Commodity Risk Management Evaluation - Essay Example

COMMODITY RISK MANAGEMENT Commodity Risk Management Introduction International trade, which is carried out across country boundaries involves the exchange of commodities such as crude oil, agricultural products, natural gas, minerals and other commodities. The market of these commodities is constantly fluctuating, this makes them very volatile. In order for companies and individuals to trade profitably, they have to critically evaluate the fluctuating price and inventory levels. Due to the vitality of the commodity markets, consumers and producers look for ways to hedge or trade risks. The dynamics of the price changes may be classified as short term dynamics and long term dynamics. Commodities with higher price volatility subject the consumer or the producer to greater probability of incurring loses or attaining gains on the future sales and buying of the product. Commodities with greater share in enterprise earning or production costs are faced with greater exposure to price risks. Various commodity risk management instrument are available and are mostly used by large producing firms, large consuming firms, trading firms, marketing firms or departments and other business ventures. The current market trends have led to the limitation of middlemen and traders and the transactions between the producer/ manufacture and final consumer have increased considerably. When the world commodity prices fall, the producer is at risk as he is not able to cover for his production costs. Also, a commodity dealer who buys products and keeps them in a warehouse is faced by the risk of not recovering his original purchasing costs. Those who process the goods are faced by double risks due to the inputs and outputs. The final consumer only experiences the problem of increased prices. Price risks also affect traders, importers and exporters (Rutten and Blarel, 1996) The are several methods that are adopted for the management of commodity price risks, These include the adoption of marketing strategies that help time sales and purchases, Forward contracts, futures long term contracts, the use of over the counter markets. Commodity linked bonds and the use of swaps (Kolb, 1991).The choice of the instrument to use is difficult as the over the counter market is not open and transparent. The price determination depends on the bargaining strength and the availability of vital information. There is also the counterpart risk if he fails to fulfill the obligations imposed on him. Types of instruments used Forwards contracts; this involves the formation of an agreement to deliver a given quantity of goods at a given future date. The agreed forward price is paid when the product is delivered. The contract contains the price of the commodity and the quantity specified for delivery at a given date in the future. The 'long position' or the buyer receives the commodity and pays the forward price and the 'short position' or the seller delivers the commodity (UNCTAD, 1998). Futures contract: this is an agreement to deliver a given commodity in the future. The price is paid at a specified future date and at a future price payable at the time of delivering the commodity. They differ from the forward markets since they are 'marked to the market' this means that the contracts are settled each trading day. Future prices are either greater or less than the forward price. Due to the evaluation of the prices per given trading day, future contracts are usually preferred. Forward contacts are usually traded in exchanges. Futures may require settlement on daily basis if the are market to market. They are safer because the clearing house guarantees the fulfillment of the contract terms by all parties (Morgan, 1992) Cash market The behavior of most commodities in the market is determined by the cash and storage markets. The term spot price is used to refer to the immediate purchase of commodities. That means the products are bought and delivered at that time. The cash market is greatly determined by the spot price and net demand relationship. The net demand is the difference between production and consumption. The total demand in a given market is greatly influenced by the spot price and other factors. These factors include weather, Total income, random shocks, certain capital stocks, changes in technology and changes in consumer preferences. The demand as a function of the market price can be denoted by the following function Where D is the demand, P is the sport price. Z1 denotes the vector of demand shifting variable and is the random shock. The supply of any commodity is a function of the spot price and a set of other factors such as production cost which encompass energy and raw materials, labor costs and random shocks. The function is as given as; Where is the supply is curve shifting variable and is the random shock. If I denotes the inventory level, then; The change in inventory level is given by; The term is the net demand. When the net demand equals the net supply, then the market is said to be in equilibrium. CRUDE OIL Introduction In the world market, crude oil futures are the most traded futures in the market. For one to invest in the crude oil trading, it is necessary to know the different types of crude oil that exists. Crude oil is classified into to broad categories. The first category is the light and sweet, while as the other category is the heavy and sour. Companies producing light sweet crude oil generate higher profits than those producing the heavy sour crude oil. The criterion of evaluating the quality depends upon the density and the sulfur content. Trading was carried out with the light sweet crude oil as it generates greater returns. The basis for my choice is that it fetches a higher price hence it is more readily traded than the heavy sour crude oil. Another strategy was that after observing the tables, it was found out that the light fuel moved faster as compared to the heavy crude oil. Index The Middle East crude oil futures contract and index was used, the contract involves the cash settlement based on a value calculated by computing the average value of Dubai and Oman crude oil. This price is reported by the Bloomberg, LOR, Reuters, RIM intelligence and ICIS. The prices are quoted in dollars and cents per barrel and the unit for the contract is 1000 barrel. The rules were consistent for the maximum and minimum fluctuation in prices. The settlement procedures were through the termination of the regular trading period which ends on the final business day before the delivery month. The daily index calculations are done suing the following formula; Daily index = (average of Dubai) + (average for Oman) 2 The data obtained from Bloomberg regarding the crude oil are as shown below (Bloomberg.L.P, 2009) Price Change % change Time NYMEX Crude future 69.16 -1.07 -1.52 06/26/2009 The commodity chart for the light sweet crude oil is indicated below (Adopted from: TSC commodity charts. 2009. Crude Oil Weekly Price Chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CO/89 Accessed 28 June 2009.) Analysis of the commodity chart The first plot is the fast moving average while plot 2 is the slow moving average. In the short term, the market is bearish since the fast moving average is at level below the slow moving average. the market in the long run is extremely bearish with analysis pointing to lower prices, the volatility is treading up. The long term price trend is upwards. GOLD Introduction The world has a lot of appeal for precious metals and in particular gold. Gold is coveted because of its beauty, rarity and its indestructible nature. Gold is used as a store for wealth, a medium for exchange and also for security against day to day uncertainties. Gold began in 1994 and have been used ever since. The gold prices are floated with respect to the supply and demand. Gold respond very fast to economic and political events. Trading rules and exchange The selected trading futures exchange was COMEX (Commodity Exchange and New York Mercantile Exchange) the advantages of using COMEX were that; Quality and quantity of the gold determine the future contract The firm offers trading risks management opportunities that are cost effective The COMEX division Gold prices are universal and are used as the reference standards. The future contract can be easily liquidated before the required receipt or delivery of the commodity. The exchange is safe and very orderly Trading months The trading period at COMEX are February, April, August and October and thereafter for a period of 23 months, the current calendar month, the next two calendar months, any June and December falling within a duration of 60 months starting with the current month. Last trading day The termination of business is at the third to the last business day of the month the delivery matures. Trading price The minimum price fluctuation is $ 0.10 per troy ounce. Delivery period The first business day of the delivery month is the first delivery day. Exchange of futures The sellers and buyers can either exchange a futures position of equal quantity or physical position. Trading unit The trading unit is 100 troy ounces At close of every day business, every transacted future trade is recorded. The clearing house performs the role of balancing all the clearing members' accounts. This is done on daily basis. To prevent counter party credit risk, the clearing house acts as the guarantor of every trade. Each clearing member is required to deposit money based on the proportion of the number of contracts cleared Due to the nature of the metals markets, the prices are sometimes volatile. The world major producers of gold are shown in the table below Number Country Quantity in metric tons 1 China 288 2 United states 234 3 South Africa 232 4 Australia 225 5 Peru 175 6 Russia 163 7 Canada 100 8 Indonesia 90 9 Uzbekistani 85 10 Ghana 81 The above table shows the top ten countries producing gold. Trends in gold production vary considerably. In 2007 china was leading with 276 metric tons, while in 2006 South Africa was leading with 275 metric tons. (Gold sheet mining directory, 2009). The recent trends in gold prices are shown in the charts below (Adapted from :( metal prices, 2009. Gold; Gold market analysis. [Online] available at http://www.metalprices.com/FreeSite/metals/au/au.asp. Accessed 27 June 2009.) COPPER Introduction Copper is an important metal and responds well to the world's event. High grade copper is an important tool for futures and a vital risk management tool. The main regulator of the international copper prices is COMEX division. The exchange offers; cost efficient risk management and trading opportunities The contacts are standardized by quality and quantity and are in form of liquid financial instruments The copper prices used serve as the world reference prices for the high grade copper There is a strong financial system that backs trading at this clearing house The market is safe, orderly and fair and is protected by high financial standards and surveillance procedures. Trading rules The copper futures contracts are commitment to make or accept delivery of a specified commodity during a specific month. The trading at COMEX is done during the current calendar month and the following 23 months. Trading unit For the futures: 25000 pounds Price quotation The price is quoted in cents per pound Minimum price fluctuation The minimum price changes are ($0.0005 or $0.05) which equal to 12.50 per contract. Last trading day The futures last trading day is the close of business of the third last business day of the maturing delivery month. Margin requirement Open futures and short positions require margins The top ten producers of copper are shown in the table below; Number Name of country Quantity of copper produced (tons) 1 Chile 5,360,800 2 USA 1,220,000 3 Peru 1,049,933 4 China 915,000 5 Australia 875,000 6 Indonesia 817,796 7 Russia 675,000 8 Canada 606,958 9 Zambia 502,998 10 Poland 497,200 The recent trends in the production of copper The recent trend shows that copper production and consumptions are steadily rising. The production increased from 8.8 million metric tons in 1976 to 13.3 million metric tons in the year 1997. Recycling of copper constitute the secondary source of copper production while the primary source is mining copper. Trends in production of copper. (Adapted from: Dzioubinski, O and Chipman, R. 1999. DESA discussion paper series, trends in consumption and production of selected minerals. United Nations. [Online]. Available at http://www.un.org/esa/sustdev/publications/esa99dp5.pdf Accessed 28 June 2009) The recent treads in the copper market are as shown in the commodity charts below Adapt (Adopted from: TSC commodity charts. 2009. Copper high grade (HG, COMEX).weekly price chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CP/W. Accessed 28 June 2009) From the trends in price, the price is above the moving average and hence the price of the commodity is trending upwards. In the short run, the market is bullish as the fast moving average is above the slow moving average, from the analysis the long term effects is that the price trends upwards. The volatility trend is downward. LIVE CATTLE The world's main producers of cattle are given below; Country Head % of World 1 India 281,700,000 28.29% 2 Brazil 187,087,000 18.79% 3 China 139,721,000 14.03% 4 United States 96,669,000 9.71% 5 EU-27 87,650,000 8.80% 6 Argentina 51,062,000 5.13% 7 Australia 29,202,000 2.93% 8 Mexico 26,489,000 2.66% 9 Russian Federation 18,370,000 1.84% 10 South Africa 14,187,000 1.42% 11 Canada 13,945,000 1.40% 12 Others 49,756,000 5.00% World Cattle Population 995,838,000 The main market providing for the live cattle futures is the Chicago mercantile market (CME), a lot of changes have been undertaken to enhance the use of cattle in risk management program. The tool aid producers of cattle have to manage their risks. THE TRADING RULES Trading unit For the live cattle futures 40,000 lbs. of 55 % choice, 45 % select grade steers Trading hours 9.05AM to 1.00 PM Trading months The trading months are February, April, June august October and December The commodity chart for the live cattle at CME markets is as shown below (Adopted from: TSC commodity charts. 2009. CME live cattle (LE, Globlex).weekly price chart. [Online]. Available at: http://futures.tradingcharts.com/chart/LE/69 . Accessed 28 June 2009) Commodity chart analysis According to the charts the volatility is raising slightly, this is explained by the difference in gap between the lower and upper brands. The market is bullish in the short run as the fast moving average is above the slow moving average. It is expected that the prices will rise. Also the market is influenced by the rise in crude oil prices. In the long run the market is extremely bullish and higher prices are expected. The simulated transactions carried out are shown in the table below; Transaction History # Trade Date Order Symbol Contract Quantity Price Paid Commission Transaction Amount 2 05/19/09 Short HGI9.CMX COPPER HIGRADE 6/09 -2 52,175.00 25 104,325.00 3 05/19/09 Buy GCQ9.CMX GOLD 8/09 2 92,820.00 25 -185,665.00 4 05/21/09 Short CLL9.NYM OIL CRUDE (SWEET) 7/09 -3 61,680.00 25 185,015.00 5 05/28/09 Cover CLL9.NYM OIL CRUDE (SWEET) 7/09 3 64,420.00 25 -193,285.00 6 05/28/09 Cover HGI9.CMX COPPER HIGRADE 6/09 2 53,587.50 25 -107,200.00 7 05/28/09 Sell GCQ9.CMX GOLD 8/09 -2 96,360.00 25 192,695.00 8 05/29/09 Short CLO9.NYM OIL CRUDE (SWEET) 8/09 -5 65,570.00 25 327,825.00 9 06/01/2009 Short CLL9.NYM OIL CRUDE (SWEET) 7/09 -10 66,480.00 25 664,775.00 10 06/01/2009 Cover CLL9.NYM OIL CRUDE (SWEET) 7/09 10 66,480.00 25 -664,825.00 11 06/04/2009 Short CLL9.NYM OIL CRUDE (SWEET) 7/09 -10 66,090.00 25 660,875.00 12 06/04/2009 Buy LCQ9.CME CATTLE LIVE 8/09 1 32,320.00 25 -32,345.00 13 06/05/2009 Buy LCQ9.CME CATTLE LIVE 8/09 4 32,460.00 25 -129,865.00 14 06/05/2009 Sell LCQ9.CME CATTLE LIVE 8/09 -5 32,460.00 25 162,275.00 26 06/05/2009 Buy LCQ9.CME CATTLE LIVE 8/09 10 32,460.00 25 -324,625.00 27 06/05/2009 Buy LCQ9.CME CATTLE LIVE 8/09 40 32,460.00 25 -1,298,425.00 28 06/05/2009 Buy LCQ9.CME CATTLE LIVE 8/09 50 32,460.00 25 -1,623,025.00 29 06/05/2009 Sell LCQ9.CME CATTLE LIVE 8/09 -100 32,400.00 25 3,239,975.00 30 06/16/09 Short CLO9.NYM OIL CRUDE (SWEET) 8/09 -5 71,000.00 25 354,975.00 31 06/16/09 Buy LCQ9.CME CATTLE LIVE 8/09 5 32,480.00 25 -162,425.00 31 06/22/09 Sell LCQ9.CME CATTLE LIVE 8/09 -5 32,920.00 25 164,575.00 33 06/22/09 Cover CLL9.NYM OIL CRUDE (SWEET) 7/09 10 66,930.00 25 -669,325.00 34 06/23/09 Cover CLO9.NYM OIL CRUDE (SWEET) 8/09 10 66,930.00 25 -669,325.00 This snapshot is as of Previous Market Close on: June 24, 2009 . Portfolio Value $498,134.44 Portfolio Ranking 20/26 Buying Power $996,268.88 Portfolio % Return -0.37% Available Cash $498,134.44 Interest Earned on Cash $1,434.44 References Dzioubinski, O and Chipman, R. 1999. DESA discussion paper series, trends in consumption and production of selected minerals. United Nations. [Online]. Available at http://www.un.org/esa/sustdev/publications/esa99dp5.pdf Accessed 27 June 2009 Gold sheet mining directory, 2009, gold production history. [Online] available at http://www.goldsheetlinks.com/production.htm accessed 27 June 2009. TSC commodity charts. 2009. Copper high grade (HG, COMEX).weekly price chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CP/W. Accessed 28 June 2009. Bloomberg.L.P 2009. Energy Prices. NYMEX crude future. [Online].Available at http://www.bloomberg.com/markets/commodities/energyprices.html Accessed 28 June 2009. TSC commodity charts. 2009. Crude Oil Weekly Price Chart. [Online]. Available at: http://futures.tradingcharts.com/chart/CO/89 Accessed 28 June 2009. TSC commodity charts. 2009. CME Live Cattle (LE, Globlex).weekly price chart. [Online]. Available at: http://futures.tradingcharts.com/chart/LE/69 Accessed 28 June 2009. UNCTAD.1998. A Survey Of Commodity Risk Management Instruments. New York: UNCTAD secretariat. Rutten, D. and Blarel, B.1996. "Managing price risks in India's liberalized agriculture: can futures markets help" World Bank/UNCTAD Report. Kolb, R. 1991. Understanding Futures Markets (3rd edition), New York: New York Institute of Finance. Morgan, J. 1992. Commodity Linked Finance. London: Euromoney Books Read More