The Commodities

The Commodities

The fundamental principles that underlie commodity futures trading and the function of commodity exchanges are centuries old. Markets had already attained a degree of formalization in ancient Greece and Rome with a fixed time and place for trading a marketplace, common barter and currency systems, and a practice of contracting for future delivery. The Agora in Athens originated as a commercial marketplace and later became the center of Athenian political and maritime power. The Forum in Rome was initially established as a trading center. At the height of the Roman Empire, 19 such trading centers, called Fora Vendalia (sales markets), served as distribution centers for commodities that the Romans brought from the far corners of the Empire.

MEDIEVAL MARKETS

Despite the fall of those civilizations, the basic principles of the central marketplace survived the Dark Ages, even though the widespread flow of commerce was disrupted. During feudal times, the scope of trading contracted into scattered local markets. The practice of preannounced markets at fixed times and places reemerged in the form of the medieval fair, arranged b the first trade associations formed by merchants, craftsmen, and promoters who organized regional fairs with the aid of political authorities. Pieds Poudres, or "men of dusty feet," as they were known, traveled from town to town arranging and promoting the fairs.
As trading practices became formalized in England, specialization developed. Certain fairs became the focus of trading between the English and Flemish, while others specialized in trade between English and Spanish, Italian, or French merchants. In 1215, the right of foreign merchants to travel freely to and from the fairs in England was established in the Magna Carta. In the 13th century, most trading at the fairs was spot (cash), for immediate delivery; but the practice of contracting for merchandise for later delivery, with standards of quality established by samples, had begun.

SELF - REGULATION ARBITRATION

In the 18th century, commodity exchanges followed some of the practices of the medieval fair in adopting rules for self-regulation and methods of arbitration and enforcement. The chief contribution of the medieval fair to modern commerce was the formalization of trading practices, which were codified and became known in medieval England as the Law Merchant. This code established standards of conduct acceptable to local authorities. In some cases, standards were minimal, but they formed a basis for common practices in the use of contracts, bills of sale and lading, warehouse receipts, letters of credit, transfer of deeds, and other bills of exchange. Any merchant who violated a provision of the code could be expelled by his fellow merchants. This principle of self-regulation was found in England’s Common Law, was followed in the American colonies, and was later adopted by the individual states.
The English merchant associations obtained the right from local and national political authorities to administer their own rules of conduct and established the courts of the fair, also known as the counts of the Pieds Poudres, to arbitrate disputes between buyers and sellers and promptly enforce their judgments with assessments of penalties and awards of damages. By the time these courts received full official recognition by English Common Law courts in the 14th century, their jurisdiction superseded that of the local courts.

EARLY COMMODITY MARKETS

The regional fairs declined in importance with improvements in transportation and communication and with the development of the modern city. Specialized market centers were developed in their place in many parts of the world. In Europe, these markets were variously called by the names Fourse, Boerse, Beurs, and in Spanish-speaking areas, Bolsa. The word comes from the surname of an 18th century innkeeper, Van der Beurs, whose establishment in Bruges, Belgium, became a gathering place for local commerce. Initially, these markets were held in the open air, usually in town squares. They later moved inside to teahouses and inns, and finally found more permanent locations of their own.

The development of the Bourses and Exchanges was not limited to England and Europe. At the same time, similar markets were formed in Japan and the United States. Japan’s commodity exchanges date to the 1700’s and preceded her securities markets by nearly a century and a half. This pattern is generally the reverse of that in Europe, England, and the United States, where securities markets usually predated commodity markets. Spot, or cash, trading in rice, the most widely used staple food in Japan, dates from the early 1700’s and forward contracting in rice on the Osaka Rice Exchange was legally recognized in 1730. Forward contracting is a transaction in which buyer and seller agree upon payment for and delivery of a specified quality and quantity of goods at a specified future date. Though there were as many as eight commodity exchanges in major Japanese population centers, the Osaka market was the largest. There were also Japanese markets for edible oils, cotton, and precious metals, though their trading volume was small in comparison with that for rice.

U.S. COMMODITY MARKETS

As early as 1752, there was an exchange in New York for trading in domestic produce. A series of small markets developed in New York and in other cities. While none of these markets exists today, they are the foundations for several of the present New York commodity exchanges. These early markets served other functions in addition to that of providing a place for trading. They attracted diverse business interests, brokers, ship owners, financiers, and speculators with risk capital, as well as primary producers and users of commodities.

The early commodity markets existed primarily for cash transactions with immediate delivery. They greatly enhanced the ease and scope of trade in all types of commodities - food and foodstuffs, textiles, hides, metals, and lumber. However, the practices of spot trading and forward contracting were not adequate to meet the problems of the sudden shifts in supply, demand and consequently, price that had always vexed producers of basic commodities.

SUPPLY / DEMAND CHAOS

In the early 1800’s, it was common for farmers to bring grain and livestock to regional markets at a given time each year. They often found that the supply of meat and grain far exceeded the immediate short-term needs of packers and millers. These processors, seeing more than adequate supplies, would bid the lowest price. Often, the short-term demand could not absorb the glut of commodities at any price, however low, and goods were dumped in the street for lack of buyers.

The marketing situation in Chicago was particularly aggravated by the lack of adequate storage and transportation facilities. Throughout most of the year, snow and rains made the dirt roads from country farmlands to the city impassable. Once the commodities reached the city, buyers were faced with the problem of inadequate storage space. Underdeveloped harbor facilities impeded the shipment of grain to eastern markets and the return movement of needed manufactured goods to western cities. The commodity exchanges, when they were organized, recognized the great need for improved transportation and storage and were a major force behind legislative efforts to improve rural roads, build inland waterways, and expand storage and harbor facilities. The exchanges made a particular contribution in leading the way to the establishment of accepted standards of grades and measures.

These efforts often bogged down in financial and legislative failure and the dismal marketing situation continued. The glut of commodities at harvest time was only part of the problem. Inevitably, there were years of crop failure and extreme shortages. Even in years of abundant yield, supplies were exhausted, prices soared, and people went hungry several months after the fall harvest and marketing of grain and livestock. Businessmen could be faced with bankruptcy because they lacked raw materials to keep their operations going. In this situation, the rural population, though having sufficient food for themselves, had crops they couldn’t sell, and therefore, did not have the income to pay for needed manufactured products - tools, building materials, textiles.

EMERGENCE OF FUTURES CONTRACTS

Imaginative men rarely tolerate such conditions for long. Some farmers and merchants had already begun to make contracts for forward delivery. This at least assured them of having a seller or buyer for their commodities. This practice of forward contracting was used in Chicago shortly after the city was founded in 1833. In 1848, a group of 82 men representing broad business interests formed the Chicago Board of Trade. Forward contracting, as well as cash trading, was practiced on the new Exchange. The problems of supply and demand were compounded by the Civil War. This stimulated the development of futures contracts.
Forward contracting solved the basic problem of finding a buyer for the seller and vice versa. It could, however, do nothing to control the financial risk that occurred with unforeseen price changes resulting from crop failures, loss of ships, inadequate storage and transportation, or economic factors. Hedging in futures developed to minimize pure risk.

Although most records were destroyed in the Great Chicago Fire of 1871, it is generally agreed that futures contracts were in use on the Chicago Board of Trade in the 1860’s.

FORMATIVE YEARS

The late 1800’s were critical years to the scope and efficiency of futures trading. In this period, trading practices were formalized and standardization of contracts, rules of conduct, clearing and settlement procedures were established by the exchanges. Representing the diverse economic interest of their membership, the exchanges became effective spokesmen for, and innovators of, improvements in transportation, warehousing, and financing, which paved the way to expanded interstate and international trade.

PRESENT

In the spring of 2008, commodities trader Chris Nygaard and his colleagues at Vermillion Asset Management were perplexed. Overseas, food riots were raging; in the U.S. big-box chain stores were rationing rice; oil was heading well north of $100 a barrel; and countless charts were showing the prices of virtually every hard and soft commodity setting new records.

Nygaard, the founding partner and co–portfolio manager of New York–based Vermillion, smelled a rat — and an opportunity. Futures prices for commodities were unfathomably higher than cash market prices, and old-fashioned supply-and-demand trading seemed to have vanished. Vermillion began putting on "calendar spreads," wagers on where prices of commodities and commodities futures would be in relation to one another on a month-by-month basis. It also placed bets on commodity options — mostly that a vast majority of them were extremely undervalued.

In time the firm was proved right, and though it came a bit too early to its assessment, the second half of 2008 made it look smart. According to investor documents, Vermillion’s flagship Viridian fund rose nearly 26 percent for the year, and its Indigo fund was up a little more than 35 percent.

Nygaard says that today a reversal is in progress. He thinks commodities are on the rebound but that they were overheated in March when the alarms were sounding on the models Vermillion uses to position and trade the more than $1.5 billion it manages in three commodities funds. Data from the Commodity Futures Trading Commission was showing speculator inflows in long futures contracts, signaling unsustainable extremes. So did a host of other indicators the firm monitors to figure out where price spreads and volatility are headed. No matter the commodity — corn, copper, cotton, oil, soybeans — the relationship between futures prices and real prices was bizarre. Measures of implied volatility on most options on futures contracts were off the charts, while fair-value pricing of extreme tail events — war, famine or some other cataclysm — was significantly below where it should have been. It was clear at the time, Nygaard says, that most commodities investors were mimicking one another and few were generating alpha. "Commodities were all going up or all going down on any given day," he notes.

It took a little more than four months for commodities to peak and then abruptly change course. But it had taken serious conviction to ignore the springtime chatter that the new global economy and the industrialization of China and the third world would make $200-a-barrel oil and $40-a-bushel wheat seem cheap (oil and wheat were at about $44 and $6, respectively, at the end of 2008). Prices for metals and timber were down by well over half by year’s end, with production across the board curtailed or shuttered. Farmers and distributors of grains, oilseed and corn were sitting on stockpiles they had thought they could make a killing on but had been unable to get out of the barn by the time winter had set in.

This, however, may not be the time to avoid commodities. "We are sticking to our knitting in terms of what is driving price moves, volatility and participants into and out of the market," Nygaard says. "Our approach this year is going to be more of a market-making approach as opposed to a market-taking approach. We are looking at providing liquidity to those looking to hedge within the commodities space."

How commodities prices grew so bloated so fast in 2008 only to come crashing back to earth is itself being hotly debated this winter. Some critics lump hedge funds into a collective basket of blame that includes the unschooled and marginally informed masses who sent commodities prices soaring the same way the public’s mindless and seemingly insatiable appetite for tech stocks fed the Internet bubble of the 1990s. But true commodities experts offer a less-simplistic explanation. They say the more recent bubble was fed by ignorance among professional investors, as many big players not well attuned to the commodities markets delved into an area way beyond their expertise.

Much of the trouble started with investable indexes like the Dow Jones-AIG commodity index and the S&P GSCI commodity index, which are made up of futures contracts. Even before commodities prices surged in early 2008, many money managers, including more than a few hedge funds, took the index route because it was an easy, cash-in-cash-out way to take advantage of big gains without having to know much about the commodities marketplace or its cycle. They also often lacked an offsetting hedge, which could have been as simple as buying into a less cyclical or more stable holding like Treasury bonds.

Of course, speculators appear in different guises. "First is hot money, which will chase anything that is moving," explains Brad Cole, founder and managing partner for Cole Asset Management, a Chicago-based, $100 million fund of hedge funds that invests in commodities-focused hedge funds and commodities trading advisors. "Second is institutional index buyers, who are really making a bet that commodities will outperform, diversifying their other holdings. Third is the hedge fund set, which should and generally does show discipline." The latter group fared better than the first two, Cole says, because hedge fund managers largely understand the fundamentals of the commodities they are trading and employ risk management.

Keith Black, an associate at Chicago-based Ennis Knupp & Associates, which advises clients on the management of some $820 billion in institutional assets, says neither institutional investors nor hedge funds are to blame for the rise and fall in commodities prices. As investments in commodities futures surged from $36 billion for all of 2004 to $240 billion in the first quarter of 2008, they still represented only 3.7 percent of global production of energy and 8.1 percent of the world production of food and fiber, by Black’s calculations.

Even more telling, he notes, were price movements in commodities that do not trade as futures contracts — iron ore, for instance, whose price has doubled every year for the past five years. Indeed, Black and others point to the markets themselves and the fact that supply-and-demand expectations led producers to increase output and expect higher prices than market fundamentals could justify — long before the surge of institutional or speculative money into futures and indexes.

"A year ago Russia was trying to create an OPEC for wheat," Nygaard says. "Today their exporters are demanding subsidies because they have grown so much they can’t get rid of it."

Speculative investors missed the supply-and-demand disconnect. "At the height of all this," Cole explains, "you had currency traders trading crude, equity traders trading corn, energy traders trading gold and agriculture — there was little correlation between expertise, price and potential risk-reward, which is a classic sign of a bubble."

Many investors, including more than a few hedge funds, are paying a high price for jumping into the commodities fray. A group of Toronto-based firms — Sprott Asset Management, Front Street Capital, Epic Capital Management, Dynamic Funds and Salida Capital — many of which bought long commodities indexes as well as the resource-heavy S&P/TSX index, suffered big declines.

Bigger firms, like New York–based Fortress Investment Group, also missed the reversal. Fortress, which had $16.4 billion in assets at the end of 2007, posted a net loss of $57 million for the third quarter as investors filed requests to pull $4.5 billion from its hedge funds. That included $900 million in redemption requests from Fortress global macro and commodities holdings. New York–based Ospraie Management was hurt by its leveraged bets on commodities-related equities, ultimately prompting the firm to announce in September that it was closing its once–$3.8 billion flagship fund. Still, many hedge funds and certainly many CTAs prospered alongside firms like Vermillion, believing that commodities must be meticulously hedged.

By New Year’s day, however, the allure of commodities was unmistakable again. "I have not seen an environment where investing in commodities and underlying sectors has looked so promising," says Donald Lindsey, chief investment officer of Washington-based George Washington University and overseer of its $1.1 billion endowment, 2 percent of which is invested in commodities. "The supply constraints — the long-term view that there isn’t enough oil and gas and farmland and fuel — never went away, and now stocks of some commodities-focused companies are trading at less than the cash on their balance sheets. It is absurd."

Lindsey, who declines to say which companies he likes, intends to increase the endowment’s broad commodities allotment in 2009 — mainly because he expects the world to be more supply-constrained once it emerges from recession. "We will be looking across a wide range of hard assets, including traded and nontraded commodities, as well as global infrastructure," he says.

Although the outlook is still far from clear on oil, gas, metals and food commodities, investors are considering alternative commodities like power generation, nontraded commodities such as water and even construction commodities related to infrastructure build-out, which most say will be the force behind any rebound in global growth over the next few years.

Of course, some hedge funds and certainly many CTAs are still basking in their commodities-investing success last year. The Barclay CTA index was up 13.23 percent in 2008, its best year since 2002. The most diversified CTAs showed the best returns; a Barclay CTA subindex called the diversified traders index was up 25.5 percent.

This year the key for commodities investors may be figuring out where in the cycle various commodities lie, and what the supply-and-demand curve will look like when credit markets return to normal and the global economy rights itself, and if global deflation is averted. Many are looking to the end of 2009, when government spending and near-zero-percent interest rates may finally create a turnabout. "There is a tremendous amount of extreme pessimism priced into the market right now that is signaling not just a recession but a potential depression," says David Abramson, a senior commodities and energy analyst at Montreal-based BCA Research.

One clear example is in the so-called petroleum crack spread — the difference between productions costs and market prices. By the end of 2008, the crack spread of gasoline rested at about negative $5, "meaning producers are losing money hand over fist on every barrel of gasoline they produce," says Abramson. "The only way you could bet that kind of contagion scenario is sustainable is if you expect the world to stop driving."

Similar theories apply to other commodities. The key to smart buying or selling will be in determining how much time it will take to get through excess capacity, as well as how long producers — particularly of oil, gas and metals — will continue to limit production.

If vast government stimulus plans in China, Europe and the U.S. do what they are supposed to do, most expectations are that the global economy will recover in the next 12 to 18 months, and demand for commodities will rebound. Indeed, longer term, the biggest issue will be whether supply can keep up with demand, Ennis Knupp’s Black argues.

David Morton, a consultant and commodities expert at Norwalk, Connecticut–based Rocaton Investment Advisors, also expects the case for commodities to improve this year, especially given their historical tendency to offer returns that don’t mirror the equity and bond markets and in view of current prices. "The lesson, if any, is that commodities are part of a different, complex market with different factors and mechanisms that bear little resemblance to price-earnings ratios or ratings, coupons and yield curves," he says.

Nygaard points to another important lesson to be learned from recent events. "Many hedge funds became something other than hedge funds over the past few years — they became one-way, levered long-beta bets," he says. "That is great when times are going well and the directional tide keeps rising, but not when there is extremely high volatility and the markets inevitably go down."

THE FUTURE OF COMMODITIES’ CONTRACTS

Across the world commodity trading activity takes place on a range of modern, regulated commodity exchanges. A wide range of commodities will be traded between end user buyers and producer sellers under the umbrella of standard contract rules and commodity trading regulations.

In effect world commodity exchanges facilitate the buying and selling of raw commodities ranging from crude oil, copper and wheat to platinum and orange juice.

Some commodities such as crude oil and coffee futures have been traded for a considerable long time in mature markets, but now in the early years of the 21st century we are seeing new markets and futures contracts being introduced.

These more exotic commodity classes include carbon in the form of emission permits. With the growing concern about the serious environmental threats from climate change caused by greenhouse gases, a rapidly growing market has developed in emissions permits, a form of activity known as carbon trading.
For the foreseeable future it is likely we will see continual growth of markets which place a price on the environment, with further development in emissions, plastics and perhaps even water.

The basis of commodity trading activity is the buying and selling of futures contracts for a whole range of commodities. While the nickel or cocoa producer will use commodity futures contracts to hedge their future sales, commercial end users will also use these contracts for hedging against sudden spikes in prices.
Yet these two actors in the commodity markets are dwarfed by the high activity levels of speculators or traders who move in and out of the markets trying to make profits.

A futures contract represents a specific type of contract either to buy or sell a specified quantity of a commodity at a price determined by supply and demand at time of contract, at an agreed date in the future.

Across the time zones of the world there are commodity traders active in the markets either using an electronic trading platform or on the floor of an exchange, called open outcry. Over recent years the volume of electronically traded futures contracts has increased significantly, as a number of exchanges have combined to form a super commodity exchange.

Inevitably, with the access afforded by the internet, a combination of an accessible online trading software package and up to date market data, commodity trading has gradually become more available to the retail speculator, who will usually trade with smaller amounts of capital.

Some traders will prefer to focus on a specific area of the commodities markets, while others look more at the price action and do not worry unduly about the fundamentals of supply and demand for raw materials or food.

With the opening up of the emerging market economies such as Brazil, Russia, India and China (or BRIC countries), we are likely to see a continuation of the growth in commodity markets in these nations. For example, Dalian Commodity Exchange in China has ambitious plans to develop beyond its current specialism in agricultural commodities, and move to industrial metals and more.

While in the Middle East, Dubai is a growing financial centre and the Dubai Gold and Commodities Exchange has an interesting product range including WTI light, sweet crude oil, steel, plastics, gold and silver and the Indian Rupee.

While the world economy has suffered some serious shocks following the credit crunch and slowing rate of growth, with a number of companies and even some countries getting into serious financial difficulties, commodities as an asset class would appear relatively unimpaired.

Despite the short term difficulties, the global economy will continue to rely on key commodities such as crude oil, steel and copper, as well as basic softs like sugar, cotton and coffee, not to mention grains such as wheat, corn and rice.

Bibliography

*History of Commodities-Futures Technology,1630ª 30th St
  Nº 365,Boulder,Colorado 80301-1-800-878-6070 and 303-442-6543,United
  States.
*Alpha Newsletter Online,March 25,2009.
*Ezine@rticles

Author:Dr Omar Gómez C,Senior,Ph.D.Post-Doctorate in Management of the Organizations from URBE,Maracaibo,Estado Zulia,Venezuela.Ph.D in Business Administration in Business Management from University of Aberdeen International,South Dakota,United States.Ph.D in Political Economy from Thomas Alva Edison College,United States.Economist from Universitatis Sancti Pauli Sigilium,Geneva,Switzerland