bargaining power of the suppliers. Another significant factor which contributes positively in the bargaining power of suppliers is the high capital cost involved in setting up oil companies. Companies enjoy the advantages of high barriers to entry in the sector which in turn increases their bargaining power in the commodities market. Seasonal factor also plays an important role. For example heating oil is expected to show backwardation structure during winter and contango structure during fall. Agriculture including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar): The effect of a number of major events determine the bargaining power of farmers in case of agricultural commodities in the futures market. For example, technological advancements in agricultural production significantly reduces the cost of production. As a result, the supply of products increases and farmers lose out on the power to bargain in the commodities market. Similarly, the bargaining power is majorly dependent on factors such as good weather (rains), high yielding seeds due to increase in the use of fertilizers. In agriculture sector, trading opportunities are largely monopolized by large farmers/traders.Low bargaining power factor: Due to lack of information and reach of the farmers, they derive the information about the price of their agricultural produce from the futures markets. This helps them make selling or holding decisions for their agricultural products.Forward Integration for Farmers: The farmers can directly participate in futures trading market to hedge their price risk. Metals: The major metal producer countries are the western countries which are forced to sell at the prices set by the futures market. The futures market volume is quite large as compared to the physical market due to which the prices are governed by the former. Livestock and Meat: Rearing cattle is harmful to the environment as it poses the threat of methane and carbon monoxide. Also it is a perishable item which cannot be stored. The suppliers have to mitigate the risk of cattle disease. All these factors contribute to the low bargaining power of the suppliers in the case of livestock and meat which includes lean hogs, pork bellies, live cattle and feeder cattle.

Threat of new entrants There are high entry barriers for entering the commodities futures market.The sector wise opportunity for growth is huge in India which is a developing economy. It is in comparison to the much lower derivative turnover/total physical flow multiple in developing markets as compared to the developed economies. The incumbent firms are highly concentrated having a huge market share in the commodity trading market. For example, MCX is a firmly rooted player with 86% share in the commodity futures trading turnover. Therefore, there is a high entry barrier for other trading firms to enter the industry.

Figure 1Market Share Distribution amongst various Indian Commodity Exchanges

Relaxed regulatory laws leading to low entry barriersThe Indian Government is on the path to relax the regulatory laws for the commodity trading to encourage fair play and more competition in the market. The increase in awareness and education in this regard has also positively helped in improving the trading turnover. For example, FMC, which is the regulatory body for Indian commodity markets, lifted the ban on gold/silver trading after four decades in 2003. The regulatory body has also introduced 5 national commodities besides a number of regional ones to increase competition. There are a few other positive regulatory initiatives taken by the authority namely EFP Exchange for physicals, AFS Alternate futures settlement, expanded delivery period. Product differentiation through the use of technology is a key indicator for an exchange. For example MCX has developed a robust, transparent and hard to imitate platform which has given it a competitive edge. It has developed on newer technology which has given it scalability as compared to the older technology based exchanges. High switching cost for the investorsThe existing exchanges have a broad based and balanced portfolio of commodities so as to facilitate the clients in investing in a single exchange for all the type of portfolios. A large part of the portfolio is comprised of non-agricultural commodities, which are not affected by the frequent regulatory interventions. Low threat of new entrant due to high initial technology costAnother important factor which determines the ease of new entrant into the market and also the profitability of the industry is the high initial capital outlay required by the exchange, which is primarily the technology cost. In turn it lengthens the payback period and increases the barriers to entry for new players.

Threat of SubstitutesThe major substitutes for the commodity futures market are stock exchange, spot market and derivative trading in commodity market. The latter is demanded as with the Indian market growing, hedging of risk associated with the commodities market has increased. This is a prevalent measure in the developed economies where the commodities traded on paper comprise of a huge volume as compared to the physical flow of commodities. Another major substitute could have been the options however due to its ban in India since 1952, it cannot be used.

In India, there are a total of 24 derivatives for the listed physical commodities market regulated by FMC. MCX is the biggest commodity exchange platform which holds the maximum share of the commodities. Its current P/E ratio is 36.79 and the book value of 258.07.

Switching options between futures market and spot marketCommodities futures market follow contango market for products which are easily storable. It means that the price of the commodities that will trade in future will be at a premium price as compared to the spot prices. The cost of carrying the physical commodities is a limiting factor on the price difference between the futures and the spot market. For the distant months, the prices for the commodities generally see an upward trend. The market can also show a bakwardation trend where the price for the nearby months is higher than for the outer months. This is particularly the pattern seen in case of seasonal products where either the demand is high or the supply is limited. The volatility in supply and demand is the major factor leading to increase or decrease in spot price. Depending on the requirements of the client to invest in a long term commodity or spot trading, the two markets are traded in. The following are a few factors which significantly influence the price of the futures and the spot. The convenience yield- It is defined as the incremental value of the spot prices over the futures prices after taking into consideration the inventory carrying and holding cost. Cost of holding the physical asset- Depending on the inventory carrying cost, the commodities are pushed into the market. The holding cost is born by the holding party and not the clients holding the futures contract. Perishable or non-storable commodities

Factors effecting the price difference between futures and spot in case of Energy commodities Quality of the product- The oil quality is of prime importance in the case of energy commodities. Location- The location of produce determines the price of the commodity due to factors such as transportation cost, intermediate demand etc. Timing and payment methods- There are generally low levels of inventory. It follows the backwardation structure for trade. Any excess supply or stock tends to lower the price levels of the energy commodities. Supply factors- Supply of oil is seasonal in nature and its price varies accordingly.

Bargaining Power of buyersThere are three kinds of buyers: Hedgers, speculators and arbitrageurs. The market was almost non-existent before 1993 but after this year, government started to look into the scope of commodity markets. Even after that the commodities available for the buyer to trade were very few. The bargaining power was very less because of the commodities traded were very less and even then the interested buyers were under so much regulations that they can hardly negotiate on the terms of the contract and hence used to exercise very less power.The commodity market opened up in year 2009 after which the number of commodities traded are around 146 across 26 exchanges including national and local exchanges, the majority is taken up by the MCX. So the concentration of the supplier makes the buyer vulnerable and being the dominant player in the market, it can exercise more power as compared to the buyer so the buyer power is very less. There are only three other recognised multi-commodity exchanges so due to lesser number of suppliers, the power of buyer is very lowThe buyers are scattered and not that huge as compared to the suppliers which reduces the bargaining power of the buyers. The major substitute of commodity future market is spot market and the spot market involves high risk due to price fluctuations because of uncertainties like bad weather, political disturbances and the majority of buyers are speculators who are there to earn profit so for them the spot market is not that favourable option and hence they have lesser power and again other substitute is the equity market which involves higher risk in the slow economic phase as it is observed in the current scenario thus reducing the bargaining power of buyers.The switching cost depends on the availability of the particular commodity on that particular exchange because every commodity is not traded on every other exchange. If the commodity is available then the switching cost is not much to restrict the switching so we can say on this parameter the bargaining power of the buyer is high.The buyers power to integrate in the backward direction is very low because a farmer whose livelihood depends on the good season of the wheat or a good monsoon will not be able to buy a fully operational commodity exchange platform so this reduces the power of buyer to bargain.Industry threat of forward integration is also very less because to enter in the business like farming or mining or importing precious metals will require expertise of that business or some technical skills or the experience.The competition for trading depends on the commodity being traded for example crude oil is highest traded commodity both in volume and value. So investors are more willing to invest in crude and thus attracting more competition and reducing the bargaining power of the buyer. The crude oil trade amounted to 571,066.04 lakh as on 9 feb, 2015 on MCX as against 267,041.12 lakh of second highest traded commodity(gold) in terms of value compared to the commodity traded.The buyers bargaining power is also affected by the buyers profitability. Since the hedgers main objective is to mitigate the risk involved with price fluctuation, the profitability of the hedgers is highly dependent on the contract price for the future trade. So the buyer bargaining power is lesser. But on the other hand the speculators try to use price fluctuations and so their profitability depends totally on their own instinct and criteria when to buy and sell the contracts. They have more power as compared to the hedgers and sometimes these speculators can cause the price of underlying commodity to increase or decrease drastically.After looking into various factors which contribute to the buyers bargaining power, it is very clear the buyer exercise very less power in commodity exchange market, only some big players can affect the price of underlying commodity.Intensity of RivalryThe commodity futures industry in India mainly comprised of regional commexes (commodity exchanges) back before year 2002 with National Broad of Trade in Indore having maximum share (>50%). The industry comprised of 21 regional players but were constrained for businesses due to government stringent regulation. Frequent bans on futures trading and low liquidity suppressed the growth of industry.Later in 2002, the government permitted electronic trading of commodity futures which brought an organized structure to the market. Currently, the major players include MCX (Multi-Commodity Exchange), NMCE (National Multi-Commodity Exchange), ICEX (Indian Commodity Exchange), ACE derivatives exchange (Promoted by Kotak Mahindra) and NCDEX (National Commodity and Derivatives Exchange) which are on a national level scale while there are 20+ commexes in regional levels. A Joint venture (IMX) of India Bulls in collaboration with MMTC is in line to become another national level exchange.MCX, has been the most dominant player of the industry with a market share greater than 80% followed by NCDEX. MCX has an edge over others due to its presence over global commodities like metals unlike others. This is a point of differentiation in this industry where consumers have limited options of buying global commodities. Some major factors that can act as points of differentiation for increasing diversity in the industry are: Infrastructure: The markets are still considered inefficient due to lack of proper warehousing system. Similarly, the requirement of labs for quality/grade check of products is essential for standardization. This all require considerable investments in the front which makes the entry of new player more competitive. Technology: Although the national exchange trading are carried out through electronic trading system, a number of the regional exchanges trade through over the counter system. A large number of investors can be attracted through use of technology which will also improve the transparency in the systemBrokers Community: A large number of members are registered in the exchanges but still the business involved is very less as compared to the equities market. The reason cited here is that the profitability is low as compared to other trading options. In order to enhance their participation capital adequacy norms can be imposed. Similarly setting up particular standards for participation as well as qualification criteria can be added for trading purposes.Although, there are certain impediments, Foreign Institutional Investors, Banks, Investor funds may plan to become active participants of the future markets. The Reserve Bank of India (RBI), in collaboration with finance ministry is planning to provide grant permission to FIIs to hold stakes in the futures commodity market. Once this is implemented, the markets will gain a wider reach and provide further growth opportunity to the incumbents.The convergence of commodity futures markets with other derivatives markets will stimulate prominent economies of scale. It would help in the utilization of capital and institution building, which are already put to use for other derivatives market in the growth of agri-commodities future markets. This will induce mutual benefit to both the financial as well as commodity markets.

Figure 2: Regional distribution of commodity futures exchanges Current Market Scenario:As per FY13 market results, MCX is the leading player with a share of 87% followed by NCDEX with 10%. The remaining 3% market is captured by smaller firms. The oligopolistic market can be an opportunity for other new entrants who can capture from this industry which is growing at significant CAGR

Figure 3: Market share splitConclusionThe report studied the industry of commodity futures with the help of Porter five forces model. The study focussed on the forces necessary to determine the competitiveness of the industry. The commencement of commodity futures industry dates back to 1875 but still the industry has not grown to its full potential. There are different commodities in which India is among the top producers like tea which is famous all across the world. The trading of commodity futures has faced lots of ups and down because of the conservative approach of the government to satisfy the basic need of the population which was suffering from extreme scarcity of resources after independence which ultimately resulted in the four decades ban on the commodity trading. But, it seems to have finally arrived now. The availability of the various commodities is also one of the major issues which dictates the trading environment. The market has made enormous progress in terms of technology, transparency and the trading activity. Interestingly, this has happened only after the Government protection was removed from a number of commodities, and market forces were allowed to play their role. This should act as a major lesson for the policy makers in developing countries, that pricing and price risk management should be left to the market forces rather than trying to achieve these through administered price mechanisms.

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