Commodity market is a place where trading in commodities takes place. Markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized Contracts. It is similar to an Equity market, but instead of buying or selling shares one buys or sells commodities.
Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded. It is important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market.
In current situation, all goods and products of agricultural (including plantation), mineral and fossil origin are allowed for commodity trading recognized under the FCRA. The national commodity exchanges, recognized by the Central Government, permits commodities which include precious (gold and silver) and non-ferrous metals, cereals and pulses, ginned and un-ginned cotton, oilseeds, oils and oilcakes, raw jute and jute goods, sugar and gur, potatoes and onions, coffee and tea, rubber and spices. Etc.
Commodity Market Structure
The structure of commodity markets dictates that there are several types of participants active in the trading of commodities and commodity derivatives. The structure of the participants and the nature of their activities/motivations are more complex than in other asset classes.
The major participants in commodity markets include:
1. Commodity Producers/Consumers
These participants have natural underlying outright long (producers) and short (consumers) positions in the relevant commodity. The inherent risk-exposure drives the use of commodity derivatives by producers and users.
The application of commodity derivatives in frequently driven by the pattern of cash flows. Producers must generally make significant capital investments (sometime significant in scale) to undertake the production of the commodity. This investment must generally be made in advance of production and sale of the commodity. This means that the producer is exposed to the price fluctuations in the commodity.
If prices decline sharply, then revenues may be insufficient to cover the cost of servicing the capital investment (including debt service). This means that there is a natural tendency for producers to hedge at levels that ensure adequate returns without seeking to optimize the potential returns from higher returns. This may also be necessitated by the need to secure financing for the project.
Consumer hedging behavior is more complex. Consumer desire to undertake hedges is influenced by availability of substitute products and the ability to pass on higher input costs in its own product market. In many commodities, producer and consumer deal directly with each other. The form of arrangement may include negotiated bilateral long term supply or purchase contracts between the producers and consumers. The contracts may include fixed. Price arrangements to reduce the price risk for both parties.
These arrangements create a number of difficulties. These include lack of transparency, low liquidity and exposure to counterparty credit risk. The bilateral structure also creates potential adverse performance incentives. This reflects the fact that the contracts combine supply/purchase obligations and price risk elements in a single contract.
2. Commodity Processors
These participants have limited outright price exposure. This reflects the fact the processors have a spread exposure to the price differential between the cost of the input and the cost of the output. For example, oil refiners are exposed to the differential between the price of the crude oil and the price of the refined oil products (diesel, gasoline, heating oil, aviation fuel, etc.). The nature of the exposure drives the types of hedging activity and the instruments used.
3. Commodity Traders
Commodity markets have complex trading arrangements. This may. include the involvement of trading companies (such as the Japanese trading companies and specialized commodity traders). Where involved, the traders act as an agent or principal to secure the sale/purchase of the commodity. Traders increasingly seek to add value to pure trading relationship by providing derivative/risk management expertise. Traders also occasionally provide financing and other services. Commodity traders have complex hedging requirements, depending on the nature of their activities.
A trader as a pure agent will generally have no price exposure. Where a trader acts as a principal, it will generally have outright commodity price risk that requires hedging. Where traders provide ancillary services such as commodity derivatives as the principal, the market risk assumed will need to be hedged or managed.
4. Financial Institution/Dealers
Dealer participation in commodity markets is primarily as a provider of finance or provider of risk management products. The dealers’ role is similar to that in the derivative market in other asset classes. The dealers provide credit enhancement, speed, immediacy of execution and structural flexibility. Dealers frequently bundle risk management products with other financial services such as provision of finance.
This covers financial investors seeking to invest in commodities as a distinct and a separate asset class of financial investment. The gradual recognition of commodities as a specific class of investment assets is an important factor that has influenced the structure of commodity derivatives markets.