Physical markets: Explaining their role in the value chain

1. S ETTING THE SCENE : T HE STRUCTURE OF COMMODITIES MARKETSCOMMODITIES MARKETS

1.2 Physical and futures markets

1.2.1 Physical markets: Explaining their role in the value chain

Physical markets bring together buying and selling interests in the physical commodity to level supply and demand imbalances, taking into account immediately available inventory levels. The spot price is the price of a commodity that is readily available to be delivered. The spot price at any time t (

) is mainly influenced by the equilibrium between supply and demand, which drives changes in inventories (available stocks).

Net demand

Net demand (∆N) is the difference between supply X and demand Q, which are influenced by currently available market prices and demand/supply endogenous and exogenous factors (such as technological improvement in production and weather conditions). Changes in net demand affect levels of inventories, which ultimately determine the spot price. If there is more production than demand, inventories will increase so markets will get more supply and prices will go down, and vice versa if demand is higher than supply. Net demand represents a de facto indicator of inventory variations.

Figure 1 illustrates an example of the structural impact of inventories on spot prices (Pyndick, 2001). Let’s assume that there is a long period of drought in the United States, which reduces the amount of corn crops that can be harvested.³ This would imply that to keep the current level of demand, sellers of corn would need to reduce their available inventories to cope with lower-than-expected production.

Figure 1. Impact of inventories on spot prices

Source: Author.

With the gradual reduction of inventories, the line representing all demand/supply equilibria for different prices (but the same level of inventories) will shift upwards and prices will initially increase to . Initially at , ∆N<0, i.e. demand is still higher than current supply. If the drought

3 The United States is one of the biggest producers in the world.

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₂

continues and the supplier cannot produce more, the price will stabilise at a higher level ( ) with lower levels of inventories but demand and supply in equilibrium (∆N=0). If the drought stops and production recovers in time, the production of corn crops will increase and the price will drop until the net demand is equal to zero, again at .

1.2.1.1 The fundamental role of inventories

Inventories are the first real barrier against market prices fluctuations. Inventories minimise the costs of adjusting production due to foreseeable (e.g. demand volatility or increases in the marginal cost of production) and unforeseeable (e.g. weather shocks) market circumstances. Inventory levels keep demand and supply in equilibrium over time. In addition, they reduce marketing costs by facilitating production and delivery schedules (Pyndick, 1994; 2001). Inventories also reduce the impact of unpredictable disruptive events, working as a buffer against exogenous factors. As a consequence, the main drivers of inventory levels may vary depending on the type of commodity. For metal (and perhaps energy) commodities, inventory levels are primarily affected by the business cycle, mainly through GDP levels (Fama and French, 1988). When a peak in demand comes, inventory levels go down drastically to absorb the adjustment of production, and vice versa. For seasonal commodities such as food and agricultural commodities, however, weather changes may have important effects on inventory levels by affecting the productivity of the harvest season. In both cases, changes in the inventory levels have immediate effects on spot and futures prices, which react differently to the high or low level of inventories (Fama and French, 1988; Section 1.2.4 of this report).

Furthermore, inventories need to be properly managed because they have explicit and implicit costs of storage that will ultimately affect production costs. If released too quickly into the market, inventories can cause excessive supply and a drop in spot and futures prices. Management of inventories is a key risk management process for commodities firms.

Carrying a commodity (storage) over time has three main costs:

 Costs of physical storage (and insurance).

 Opportunity costs. degradation. The storability of the commodity may be fairly limited – green coffee beans can only be stored for few months before losing their original properties, for instance. Another important cost of storage is the opportunity cost of carrying a commodity over time, which includes the interest foregone by not investing the capital in risk-free instruments instead of in the commodity. The central bank’s nominal interest rate is usually considered as point of reference to calculate foregone interest.

Current and future rates of consumption, as well as price volatility, are elements that contribute to the cost of carry, but they may not be easily predicted. A third element is the potential cost (or benefit) if prices move against the commodity holder, in particular if the future spot price will be below expectations. In effect, expectations about spot prices are part of the storage costs internalised through futures prices. This cost can usually be efficiently hedged in the derivatives markets.

As already mentioned, storage levels change vis-à-vis changes in net demand levels (i.e.

differences between supply and demand), N=X-Q. Net demand and thus storage levels are affected by the three costs mentioned above, which are main components of the marginal convenience yield (MCY), Ψ. The MCY represents the cost of carry for a commodity, i.e. the benefits of holding a commodity. The higher the MCY, the more negative the difference between futures and spot prices (‘backwardation’, i.e. spot prices are higher than futures prices), as the pressures to hold the commodity rather than buying a futures contract are higher.

Ψ=f(N,σ, r, p, ε)

The function Ψ, representing the marginal convenience yield, is affected by a key endogenous variable, i.e. the level of net demand N, the evolution of supply (production) and demand

P

(consumption).⁴ Other (exogenous) variables that directly impact levels of inventories, and so MCY, are σ, r, p, ε, which cause a shift in the curve of the Ψ function. Price volatility σ has a positive relationship with inventory levels. The higher the volatility, the greater the protection requested, through higher inventory levels, by market participants. Inventories are the link between volatility and spot prices in the future, through the impact of current spot prices on inventory levels.⁵ Risk-free interest rates r affect the cost of carry of a commodity with a positive sign. The lower the interest rate, the smaller the cost opportunity to exploit potentially higher spot prices in the future. The expected spot price p affects the current and future rate of consumption, and so the inventory levels will shift accordingly. Other exogenous variables that may affect inventories, such as problems with the operational aspects of storage, can cause a shift of the MCY curve as well.

The MCY can be therefore represented (Pyndick, 2001) by,

Ψ = (1+ ) -[ ( ) + ] + (1)

where (1+ ) is the opportunity cost of investing money in other assets, [ ( )+

] is the future spot price at T (usually represented by the price of a future contract at time T), which is composed of the expected future spot price at time t (now), plus the value added of holding a commodity rather than an alternative investment. The , so called ‘risk-adjusted discount rate’ (Pyndick, 2001), measures the excess return of a commodity over an alternative risk-free investment. It can be derived from equation (1), i.e.

= (2)

where is the price of a future contract with delivery date T. In addition, from equation (1) we can derive the dividend yield of a commodity, which is

(3) The dividend yield of a commodity is the return of carrying the commodity, minus the cost of physical storage, which unlike bonds or equities may be also negative. Further analysis of the interaction between spot and futures markets through inventories will be discussed in Section 1.2.4.

As shown above, inventories and supply/demand factors show strong links with spot prices.

Empirical evidence confirms the significance of the link between prices and inventories over time and the sign of the relationship. Higher inventory levels put downward pressure on prices, and vice versa (see also the following chapters). As examples, let us consider two important commodities – corn and copper. For corn, we take annual data in logarithms for beginning stocks⁶ and real prices⁷ from 1960 to 2011. The data confirm a strong negative correlation (ρ=-85%) between spot prices and inventory levels, even though the coefficient is low (i.e. the impact of the variable is somewhat limited). This is particularly the case for commodities that are subject to seasonal patterns and so to exogenous shocks, such as weather-related events, which can materially affect the supply of the product.⁸

4 We refer to actual production and consumption, rather than expectations.

5 This finding is confirmed by the extensive empirical analyses run in the following chapters on the single markets and summarised in the last chapter.

6 We used beginning stocks (ending stock lagged of one period) rather than actual ending stocks because this data may feed better into price expectations. Estimations with ending stocks, however, are not significantly different from results with beginning stocks.

7 Real prices are calculated with 2005 GDP deflator based on data from 15 countries.

8 For a more detailed analysis of fundamental drivers of supply and demand, see following chapters.

r

P

E

P

( r

 

) P

k

Figure 2. Link between real spot prices and inventories for corn, 1960-2011

Sources: Author’s estimates from US Department of Agriculture (USDA) and World Bank.

Note: Natural logarithms.

The relationship with underlying spot prices is confirmed even when taking into consideration the size of global ending stocks over global consumption (stock-to-use ratio). Demand affects underlying prices by reducing the inventory levels, waiting for the production to adjust over time.

By adding consumption data, the relationship suggests a greater impact on prices but it explains less. As it is generally the case for agricultural commodities, demand does explain a great deal of price movements, but factors that constrain supply and ultimately impact on inventory levels, such as weather-related events, may often dominate price patterns.

Figure 3. Stock-to-use ratio and real prices for corn, 1960-2011

Sources: Author’s calculation from USDA and World Bank. Note: Natural logarithms.

Continuous interaction between inventories and production/demand determines general price trends. However, inventories are not always available if, for example, the product degrades quickly (or cannot be stored, as with electricity) or costs of production are high (due to fixed costs) and producers cannot increase capacity in the short term. For commodities that are not subject to seasonality, such as industrial metals, storage is less costly and consumption is fairly predictable. In this case, inventory levels generally play a more limited role and typically form a smaller fraction of

total production, while external shocks to supply can have a strong impact. As production can only adjust slowly over time due to high fixed costs of increasing scale, however, consumption is also a key driver of price formation.

Annual data for LME copper (1992-2011) shows a weaker link between LME inventories⁹ and LME real prices (Figure 4).

Figure 4. Link between inventories and real spot prices for copper, 1992-2011

Sources: LME, World Bank. Note: Natural logarithms.

As mentioned above, the complexity and costs of the production process for industrial metals, coupled with a fairly predictable demand, keep the absolute value of inventories very low in relation to total consumption (left-hand panel, Figure 5). Incentives to ‘produce and store’ may cause oversupply and so the supply side keeps a tight control over production and, thus, inventories. This limits the impact of inventory holdings on prices.

Figure 5. Real prices link with copper inventories and consumption, 2000-2011

Sources: World Copper Association (WCA), World Bureau of Metal Statistics (WBMS), LME, World Bank.

When taking into account the impact of consumption on global ending stock (stock-to-use ratio), however, data show that consumption has a major impact on prices, which have a negative correlation (-74.64%) with stock-to-use ratio over the sample (as shown by the left-hand panel of Figure 5). This preliminary analysis confirms that commodities may have common drivers of price

9 The study uses the words ‘inventories’ and ‘stocks’ as interchangeable.

3.80

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Global ending stocks/consumption Real prices ($MT, rhs)

formation, but the impact of each driver on price patterns may be completely different depending on the type of commodity being analysed. A generalised approach across commodities, even with sophisticated statistical models, may be therefore unable to capture the significant divergences among commodities and their product characteristics. Following chapters present more detailed empirical analyses of drivers of price formation looking at each commodity market covered by this report.

For commodities that cannot be stored, such as electricity, there are no inventory levels that can smooth the impact of supply and demand imbalances on market prices. However, the use of derivative contracts (such as futures) can help to smooth volatility (see Section 1.2.2). With no inventories, it is typically difficult to build an open spot market because it requires high liquidity and a high number of participants. The inability to create such a market typically encourages long-term contracts between the supplier and the end user for quantities that may vary within a specific range agreed ex ante.

A second factor that has a strong impact on spot markets is ‘seasonality’. For agricultural commodities, seasonal factors affect volumes and timing of production and distribution of products.

In effect, production can only take place at a specific time of the year. Therefore, if external factors – such as dry weather – emerge, the impact on prices can be devastating if demand remains stable.

Wheat, for instance, can be harvested from May to September in all different quality grades. Anything that affects the plantation during the autumn or the harvest from May to September can have an immediate impact on prices, which can have long-term effects if this impact is prolonged and inventories are not large enough or cannot store wheat for long periods.

1.2.1.2 Physical markets organisation and reference prices

Physical markets can be mainly organised in two ways: as auction markets, or bilateral markets.

Auctions bring together multiple buying and selling interests in a centralised and open platform, whereby interests interact through ex- ante transparent prices. The platform can be organised with a system of warehouses and depository receipts for each purchase, a standardised contract (ex ante information about quality and quantity of the commodity for each contract), and a clearinghouse that minimises counterparty risks in order to increase liquidity and attract key players at the global level.

This platform is generally called ‘exchange’. Exchanges typically act as ‘riskless counterparties’, i.e.

they do not use own capital to interpose itself and facilitate market transactions.

Exchanges differ from regional physical markets, which are small markets with limited size.

Small physical market hubs have limited storage capacity and are able to serve only specific, small areas. They can be even pure auction mechanisms, which differ from a centralised exchange since no clearinghouse would interpose itself between the two parties and transactions may be customised and/or occasional. These market hubs are close to pure bilateral markets, which are typically over-the-counter spot or forward contracts between a producer and an end user. Bilateral transactions can be also drafted as long-term contracts (LTCs), with agreement over long-term provision of a commodity (still frequently used in markets such as iron ore). These contracts are highly customised transactions to support hedging strategies, and are often complemented by transactions in open auction markets. Depending on the nature of transaction, whether it is to exchange cash flows or a physical commodity, an intermediary (respectively an investment bank or a commodity trading house) may also interpose between the two parties to facilitate the customisation of the transaction, even if this requires the direct holding of a commodity.

Spot physical markets can therefore have three different price settings:

1. Spot physical transactions (bilateral or through auctions).

2. Cash forward market with short-term delivery (bilateral or through auction if standardised).

3. Cash rolling front-month futures market (auction).

The pure spot physical markets are mainly regional hubs, bilateral transactions or any other market that provides the commodity on the spot, i.e. delivery is immediately after the transaction is concluded. These markets are typically not fully developed, since the immediate delivery of the product for large players cannot physically be done on the spot and requires a proper and efficient system of warehouses. These regional markets are decentralised and do not necessarily act as a riskless counterparty. They may, in fact, mix centralised transactions and over-the-counter bilateral negotiations, which may even involve risk capital of the market infrastructure.

The vast majority of international physical markets work as a cash physical forward market. A cash forward market is a cash physical market with physical delivery linked to the characteristic of the product. For some industrial metals, it may even go down to T+2 or T+3, while for agricultural commodities it would be closer to harvesting season. For instance, the London Metal Exchange offers this kind of forward market for metals, and in particular for aluminium and copper which are considered in this study, because of its widespread network of warehouses across key regional areas (742 sponsored warehouses in 14 countries¹⁰). The LME forward prices have thus become reference prices for several industrial metals in bilateral transactions.

Lastly, the rolling front-month futures contract is not strictly a physical market, but its price is very close to the underlying physical market because it is based on a futures contract that is deliverable at an imminent maturity (generally, up to three months). This means that market arbitrage pushes the price of the contract close to the underlying physical market price at maturity because it becomes a deliverable contract. It is typically the first futures contract available for delivery in the upcoming month, and is the futures contract with the shortest delivery date. It can be physically delivered or closed-out with an offsetting transaction before delivery. However, the front-month price would never have a perfect correspondence to a specific physical spot price, since differences in quality and location of delivery with the cash physical market need to be discounted in the final prices.

Reference prices

A benchmark (or reference) price is a price recognised by parties as fair for their bilateral transactions (Clark et al., 2001). The growth of multiple global liquid exchanges has increased the availability of liquid reference prices, which have promoted a more competitive environment, as markets that have been historically dominated by cartels or by a dominant producer are replaced by new and more competitive market settings. Even though the historical tensions in market structure between liquidity fragmentation and competition (market fragmentation) may emerge, ‘liquidity’ is the crucial aspect for a market price to become the reference for thousands of bilateral commodities transactions in the first place. Benchmark or reference prices usually differ by region. For instance, the West Texas Intermediate crude oil price used for North American production and distribution through pipelines (but also for bilateral contracts) is different from the Brent crude oil price, which is used more for European and Middle East benchmark prices, as well as for seaborne crude oil. The divergence between the two prices (spread or basis¹¹) takes into account regional differences that the benchmarks represent, in terms of costs of transport, storage, delivery, and availability of the product. These aspects apply to all benchmark prices that have acquired a broader regional status over the years.

The rolling front-month futures price is often considered as a useful proxy for physical markets prices across commodities, even though cash forward auctions (e.g. for industrial metals) and benchmark regional spot market (assessed) prices (such as Dated Brent) are an important part of the market. Liquid reference prices are not available in every commodities market, however. For instance, even though spot regional prices have become available recently, iron ore has been until recently priced through LTCs between producers and users yearly revised in bilateral negotiations. The calculation of price in LCTs may also rely on external benchmarks, such oil-indexed prices for pipeline gas (see section 3.1). The reasons for the existence of less developed markets can be multiple. For instance, the high costs of production may induce the seller to link herself to a specific counterparty

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