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Performance Analysis of Indian Commodity Market

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This article presented in the International Seminar on “Financial Markets : Issues and
Challenges”
Organised by :
Dept. of commerce and Financial Studies, Bharathidasan University, Tiruchirappalli.India
th th
Date : 7 and 8 January 2012

Performance Analysis of Indian Commodity Market

Dr. A. Seilan, Assistant Professor, Department of Economics, Scott Christian College,

Nagercoil – 629 003, India.

*****************************************************************************

ABSTRACT

India is one of the top producers of a large number of commodities, and also has a long
history of trading in commodities and related derivatives. The commodities derivatives market
has seen ups and downs, but seem to have finally arrived now. The market has made enormous
progress in terms of technology, transparency and the trading activity. Current futures volumes
are miniscule compared to underlying spot market volumes and thus have a tremendous potential
in the near future.

Keywords : hedging, price volatility, commodity derivatives, price risk management

Introduction

Commodity Market : A Perspective

A market where commodities are traded is referred to as a commodity market. These

commodities include bullion (gold, silver), non-ferrous (base) metals such as copper, zinc, nickel,
lead, aluminum, tin, energy (crude oil, natural gas, etc.), agricultural commodities such as soya
oil, palm oil, coffee, pepper, cashew, etc. Existence of a vibrant, active, and liquid commodity
market is normally considered as a healthy sign of development of a country’s economy. Growth
of a transparent commodity market is a sign of development of an economy. It is therefore
important to have active commodity markets functioning in a country.

Commodity Futures
A Commodity futures is an agreement between two parties to buy or sell a specified and
standardized quantity of a commodity at a certain time in future at a price agreed upon at the time
of entering into the contract on the commodity futures exchange. The need for a futures market
arises mainly due to the hedging function that it can perform. Commodity markets, like any other
financial instrument, involve risk associated with frequent price volatility.

The Need for Commodities Market in India

India is among the top-5 producers of most of the commodities, in addition to being a
major consumer of bullion and energy products, which needs use of futures and derivatives as
price-risk management system. Fundamentally price you pay for goods and services depend
greatly on how well business handle risk. By using effectively futures and derivatives, businesses
can minimize risks, thus lowering cost of doing business. Commodity players use it as a hedge
mechanism as well as a means of making money. For an agricultural country like India, with
plethora of mandis, trading in over 100 crops, the issues in price dissemination, standards,
certification and warehousing are bound to occur. Commodity Market will serve as a suitable
alternative to tackle all these problems efficiently.

Commodities Market in India -- Evolution and Regulation

India has a long history of futures trading in commodities. In India, trading in commodity
futures has been in existence from the nineteenth century with organised trading in cotton,
through the establishment of Bombay Cotton Trade Association Ltd. in 1875. Over a period of
time, other commodities were permitted to be traded in futures exchanges. Spot trading in India
occurs mostly in regional mandis and unorganised markets, which are fragmented and isolated.
Over time the derivatives market developed in several other commodities in India.
Following cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute and jute
goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay (1920). However,
many feared that derivatives fuelled unnecessary speculation in essential commodities, and were
detrimental to the healthy functioning of the markets for the underlying commodities, and hence
to the farmers. With a view to restricting speculative activity in cotton market, the Government of
Bombay prohibited options business in cotton in 1939. Later in 1943, forward trading was
prohibited in oilseeds and some other commodities including food-grains, spices, vegetable oils,
sugar and cloth.
After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952
which regulated forward contracts in commodities all over India. The Act applies to goods, which
are defined as any movable property other than security, currency and actionable claims. The Act
prohibited options trading in goods along with cash settlements of forward trades, rendering a
crushing blow to the commodity derivatives market. Under the Act, only those
associations/exchanges, which are granted recognition by the Government, are allowed to
organize forward trading in regulated commodities. The Act envisages three-tier regulation: (i)
The Exchange which organizes forward trading in commodities can regulate trading on a day-to-
day basis; (ii) the Forward Markets Commission provides regulatory oversight under the powers
delegated to it by the central Government, and (iii) the Central Government - Department of
Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution - is the ultimate
regulatory authority.
The era of widespread shortages in many essential commodities resulting in inflationary
pressures and the tilt towards socialist policy, in which the role of market forces for resource
allocation got diminished, saw the decline of this market since the mid-1960s. This coupled with
the regulatory constraints in 1960s, resulted in virtual dismantling of the commodities future
markets.
Liberalization of Indian economy since 1991 recognised the role of market and private
initiative for the development of the economy. The much maligned market instruments such as
the futures trading were also given due recognition. Forward trading was permitted in cotton and
jute goods in 1998, followed by some oilseeds and their derivatives, such as groundnut, mustard
seed, sesame, cottonseed etc. in 1999.
The year 2003 marked the real turning point in the policy framework for commodity
market when the government issued notifications for withdrawing all prohibitions and opening up
forward trading in all the commodities. This period also witnessed other reforms, such as,
amendments to the Essential Commodities Act, Securities (Contract) Rules, which have reduced
bottlenecks in the development and growth of commodity markets. Of the country's total GDP,
commodities related (and dependent) industries constitute about roughly 50-60 %, which itself
cannot be ignored. Responding positively to the favourable policy changes, several Nation-wide
Multi-Commodity Exchanges have been set up since 2002, using modern practices such as
electronic trading and clearing.
The Forward Markets Commission is the regulatory authority of the Commodity Futures
Market in India. The Commodity Futures Market comprises three National Commodity
Exchanges and nineteen Regional Commodity Exchanges. The National exchanges operating in
the Indian Commodity futures market are Multi Commodity Exchange of India (MCX), National
Commodity and Derivative Exchange of India (NCDEX) and National Multi Commodity
Exchange of India (NMCE).
MCX is an independent and de-mutulised multi commodity exchange has permanent
recognition from Government of India for facilitating online trading, clearing and settlement
operations for commodity futures markets across the country. NCDEX is a nation-level,
technology driven de-mutualized on-line commodity exchange. It is committed to provide a
world-class commodity exchange platform for market participants to trade in a wide spectrum of
commodity derivatives driven by best global practices, professionalism and transparency.
The recent policy changes and upbeat sentiments about the economy, particularly
agriculture, have created lot of interest and euphoria about the commodity markets. Even though
a large number of the traditional exchanges are showing flat volume, this has not weakened
excitement among new participants. Many of these exchanges have been permitted with a view to
extend the culture and tradition of forward trading to new areas and commodities and also to
introduce new technology and practices.
The current mindset of the people in India is that the commodity exchanges are
speculative (due to non delivery) and are not meant for actual users. One major reason being that,
the awareness is lacking amongst the actual users. In India, interest rate risks, exchange rate risks
are actively managed, but the same does not hold true for the commodity risks. Some additional
impediments are centered around the safety, transparency and taxation issues.

Benefits of Commodity Futures Markets

The primary objectives of any futures exchange are authentic price discovery and an
efficient price risk management. The beneficiaries include those who trade in the commodities
being offered in the exchange as well as those who have nothing to do with futures trading. It is
because of price discovery and risk management through the existence of futures exchanges that
a lot of businesses and services are able to function smoothly.
• Price Discovery:-Based on inputs regarding specific market information, the demand and
supply equilibrium, weather forecasts, expert views and comments, inflation rates,
Government policies, market dynamics, hopes and fears, buyers and sellers conduct trading
at futures exchanges. This transforms in to continuous price discovery mechanism. The
execution of trade between buyers and sellers leads to assessment of fair value of a
particular commodity that is immediately disseminated on the trading terminal.

• Price Risk Management: - Hedging is the most common method of price risk
management. It is strategy of offering price risk that is inherent in spot market by taking an
equal but opposite position in the futures market. Futures markets are used as a mode by
hedgers to protect their business from adverse price change. This could dent the
profitability of their business. Hedging benefits who are involved in trading of commodities
like farmers, processors, merchandisers, manufacturers, exporters, importers etc.

• Import- Export competitiveness: - The exporters can hedge their price risk and improve
their competitiveness by making use of futures market. A majority of traders which are
involved in physical trade internationally intend to buy forwards. The purchases made from
the physical market might expose them to the risk of price risk resulting to losses. The
existence of futures market would allow the exporters to hedge their proposed purchase by
temporarily substituting for actual purchase till the time is ripe to buy in physical market. In
the absence of futures market it will be meticulous, time consuming and costly physical
transactions.

• Predictable Pricing: - The demand for certain commodities is highly price elastic. The
manufacturers have to ensure that the prices should be stable in order to protect their market
share with the free entry of imports. Futures contracts will enable predictability in domestic
prices. The manufacturers can, as a result, smooth out the influence of changes in their
input prices very easily. With no futures market, the manufacturer can be caught between
severe short-term price movements of oils and necessity to maintain price stability, which
could only be possible through sufficient financial reserves that could otherwise be utilized
for making other profitable investments.

• Benefits for farmers/Agriculturalists: - Price instability has a direct bearing on farmers in

the absence of futures market. There would be no need to have large reserves to cover
against unfavorable price fluctuations. This would reduce the risk premiums associated with
 the marketing or processing margins enabling more returns on produce. Storing more and
being more active in the markets. The price information accessible to the farmers
determines the extent to which traders/processors increase price to them. Since one of the
objectives of futures exchange is to make available these prices as far as possible, it is very
likely to benefit the farmers. Also, due to the time lag between planning and production, the
market-determined price information disseminated by futures exchanges would be crucial
for their production decisions.

• Credit accessibility: - The absence of proper risk management tools would attract the
marketing and processing of commodities to high-risk exposure making it risky business
activity to fund. Even a small movement in prices can eat up a huge proportion of capital
owned by traders, at times making it virtually impossible to payback the loan. There is a
high degree of reluctance among banks to fund commodity traders, especially those who do
not manage price risks. If in case they do, the interest rate is likely to be high and terms and
conditions very stringent. This possesses a huge obstacle in the smooth functioning and
competition of commodities market. Hedging, which is possible through futures markets,
would cut down the discount rate in commodity lending.

• Improved product quality: - The existence of warehouses for facilitating delivery with
grading facilities along with other related benefits provides a very strong reason to upgrade
and enhance the quality of the commodity to grade that is acceptable by the exchange. It
ensures uniform standardization of commodity trade, including the terms of quality
standard: the quality certificates that are issued by the exchange-certified warehouses have
the potential to become the norm for physical trade.

• Commodities as an asset class for diversification of portfolio risk: Commodities have

historically an inverse correlation of daily returns as compared to equities. The skewness of
daily returns favors commodities, thereby indicating that in a given time period
commodities have a greater probability of providing positive returns as compared to
equities. Another aspect to be noted is that the “sharpe ratio” of a portfolio consisting of
different asset classes is higher in the case of a portfolio consisting of commodities as well
as equities. Thus, an Investor can effectively minimize the portfolio risk arising due to price
fluctuations in other asset classes by including commodities in the portfolio.
• Commodity derivatives markets are extremely transparent in the sense that the
manipulation of prices of a commodity is extremely difficult due to globalisation of
economies, thereby providing for prices benchmarked across different countries and
continents. For example, gold, silver, crude oil, natural gas, etc. are international
commodities, whose prices in India are indicative of the global situation.

• An option for high net worth investors: With the rapid spread of derivatives trading in
commodities, the commodities route too has become an option for high net worth and savvy
investors to consider in their overall asset allocation.

• Useful to the producer: Commodity trade is useful to the producer because he can get an
idea of the price likely to prevail on a future date and therefore can decide between various
competing commodities, the best that suits him.

• Useful for the consumer: Commodity trade is useful for the consumer because he gets an
idea of the price at which the commodity would be available at a future point of time. He
can do proper costing/financial planning and also cover his purchases by making forward
contracts. Predictable pricing and transparency is an added advantage.

Risks associated with Commodities Markets

No risk can be eliminated, but the same can be transferred to someone who can handle it
better or to someone who has the appetite for risk. Commodity enterprises primarily face the
following classes of risks, namely: the price risk, the quantity risk, the yield/output risk and the
political risk. Talking about the nationwide commodity exchanges, the risk of the counter party
(trading member, client, vendors etc) not fulfilling his obligations on due date or at any time
thereafter is the most common risk.

This risk is mitigated by collection of the following margins: -

• Initial Margins
• Exposure margins
• Market to market of positions on a daily basis
• Position Limits and Intra day price limits
• Surveillance

Commodity price risks include: -

 • Increase in purchase cost vis-a-vis commitment on sales price
• Change in value of inventory
• Counter party risk translating into commodity price risk

Current Scenario of Indian Commodity Market

The growth paradigm of India’s commodity markets is best reflected by the figures from
the regulator’s official website, which indicated that the total value of trade on the commodity
futures market in the financial year 2008/09 was Rs. 52.49 lakh crore (over US$1 trillion) as
against Rs. 40.66 lakh crore in the preceding year, registering a growth of 29.09%, even under
challenging economic conditions globally. The main drivers of this impressive growth in
commodity futures were the national commodity exchanges. MCX, NCDEX and NMCE along
with two regional exchanges – NBOT Indore and ACE, Ahmedabad – contributed to 99.61% of
the total value of commodities traded during 2008/09.
So far, this year’s volumes have seen a significant jump over the last year in agro-
commodities, as well as international commodities like gold, silver, crude oil and copper. More
than 100 commodities are today available for trading in the commodity futures market and more
than 50 of them are actively traded. These include bullion, metals, agricultural commodities and
energy products. Most importantly, an archaic market has suddenly turned into an organised,
service-oriented set-up with shooting volumes.
The unqualified success of the futures market has ensured the next step, i.e., the launch of
electronic spot markets for agro-products. Being in a time-zone that falls in the gap left by the
major commodity exchanges in the US, Europe and Japan has also worked in India’s favour
because commodity business by its very nature is a 24/7 business.
Innovation coupled with modern and successful financial market environment has ensured
the beginning of a success story in commodities which will eventually see India becoming a
price-setter in major commodities on the strength of its large production and consumption.

Performance Analysis of Indian Commodity Market

Commodity group-wise value of trading since 2004-05 is given in Figure 1.

 Figure 1

SOURCE: www.fmc.gov.in
The year 2003 is a watershed in the history of commodity futures market. The last group
of 54 prohibited commodities was opened up for forward trading. Prohibition on forward trading
was completely withdrawn, including in sensitive commodities such as wheat, rice, sugar and
pulses. These markets notched up phenomenal growth in terms of number of products on offer,
participants, spatial distribution and volume of trade.
Starting with trade in 7 commodities till 1999, the volume of trade has increased
exponentially since 2003- 04 to reach Rs. 36.77 lakh crore in 2006-07. Almost all of this (97.2%)
of this is now accounted for by the three national exchanges. The other 21 Exchanges have a
miniscule share in the total volume. There are more then 3000 members registered with the
exchanges. More than 20,000 terminals spread over more than 800 towns/cities of the country
provide access to trading platforms.
Although agricultural commodities led the initial spurt, and constituted the largest
proportion of the total value of trade till 2005-06 (55.32%), this place was taken over by bullion
and metals in 2006-07. The growth in 2006-07 was almost wholly (88.7%) accounted for by
bullion and metals, with agricultural commodities contributing a small fraction (10.7%). This was
partly due to the stringent regulations, like margins and open interest limits, imposed on
agriculture commodities and the dampening of sentiments due to suspension of trade in few
commodities. Futures market growth in 2006-07 appears to have bypassed agriculture
commodities.
Moreover, there has been a very significant decline in volume of futures trade in
agriculture commodities during the year 2007-08, by 28.5%. The overwhelming bulk of this
decline is accounted for by Chana, Maize, Mentha Oil, Guar seed, Potato, Guar Gum, Chillies
and Cardamom. Trade in these eight commodities, which accounted for 57.9% of total futures
trade in agricultural commodities in 2006-07, declined by over 66.4% during 2007-08 compared
to previous year. The decline in these eight commodities exceeded the decline of futures trading
volumes in all agricultural commodities taken together.
Four commodities (wheat, rice, urad and tur) were de-listed for futures trading towards
the end of financial year 2006-07. This de-listing has been held responsible in many circles for
the recent general downturn in futures trading in agricultural commodities. But these four de-
listed commodities together accounted for only 6.65% of the total value of futures trading in all
agricultural commodities in 2006-07. Thus, although this may have affected market sentiments
adversely, the delisting did not have any major direct contribution to the decline in trading
observed during 2007-08. The combined share of other food grains (i.e. wheat, rice, maize and
tur) peaked at 5.0% in 2005-06 and of sugar at only 2.2%.
Figure 2
SOURCE: www.fmc.gov.in

Figure 2 gives overall information of commodity market during year 2008-09 and 2009-
10. Here, for instance, during the year 2008-09 and 2009-10 from April to mid of May, the
market was moving almost parallel; with fall of 2% during commence of July, and 8% peak in
commence of September in 2009. Again in December 2009 there is a peak of 30% in the
commodity market. This is mainly because in this tenure, gold was at its top in the commodity
market. And the prices of gold touched pinnacle of 10 years of market.
Figure 3
SOURCE: www.mcx.com

Figure 4
Future Trading in Agricultural Commodity
SOURCE: www.fmc.com

Figure 4 is specific for agricultural commodity market. It shows market trend for the
years 2008-09 and 2009-10. In 2008-09 due to inflation in the world economy the market go to
the bottom of 12000 crore. And it has started gradually growing up till January and again it falls
down and goes up in March. If trends of April 2009 -10 is observed, in the mid of April there is a
peak and commodity market reach to 50,000 crore. Here market went up because of summer
harvest. Again at commence of August it is peaked up and cross the line of 60,000 crore. Then it
goes down due to draught condition. Again in the months of November, December 2009 it went
to peak and crossed the line of 70,000 crore which was the highest of 2 years, which was due to
better harvest of winter crops.

Problems faced by Commodities Markets in India

Institutional issues have resulted in very few deliveries so far. Currently, there are a lot of
hassles such as octroi duty and logistics. If there is a broker in Mumbai and a broker in Kolkata;
transportation costs, octroi duty, logistical problems prevent trading to take place. Exchanges are
used only to hedge price risk on spot transactions carried out in the local markets. Also multiple
restrictions exist on inter-state movement and warehousing of commodities.

Future Prospects
 With the gradual withdrawal of the Government from various sectors in the post
liberalization era, the need has been left that various operators in the commodities market be
provided with a mechanism to hedge and transfer their risk. India’s obligation under WTO to
open agricultural sector to world trade require future trade in a wide variety of primary
commodities and their product to enable market functionaries to cope with the price volatility
prevailing in the world markets.

Following are some of applications, which can utilize the power of the commodity market
and create a win-win situation for all the involved parties:-

 Regulatory approval/permission to FIIs to trading in the commodity market.

 Active Involvement of mutual fund industry of India.
 Permission to Banks for acting as Aggregators and traders.
 Active involvement of small Regional stock exchanges.
 Newer Avenues for trading in Foreign Derivatives Exchanges.
 Convergence of variance market.
 Amendment of the commodities Act and Implementers of VAT.
 Introduction of option contract.

Conclusion
India is one of the top producers of a large number of commodities, and also has a long
history of trading in commodities and related derivatives. The commodities derivatives market
has seen ups and downs, but seem to have finally arrived now. 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. The
management of price risk is going to assume even greater importance in future with the
promotion of free trade and removal of trade barriers in the world. All this augurs well for the
commodity derivatives markets.
As majority of Indian investors are not aware of organized commodity market; their
perception about is of risky to very risky investment. Many of them have wrong impression about
commodity market in their minds. It makes them specious towards commodity market.
 Concerned authorities have to take initiative to make commodity trading process easy and simple.
Along with Government efforts NGOs should come forward to educate the people about
commodity markets and to encourage them to invest in to it. There is no doubt that in near future
commodity market will become ‘hot spot’ for Indian farmers rather than spot market. And
producers, traders as well as consumers will be benefited from it. But for this to happen one has
to take initiative to standardize and popularize the Commodity Market.

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