Introduction of Steel Futures Contracts on the Commodity Futures Market

Effects of Hedging and Speculation on Commodity Prices

Introduction Commodity Futures markets are prominent parts of the global financial economy. Futures trading has been an important agency in the way the financial economy has grown to its contemporary form. This paper investigates the role of commodity futures markets in the financial economy and discuses its theoretical understanding in light of the trading practices in these futures markets. The focus of this study has been maintained on steel futures traded on a commodity exchange, which recently started to trade at the London Metal Exchange. A theoretical analysis of the futures trading provides with the fundamentals of the investor behavior in derivative markets. This paper engages in investigating these theoretical fundamentals against the evident practices in the futures markets, especially the commodity futures markets. The result of this investigation brings forth a uncertainty of investor behavior and challenges the market oriented idea of rational investors as proposed by the theory of futures trading. This paper focuses on the importance of commodity futures markets and the role they play in commodity price stabilization. The proponents of futures markets argue about the importance of futures markets based on the factors like price discovery and price stability. Price discovery and price stability parameters are only partly true in any given derivative market and, therefore, show the weakness in the theoretical argument in favor of commodity futures markets. Derivative trading in steel has been chosen as the commodity futures in focus due to the inherent steel price instability and its latest introduction as a commodity to be traded on the futures market. This paper argues that steel futures trading will atleast not fulfill parameters of price stability and price discovery, if not further destabilize the global steel prices. In support of this argument a detail has been provided based on irrational investor behavior as noted by Robert Shriller in his „Irrational Exuberance‟ and also on the concepts of price over-shooting and the formation of financial bubbles. Commodity prices have a dependency on various exogenous factors which creates a further divergence from the underlying fundamental expectations of a perfect market condition for futures trading. Steel demand has been growing continuously in the developing economies and any sudden price fluctuations creates detrimental effects in the production process within these economies, as they heavily depend on steel for infrastructural growth. So, steel futures might create a condition of further price fluctuations due to speculative activity and thus can prove to be harmful for the producers and consumers of the emerging economies. These producers and consumers lack the capability to accommodate with the problems of over-

production and sudden price rise, impacting the aggregate demand and supply which often has been observed to be imbalanced. This paper broadly presents the problems with commodity futures trading and its relationship to the role played by hedging and speculation. Speculative activity tends to dominate the investments in futures markets and thus break the link between the futures market and underlying physical commodity, when the commodity futures reflect the expected future price of the underlying commodity. Commodity Futures Market and the Steel Futures A futures contract is a standardized agreement for the sale or purchase of an underlying instrument at a specified price on a certain date and place, in the future. These contracts, known as futures, are traded on an exchange, Futures Exchange, where the settlement of these highly standardized agreements takes place. Commodity Futures Market is such an organized exchange for the trading of standardized contracts based on an underlying commodity. Each commodity traded on the futures market has a parallel market running for trading in the actual physical commodity, which marks the spot price for the particular commodity being traded in its futures (Venkataramanan, 1965). A commodity futures exchange acts as a clearinghouse both in the case of a market settlement of a contract or a settlement by the actual delivery of a commodity. The standardization of the futures contract brings in some fundamental differences between the actual physical trading of the commodity and the trading done over its futures contract at the exchange. Contracts in the futures market, being highly standardized, create a homogeneity which facilitates trading not only by buyers and sellers of the actual physical commodity but also by actors seeking profit without transacting in the physical commodity. This results in only a small percentage of the futures settled by the actual delivery of a commodity and majority of the trading volumes comprised of market settlements of these contracts. A market settlement of a futures position can be achieved by offsetting the held position through selling a long position or buying back a short position in the related commodity futures prior to the commitment date of the contract (). As noted in a report by a management corporation: “Actually, only a very small percentage, usually less than two percent, of the total futures contracts that are entered into are ever settled through deliveries. For the most part they are cancelled out prior to the delivery month”. (Lerner, 2000) This paper focuses on the Commodity Futures Market as it has implications on the exchange of real commodities which are engaged directly in the process of production of goods and capital in the real economy. Commodity futures markets have been developed for the

purpose of facilitating the exchange between producers and consumers of different commodities, thus, providing a medium through which all trade interests converge at a single platform reflecting the broad demand and supply. In theory of Commodity Trading and Commodity Futures this creates price stability and removes anomalies in commodity pricing, which may arise otherwise due to imbalances or inadequate representation in the demand or supply. But an analysis of the nature of trading within the commodity futures market with historical references substantiates the debate on destructive nature of the derivatives trading which often questions the fundamentals of existence of any commodity futures market. A variety of derivatives are traded on a commodity exchange which introduce a rouge pattern of inter-locking of different underlying assets that drives pricing of these derivative products to become dependent on each other. The manifestation of price distortion and volatility due to these financial innovations in derivative trading can be observed through a critical analysis of certain inherently volatile commodities. For the purpose of this paper, the focus commodity has been maintained as steel, a recent inclusion in the world of derivative trading, for steel price stability and facilitation of exchange between producers and consumers of steel. Steel has a long history of production and distribution, with different forms of steel originating in different parts of the ancient world. Steel is a major raw material input for majority of the modern infrastructure in the developed economies and has witnessed an increasing demand in the developing world, especially the during the recent growth period of emerging markets like China, India, and Brazil. The high demand is driven by the development projects mostly for infrastructural growth and real estate projects. The steel production has also encountered a fundamental shift from the dominance of OECD countries, till late 1980s, as the major producers of steel to growing share of production market by emerging economies like China, India, and South Korea. The major consumption sectors of steel in the economy are Automobile Industry, Construction Industry, Oil and Gas Industry, Container Industry, etc. Steel industry around the world has been faced with price volatility over different periods of time which has been reflected as an added pressure on the production and consumption of steel. Volatility in the steel industry has been fueled by various factors like demand-supply imbalance, raw material prices, changes in the crude-oil price.

(million metric tons crude steel production)

2006 Rank China Japan United States Russia South Korea Germany India Ukraine Italy Brazil World 1 2 3 4 5 6 7 8 9 10 Mmt 422.7 116.2 98.6 70.8 48.5 47.2 44.0 40.9 31.6 30.9 1 244.2

2005 Rank 1 2 3 4 5 6 7 8 10 9 Mmt 355.8 112.5 94.9 66.1 47.8 44.5 40.9 38.6 29.3 31.6 1 141.9

Major Steel Producing Countries, 2006: Source IISI World Steel in Figures 2007 While there is a growing support for futures trading for finished or semi-finished products of steel, major steel corporations like MittalArcelor has shown resentment to the use of derivatives as anchors of price stability. There view on steel pricing and curbing volatility is inclined towards steel industry consolidation and adjustment of production levels with aggregate demand for steel in the international markets. Risk Management and Futures Trading The fundamental argument in theory of futures market presents commodity futures market as an institutional mechanism of risk management. Commodity markets can be used by producers and consumers to sell or buy a certain actual physical commodity on a future date at the current price. This mitigates the risk of price change that could create unintended costs for the buyers and sellers. In order to manage the risk of price change, one can hold a futures contract in the commodity futures market to either buy or sell a

particular physical commodity. The standard futures contract describes a certain quality and quantity of the commodity to be delivered on specified date and place, in the future. In financial literature, the process of risk aversion of price volatility in a transaction made in the actual physical commodity market by making a concomitant opposite transaction in the futures market is called „hedging‟. Hedging of risk in the futures market is a method by which buyers and sellers can exercise a „price lock-in‟ for ascertaining a preconceived cost or return. Futures trading is considered important for commodities which have a lag between the demand and actual supply of the physical commodity, for example, agricultural products and mined metals etc. Based on the expectation of price fall the sellers hold „short‟ future positions while buyers, with an expected price rise, hold „long‟ future positions. Although, hedging strategies wipe out the possibility of any profits that could be made if the prices were to go in the opposite direction than expected, it is still a mechanism for price stability in the commodity trade (Goss and Yamey, 1978). According to futures market theory, the derivatives traded in commodities helps create an efficient allocation of risk and, therefore, demonstrates sustainable price levels for different commodities traded on the exchange. This is based on the effect of a broad and transparent platform for demand and supply which restraints any disproportionate influence on price determination of a particular commodity. The underlying assumption for the explanation of existence of a price discovery mechanism is that the supply and demand factors related to the market are based on the actual physical trade of the commodity and there is a longterm (contract length) view for an appropriate price for buying or selling the commodity on a future date. So, hedging strategy in a futures market is interpreted as an insurance against any loss bearing price movements for a commodity. Brian and Rafferty argue that derivatives act as the anchor of the global financial system (Brain and Rafferty, 2007). According to this argument, beyond hedging and speculation, derivatives in aggregate commensurate the value of financial assets traded on the exchange. So, derivatives, or what the authors call – „system of derivatives‟, create complex networks of relative pricing mechanism for different financial assets, in different markets. Due to this interlinking of different financial asset prices, the reflection of any individual financial asset price is going to reflect the anchored value dependent on its relationship with all other financial assets, or the relative value. They introduce two concepts of „Binding‟ and „Blending‟, where binding is of the future value of a financial asset into the present and blending is the swift convertibility of different financial asset forms, like swaps for interest

rates to commodity futures. This view is problematic in terms of analyzing a derivative market which is based on the assumption of „real‟ and „rational‟ valuations of future prices in the present. With this assumption the whole system of derivative pricing gets deteriorated, as in practice the pricing of financial assets in a futures market does not necessarily reflect the real „anchored‟ future value. If this assumption was to be correct, price-overshooting in stock and futures markets would cease to exist and derivatives would become the real reflection of demand and supply created by forces of production and consumption. When Brian and Rafferty comment on financial asset pricing „beyond speculation‟, there arises an inherent question as to why the speculation would exist if there was a real reflection of prices in any financial market. Speculation is an activity that is fundamentally motivated by the market oriented profit maximization strategy. Theoretically speculation supports a derivative market, like that of the commodity futures market, by ensuring that changes that appear in financial asset values due to price fluctuations, following the changes in demand and supply, are evened out by speculating in the opposite direction of price movements. So, if the price fluctuations lead to asset price appreciation, the speculator would sell and in case of asset price depreciation the speculator would buy, therefore, correcting the price value of financial assets through trading in futures markets. In theory this mechanism is useful as would stabilize the underlying spot prices for commodities through trading in the derivatives on the commodity futures exchange. Futures markets consist of the following two broad division of actors - Hedgers and Speculators. Fundamentally, hedgers engage in risk aversion of price changes in the future by buying or selling a commodity at the present price for a future delivery of the actual commodity. Speculators, on the other hand, are actors which invest in the futures market to profit from the price change of a certain financial asset, or an underlying commodity in the case of commodity futures, based on the expected price fluctuations. As the commodity futures markets have witnessed that the majority of the trading in popular commodities is undertaken by speculators as compared to hedgers which creates a contradiction to the original argument provided by the market oriented proponents of the commodity futures market that hedgers and speculators balance out the price fluctuations that can occur in the underlying commodity. The contradiction arises because the more the speculative activity exists the more will be the expectations of a price change in the underlying commodity, as speculation dwells on price change or price volatility.

Financial Fragility and Futures Trading Financial Fragility is the concept of self-fueling financial asset bubbles which are selffulfilling and with intangible factors like investor mood swings these bubbles can bust creating dramatic consequences for financial markets, which spill over to the real economy which depend on these markets (Stanford, 1999). With an initial asset price rise, weather based on real fundamentals or subjective expectations, the investors will buy financial assets to make profit by selling them in the future at a higher price. But these expectations of future profits are not always serviced by the financial markets. It would be too simplistic to discuss financial rise and fall affecting asset prices concentrated in the financial institutional framework. In reality, it is a complex relationship between real economy where real goods are produced and real investment takes place and the financial markets where these asset prices are hedged and speculated. This complex relationship forms actor expectations in the financial markets based on economic fundamentals, but often leads to an overvaluation of assets in a financial market which is responsible to create the bubble effect within the real underlying fundamentals, thus creating drastic consequences, beyond the financial arena into the real economy, when actor expectations are not met by financial markets. So commodity futures are not just basic tools to hedge against the risk of commodity price changes in the future, but an important mechanism through which a large number of investors engage in making profit without having any direct relation to the underlying commodity. In the case of steel, it is an added advantage that the price volatility is very high which inturn will attract high volumes of speculative activity. Volatility is a major factor in speculation as it provides the short-term investors to make profits by trading against frequent price changes. Commodity futures markets are subject to sudden shift of investor expectations which leads to switching of large funds in and out of these commodity markets. The switching of large funds creates an impact on the price levels of the commodity futures, which are theoretically reflecting the „real‟ future expectations of price change in the underlying commodity. So, this produces an externality in the pricing mechanism of commodity futures. The externality could be exogenous factors like change in exchange rates, interest rates, and macroeconomic fundamentals of developed and developing economies, creating accentuating effects within the commodity price cycles (Maizels, 1992).

The analysis of the undergoing credit crisis, which was initiated by the sub-prime lending defaults in the US economy, provides an outlook discussed above for the commodity markets. The weakening of the US dollar puts direct pressure on oil prices, and the weak expectation in the equity markets lead to a shift in the investing strategies of large funds and other investors. There has been an increased investment towards commodity markets in order to decouple from the fluctuations in the equity markets and depreciation of the US dollar. This is a hedging strategy is used by investors holding stocks and futures positions affected by the devaluation of the US dollar, creating sudden price appreciation for various commodities. A falling dollar has continuously created an upward movement of the commodity prices, with an acute price appreciation in the month of January 2008 (Economist Feb. 21st, 2008), in primary commodity prices like that of oil, gold, soyabeen, etc. Investors tend to create futures positions in the commodity markets in order to hedge against the risk of incurring losses due to a further US dollar devaluation. Also, the rising oil prices for the same reason has been another external factor pushing the commodity prices to higher levels, independent of the character of demand and supply within this short-term price accentuation. These commodity price levels in the futures market are not based on any underlying fundamentals which could affect the demand and supply of the commodities, but instead they reflect the investor‟s perception towards certain markets at a certain time in history.

Financial Leverage and Commodity Price Reflection Futures trading has a very important aspect that provides incentives for investors to go beyond the traditional methods of trading in futures markets, especially the commodity futures markets. In futures trading the investors only need a margin, which is only a small percentage of the total cost of the actual physical commodity trade or exchange. This provides an extreme leverage to the investors trading in a futures market like that of the commodities because it generates avenues for traders who are not involved in the actual commodity transaction but only in the short-term outlook for profit motives vested in expected price change. This creates a potential condition for the use of speculative activity by even those who are hedging their risk exposures on these markets, in the attraction towards earning extra profits by engaging in investments for generating favorable price changes. Enron was an American energy corporation which went bankrupt in late 2001 due to their shift from the productive business of electricity and gas to large risky exposures in

energy futures lead to massive losses. These losses were attempted to be hidden by fraudulent accounting principles, but revelation of such irregularities lead to the Enron debacle (Blackburn, 2002). So, there exists no clear line between the different actors involved in futures trading that can classify them as hedgers and speculators. Also, speculative capital generates large profits during the times of favorable investor expectations but such risk exposures often lead to massive losses to real corporations and real units of production and consumption within an economy. As Robert Shriller argues in his book on investor psychology named „irrational exuberance‟ that investors are not always motivated by complex mathematical calculations of risk in certain investments. Investor response to market conditions is mostly governed by herd behavior, as is also noted by Adam Harmes who gives an explanation of the role of mutual funds in a financial crisis (Harmes, 2001). Commodity futures more than often face the problem of volatility in prices due to exogenous changes like interest and exchange rates and also due to the fact that many commodities have interlinking relationships in the „real‟ productive economy, where these commodities are used as raw materials or other inputs towards a particular production process. In such a condition, the „rationality‟ of the investors trading on the commodity futures is governed more by their subjective valuations of market sentiment rather than the theoretical arguments provided in favor of hedging strategies as the underlying fundamentals behind the existence of commodity futures markets In the case of Steel production the raw material supplies involve various other volatile commodities like scrap, iron ore, and coke. These commodities have inherent price volatility which is reflected in the pricing for steel finished and semi-finished products. Dependency of oil prices for these commodities creates an imperative for price fluctuations for any commodity dependent on oil-based raw material. There has been an evidenced price variation even in the non-oil primary commodities, but the dependency of oil for other commodities brings an entirely external cause for price corrections. This arugemnt can be extended to all traded commodities in general as the dependency of different commodities on each other creates a complex web of commodity price changes and a reflection of an aggregate change in the demand and supply of all dependent commodities in this web and not just that of an individual commodity independently. Steel future contracts have been traded in the past on the Dubai Gold and Commodities Exchange (DGCX), since October 2007, and also on the National Commodity & Derivatives

Exchange (NCDEX) and the Multi Commodity Exchange of India (MCX). But treading volume of these contracts has been observed to be very low. The problem that can be associated with the low volumes of trade provides a clear view that the steel as a commodity is not attractive to be traded on futures for the purpose of hedging. Moreover, steel prices have been fluctuating and, therefore, it does not provide enough incentive to the speculators to create exposures with high risk due to low trading volumes. Recently steel futures contracts have been launched by the London Metal Exchange (LME) based on steel billets (a semifinished steel product). LME has provided a detailed survey on the international steel market and the need for a futures market to promote stability in the global steel prices. The futures trading in any particular commodity is subject to market expectation and participation. Historically steel futures have seen low volumes of trading on various commodity markets. One reason has been the low incentive for major steel producers to engage in hedging strategies on the future steel prices due to high levels of fluctuation in the global steel prices. Most producers agree that price fluctuations are based on overproduction or sudden increase in demand from certain economic regions which can be checked by making production close in capacity to the demand levels in the international market. So the problem that arises with steel futures in particular is that of the liquidity in terms of trading volumes on the futures exchange. With high liquidity the corporations tend to engage in substantially large open positions in the futures market which tends to stabilize the underlying commodity prices to certain extent, which is not the case with steel as major corporations have not been attracted by the steel futures trading.

Impacts of Steel Futures on Emerging Markets In recent times, the infrastructural growth in emerging economies like India, China, Brazil, etc. has created a substantial increase in the demand for steel. This new demand creates strong impact of the global steel price changes and on the developing economy producers and consumers. For the steel production in developed economies, the steel industry has been consolidating and these large steel corporations can accommodate price changes due to changing demands by sustaining large inventories and other mechanisms of sustaining over-production or a sudden price rise. But comparatively the developing economies have drastically increasing demand for steel and the consumption levels cannot be met by domestic production, except for the case of China which is the world‟s largest steel

2000 China India Japan South Korea Taiwan, China Other Asia Asia World 124.3 26.3 76.1 38.5 21.1 36.8 323.0 756.6

2001 153.6 27.4 73.2 38.3 17.4 41.2 351.1 774.5

2002 186.3 28.9 71.7 43.7 20.4 41.6 392.7 814.7

2003 247.0 31.2 73.4 45.4 19.9 42.9 459.8 894.8

2004 272.0 34.3 76.8 47.2 22.1 47.1 499.4

2005 326.8 39.2 78.0 47.1 19.9 49.0 560.0

2006 356.2 43.1 79.0 49.3 19.8 47.6 595.0

974.3 1,026.0 1,113.2

Country wise Steel Use since 2000 to 2006: Source IISI World Steel in Figures 2007 producing country. So, steel price fluctuations hamper the production as well as consumption of steel within these developing economies, therefore, impacting the development of infrastructure and industrial expansion within these economies. The demand and supply of steel and other commodities partly depends on the future expectations of price change and would create certain indications for steel producers to adjust to this changing demand and supply balance which is not based on the actual fundamental demand for the real physical commodity.

Conclusion London Metal Exchange survey on steel industry, before the launching the steel futures contract, points to an existing higher price volatility in steel prices which would require a futures market for steel price stabilization. But according to the argument presented in this paper, it is unlikely that functioning of futures market remains within the theoretical framework of commodity futures market which assumes a „rational‟ investor behavior. They also argue that the futures trading in steel will create strong linkages between the futures market and the actual physical market for steel. According to this report price volatility of steel is only slightly less than that of two other commodities traded on futures markets, i.e., aluminum and oil. As is evident by the fluctuation of prices in these commodities even with

their existing futures contracts in various markets that the derivative trading has, ironically, lead to a destabilization of price stability rather than providing any price support to commodities traded on the exchange. Commodity markets have been affected by external factors which justify the argument made in the paper that futures markets don‟t necessarily reflect the true expectation of future price change. The reflection in price due to sudden changes is based on investor perception of market conditions in various different sections, like the currency markets, government bond markets, etc. Moreover, speculators always dominate the volumes of trading in a futures exchange, and when speculation is not made for the purpose of hedging risk but to gain profits in the form of risk (shifted by the hedgers onto the speculators) premium. For developing economies, the introduction of steel futures may not work as is expected by the theory of futures trading. Detriments to the growth of infrastructure are a major hindrance in other forms of growth within the emerging economies. Steel futures, if fueling further price instability, would have a direct impact on a broad section of growth in the emerging market societies. By current levels of growing demand for steel within some developing economies, they would be indirectly subject to the deteriorating effects of speculation on different commodities as it will have a an impact on the reflected futures price of steel itself. References Venkataramanan, L.S. (1965), “The Theory of Futures Trading: Hedging, Speculation, and Storage in Organized Commodity Markets”, Asia Publishing House Maizels, Alfred (1992), “Commodities in Crisis: The Commodity Crisis of the 1980s and the Political Economy of International Commodity Policies”, Clarendon Press Brian, D., and Rafferty, M. (2007) “Financial Derivatives: Bubble or Anchor?”, in Assassi, L., Nesvetailova, A., and Wigan, D. (ed.), Global Finance in the New Century: Beyond Deregulation, Palgrave Mcmillan, 25-37 Working, H. (1978) “Futures Trading and Hedging”, in Goss, B. A., and Yamey, B. S. (ed.), The Economics of Futures Trading, Macmillan Press, 68-82

Johnson, Leland L. (1978) “The Theory of Hedging and Speculation in Commodity Markets”, in Goss, B. A., and Yamey, B. S. (ed.), The Economics of Futures Trading, Macmillan Press, 83-99 Gilbert, Ghosh, and Hallett, Hughes (1987) “Stabilizing Speculative Commodity Markets”, Oxford University Press Shriller, Robert J. (2005) “Irrational Exuberance”, Princeton University Press London Metal Exchange (LME). (2003) “Analysis and Survey Results for the Establishment of Steel Future Contract” Brown, O., Crawford, A., and Gibson, J. (2008) “Boom or Bust: How Commodity Price Volatility Impedes Poverty Reduction, And What to do About It”, International Institute for Sustainable Development Sunni, P. (2006) “Commodity Futures as Predictors of Future Spot Prices”, ETLA Research Paper Blackburn, R. (2002) “The Enron Debacle and the Pension Crisis”, New Left Review, MarApr, 26-51 Ciner, C. (2006) “Hedging and Speculation in Derivative Markets: the Case of Energy Futures Contracts”, Applied Financial Economics Letters, 2, 189-192 Lerner, Robert L. (2000) “The Mechanics of the Commodity Futures Markets: What They Are and How They Function”, Special Report No.-2, Mount Lucas Management Corp., June Stanford, Jim (1999), “Paper Boom: Why the Real Prosperity Requires a New Approach to Canada‟s Economy”, (Chap 3 and 13), pp. 41-71, 283-303 Harmes, Adam (2001), “Unseen Power: How Mutual Funds Threaten the Political and Economic Welfare of Nations”, Toronto: Stoddart; pp. 18-82

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