International Business Environment

Group Assignment
Industry Analysis: Commodity Futures
Submitted by:
Gautam Jain(Pgp30076)
Priyanshu Jain(Pgp30095)
Sonali Gupta(Pgp30107)
Submitted to:
Prof. K. G. Sahadevan
IIM Lucknow
February 2015

The report entitled Industry Analysis: Commodity Futures is the original work carried out by
Gautam, Priyanshu and Sonali and no part of report is copied from other published/unpublished
sources

Table of Contents
Executive Summary............................................................................................... 2
Introduction........................................................................................................... 3
Reforms in commodity futures industry post liberalization.....................................................4
Porter five forces Model............................................................................................... 4
Bargaining power of Suppliers..................................................................................... 4
Threat of new entrants............................................................................................... 5
Threat of Substitutes................................................................................................. 7
Bargaining Power of buyers........................................................................................ 8
Intensity of Rivalry.............................................................................................. 9
Infrastructure................................................................................................... 9
Technology...................................................................................................... 9
Brokers Community......................................................................................... 9
Current Market Scenario:............................................................................... 10
References........................................................................................................... 11

TABLE OF FIGURE

Figure 1Market Share Distribution amongst various Indian Commodity Exchanges

.............................................................................................................................. 6
Figure 2: Regional distribution of commodity futures exchanges........................10
Figure 3: Market share split..................................................................................10

Executive Summary
India is the worlds leading producer of numerous commodities, which has
holds an important role in defining a balance in the economy. The
commodity futures trading in India has witnessed exponential growth of
around 50-60% since the inception of electronic-trading in 2003. Still, the
industry faces numerous challenges and with the imposition of new tax
rules (Commodity Transaction Tax) as well the 5600 crores payment crisis
(NSEL Scam) can act as a setback in the future growth of the industry.
The report is a vivid description about the fundamentals of the commodity
futures industry with a detailed description about the stakeholders
involved in it. The major reforms brought in by the government to regulate
fair and transparent trading practices. The primary objective for the
trading is price discovery as well as use hedging and speculation practices
to provide liquidity to the market. Currently, the market has an
oligopolistic structure with MCX having captured more than 80% of the
market share. The differentiation achieved by this exchange is through
trading of global commodities in large volumes.
The later part of the report deals with the detailed industry analysis
though analyzing the value chain that includes buyers and suppliers. The
competitive nature of the market is observed gaining insights about the
impediments to entrance in the industry. Similarly, the current threats
faced by the industry from new exchanges establishments and
competitive firms that supply substitute products are analyzed in detail.
The major challenge still faced is to get higher participation of farmers in
the industry and bring about innovative designs in the development of the
market.

Keywords: Commodity, Exchanges, Price-Discovery,

Bullions, Agri-commodities, Spot, Futures

Reforms,

Introduction
The commodity futures are the contracts between the two parties to buy/sell a particular
quantity of commodity on a future date at a predetermined price. The party buying the future
contract is said to have long position in the future contract and the party selling the contract is
said to have short position in the future contract. The contracts are made generally for
standardised quantities and standardised quality commodities. These are traded in commodity
future exchanges.
The buyers are generally of following types:
Hedgers: These are the businesses which will use the commodities for their businesses and
their main objective is to lock the favourable prices for the commodities so as to avoid loss
due to price fluctuations because of bad weather, political disturbances, government
intervention etc. They only try to reduce the risk involved with the adverse price change.
Speculators: These trade for making profits and with no intention of using these commodities
for any business activity. These closely watch the market so as to use the small fluctuations
for their benefits by buying and selling at low and high price respectively. In theory, the main
objective of the speculators is to bring the liquidity into the market so as to make it function
smoothly.
Arbitrageur: These trade in the risk free contracts. When markets are imperfect, they buy
from one market at lower price and sell in the market with higher price, earning risk free
profits
The futures buyers do not pay the entire amount at the time of contract but they only pay a
part of the amount known as the margin payment. The eventual settlement does not include
actual delivery but includes the payment of difference between the amount of current spot
price and the contracted price on the date of expiry.
The commodities which are suitable for the future trading are as follows:

The commodity should have a suitable demand and supply condition.

Prices should be volatile enough to have a significant demand for future to hedge the
risk of price fluctuation in spot market.
The government regulations should be minimum which can restrict the price thus
supply and demand.
The commodities should have a measurable quality which can be compared against
some standard because the commodities traded with the future contract should have
some quality
The commodity should be storable otherwise the hedging of risk between the future
and spot market will not be possible.

The trading of futures has been an integral part of Indian derivative market and the first
derivative market was setup in Mumbai in 1875 to trade cotton futures. This was followed by
future markets of edible oil seeds, raw jute, jute goods and bullion. In the early independence
era, the scarcity of food forced the Indian government to restrict the commodity trading. After
adoption of the constitution of republic, a central legislation was passed known as Forward
Contract act in 1952, which crushed the commodity market prohibiting the cash settlement of
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the commodities future. Under this act, trading of the contracts was allowed through the
recognised exchanges and more regulations were imposed by forming the Forward Markets
Commission. The commodities were notified for prohibition under this act which left only a
handful of insignificant commodities available for trade. For almost four decades, the futures
market remained dormant in spite of few attempts to revive the commodity futures market but
in 1993 a committee was setup to examine the scope of commodity trading.

Reforms in commodity futures industry post liberalization

1994: As per the recommendation of kabra committee, commodity futures market

went open for 17 commodities but did not favour the same for other commodities like
pulses, tea, maize, coffee, sugar and others due to their unstable market. These were
termed as sensitive items and their trading was banned.
2001: The Guru Committee expressed the role of futures markets as a medium for
marketing agriculture products as well as for price risk management. The medium will
be supportive for farmers to make an informed, rational decisions to get appropriate
price and participate directly in the market to prevent price risks
2003: The market got a boost with the opening of future markets for 54 commodities
including sensitive items and platforms were established for electronic trading giving
organized structure to the industry
2007: Irregular rise in prices of agriculture commodities like urad, wheat, rice and tur
developed suspicion among government officials causing their delisting from the
market. This was done to curb the rise in inflation caused due to price increase in
essential commodities.
2008-09: Almost all the bans were uplifted for agricultural commodities with a count
of 95 commodities trading in future markets
2013: Government levied a Commodity Transaction Tax (CTT) of 0.01% on trade of
some commodity futures and all non-commodity futures. This has increased the
trading cost significantly with an impact of decline in volume for two consecutive
years. In value terms it is a decline from Rs 170.46 lakh crore to Rs 101.44 lakh crore

Porter five forces Model

The assessment of any business requires the analysis of the various components
of the internal and external environment. To understand this in detail, the most
influential and widely used framework is five forces model proposed by porter. It
examines the attractiveness of the industry from the perspective of suppliers,
buyers, ease of entry for new players, substitutability of the products and the
competition among the existing players. The detailed discussion of the five
forces is given below:

Bargaining power of Suppliers

The commodities market is a highly volatile market with the following categories of
commodities being traded.

Energy: The supplier companies of crude oil, heating oil, natural gas and gasoline
generally do not have strong bargaining power. However in case of events such as
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recession or OPEC meet to decide on the oil supply for the coming months, the prices
fluctuate widely. In case of supply shocks, the demand of oil increases, which in turn
increases the bargaining power of the suppliers. Another significant factor which
contributes positively in the bargaining power of suppliers is the high capital cost
involved in setting up oil companies. Companies enjoy the advantages of high barriers
to entry in the sector which in turn increases their bargaining power in the
commodities market. Seasonal factor also plays an important role. For example
heating oil is expected to show backwardation structure during winter and contango
structure during fall.
Agriculture including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar):
The effect of a number of major events determine the bargaining power of farmers in
case of agricultural commodities in the futures market. For example, technological
advancements in agricultural production significantly reduces the cost of production.
As a result, the supply of products increases and farmers lose out on the power to
bargain in the commodities market. Similarly, the bargaining power is majorly
dependent on factors such as good weather (rains), high yielding seeds due to increase
in the use of fertilizers. In agriculture sector, trading opportunities are largely
monopolized by large farmers/traders.
Low bargaining power factor: Due to lack of information and reach of the farmers,
they derive the information about the price of their agricultural produce from the
futures markets. This helps them make selling or holding decisions for their
agricultural products.
Forward Integration for Farmers: The farmers can directly participate in futures
trading market to hedge their price risk.

Metals: The major metal producer countries are the western countries which are
forced to sell at the prices set by the futures market. The futures market volume is
quite large as compared to the physical market due to which the prices are governed
by the former.
Livestock and Meat: Rearing cattle is harmful to the environment as it poses the threat
of methane and carbon monoxide. Also it is a perishable item which cannot be stored.
The suppliers have to mitigate the risk of cattle disease. All these factors contribute to
the low bargaining power of the suppliers in the case of livestock and meat which
includes lean hogs, pork bellies, live cattle and feeder cattle.

Threat of new entrants

There are high entry barriers for entering the commodities futures market.
The sector wise opportunity for growth is huge in India which is a developing
economy. It is in comparison to the much lower derivative turnover/total physical
flow multiple in developing markets as compared to the developed economies. The
incumbent firms are highly concentrated having a huge market share in the
commodity trading market. For example, MCX is a firmly rooted player with 86%
share in the commodity futures trading turnover. Therefore, there is a high entry
barrier for other trading firms to enter the industry.

Figure 1Market Share Distribution amongst various Indian Commodity Exchanges

Relaxed regulatory laws leading to low entry barriers

The Indian Government is on the path to relax the regulatory laws for the commodity
trading to encourage fair play and more competition in the market. The increase in
awareness and education in this regard has also positively helped in improving the
trading turnover. For example, FMC, which is the regulatory body for Indian
commodity markets, lifted the ban on gold/silver trading after four decades in 2003.
The regulatory body has also introduced 5 national commodities besides a number of
regional ones to increase competition. There are a few other positive regulatory
initiatives taken by the authority namely EFP Exchange for physicals, AFS
Alternate futures settlement, expanded delivery period.

Product differentiation through the use of technology is a key indicator for an

exchange. For example MCX has developed a robust, transparent and hard to imitate
platform which has given it a competitive edge. It has developed on newer technology
which has given it scalability as compared to the older technology based exchanges.
High switching cost for the investors
The existing exchanges have a broad based and balanced portfolio of commodities so
as to facilitate the clients in investing in a single exchange for all the type of
portfolios. A large part of the portfolio is comprised of non-agricultural commodities,
which are not affected by the frequent regulatory interventions.

Low threat of new entrant due to high initial technology cost

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Another important factor which determines the ease of new entrant into the market
and also the profitability of the industry is the high initial capital outlay required by
the exchange, which is primarily the technology cost. In turn it lengthens the payback
period and increases the barriers to entry for new players.

Threat of Substitutes
The major substitutes for the commodity futures market are stock exchange, spot market and
derivative trading in commodity market. The latter is demanded as with the Indian market
growing, hedging of risk associated with the commodities market has increased. This is a
prevalent measure in the developed economies where the commodities traded on paper
comprise of a huge volume as compared to the physical flow of commodities. Another major
substitute could have been the options however due to its ban in India since 1952, it cannot be
used.

In India, there are a total of 24 derivatives for the listed physical commodities market
regulated by FMC. MCX is the biggest commodity exchange platform which holds the
maximum share of the commodities. Its current P/E ratio is 36.79 and the book value of
258.07.

Switching options between futures market and spot market

Commodities futures market follow contango market for products which are easily storable.
It means that the price of the commodities that will trade in future will be at a premium price
as compared to the spot prices. The cost of carrying the physical commodities is a limiting
factor on the price difference between the futures and the spot market. For the distant months,
the prices for the commodities generally see an upward trend. The market can also show a
bakwardation trend where the price for the nearby months is higher than for the outer months.
This is particularly the pattern seen in case of seasonal products where either the demand is
high or the supply is limited. The volatility in supply and demand is the major factor leading
to increase or decrease in spot price. Depending on the requirements of the client to invest in
a long term commodity or spot trading, the two markets are traded in. The following are a
few factors which significantly influence the price of the futures and the spot.

The convenience yield- It is defined as the incremental value of the spot prices over
the futures prices after taking into consideration the inventory carrying and holding
cost.
Cost of holding the physical asset- Depending on the inventory carrying cost, the
commodities are pushed into the market. The holding cost is born by the holding party
and not the clients holding the futures contract.
Perishable or non-storable commodities

Factors effecting the price difference between futures and spot in case of Energy commodities

Quality of the product- The oil quality is of prime importance in the case of energy
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commodities.
Location- The location of produce determines the price of the commodity due to
factors such as transportation cost, intermediate demand etc.
Timing and payment methods- There are generally low levels of inventory. It follows
the backwardation structure for trade. Any excess supply or stock tends to lower the
price levels of the energy commodities.
Supply factors- Supply of oil is seasonal in nature and its price varies accordingly.

Bargaining Power of buyers

There are three kinds of buyers: Hedgers, speculators and arbitrageurs. The market was
almost non-existent before 1993 but after this year, government started to look into the scope
of commodity markets. Even after that the commodities available for the buyer to trade were
very few. The bargaining power was very less because of the commodities traded were very
less and even then the interested buyers were under so much regulations that they can hardly
negotiate on the terms of the contract and hence used to exercise very less power.
The commodity market opened up in year 2009 after which the number of commodities
traded are around 146 across 26 exchanges including national and local exchanges, the
majority is taken up by the MCX. So the concentration of the supplier makes the buyer
vulnerable and being the dominant player in the market, it can exercise more power as
compared to the buyer so the buyer power is very less. There are only three other recognised
multi-commodity exchanges so due to lesser number of suppliers, the power of buyer is very
low
The buyers are scattered and not that huge as compared to the suppliers which reduces the
bargaining power of the buyers. The major substitute of commodity future market is spot
market and the spot market involves high risk due to price fluctuations because of
uncertainties like bad weather, political disturbances and the majority of buyers are
speculators who are there to earn profit so for them the spot market is not that favourable
option and hence they have lesser power and again other substitute is the equity market which
involves higher risk in the slow economic phase as it is observed in the current scenario thus
reducing the bargaining power of buyers.
The switching cost depends on the availability of the particular commodity on that particular
exchange because every commodity is not traded on every other exchange. If the commodity
is available then the switching cost is not much to restrict the switching so we can say on this
parameter the bargaining power of the buyer is high.
The buyers power to integrate in the backward direction is very low because a farmer whose
livelihood depends on the good season of the wheat or a good monsoon will not be able to
buy a fully operational commodity exchange platform so this reduces the power of buyer to
bargain.
Industry threat of forward integration is also very less because to enter in the business like
farming or mining or importing precious metals will require expertise of that business or
some technical skills or the experience.
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The competition for trading depends on the commodity being traded for example crude oil is
highest traded commodity both in volume and value. So investors are more willing to invest
in crude and thus attracting more competition and reducing the bargaining power of the
buyer. The crude oil trade amounted to 571,066.04 lakh as on 9 feb, 2015 on MCX as against
267,041.12 lakh of second highest traded commodity(gold) in terms of value compared to the
commodity traded.
The buyers bargaining power is also affected by the buyers profitability. Since the hedgers
main objective is to mitigate the risk involved with price fluctuation, the profitability of the
hedgers is highly dependent on the contract price for the future trade. So the buyer
bargaining power is lesser. But on the other hand the speculators try to use price fluctuations
and so their profitability depends totally on their own instinct and criteria when to buy and
sell the contracts. They have more power as compared to the hedgers and sometimes these
speculators can cause the price of underlying commodity to increase or decrease drastically.
After looking into various factors which contribute to the buyers bargaining power, it is very
clear the buyer exercise very less power in commodity exchange market, only some big
players can affect the price of underlying commodity.

Intensity of Rivalry
The commodity futures industry in India mainly comprised of regional commexes
(commodity exchanges) back before year 2002 with National Broad of Trade in Indore
having maximum share (>50%). The industry comprised of 21 regional players but were
constrained for businesses due to government stringent regulation. Frequent bans on futures
trading and low liquidity suppressed the growth of industry.
Later in 2002, the government permitted electronic trading of commodity futures which
brought an organized structure to the market. Currently, the major players include MCX
(Multi-Commodity Exchange), NMCE (National Multi-Commodity Exchange), ICEX
(Indian Commodity Exchange), ACE derivatives exchange (Promoted by Kotak Mahindra)
and NCDEX (National Commodity and Derivatives Exchange) which are on a national level
scale while there are 20+ commexes in regional levels. A Joint venture (IMX) of India Bulls
in collaboration with MMTC is in line to become another national level exchange.
MCX, has been the most dominant player of the industry with a market share greater than
80% followed by NCDEX. MCX has an edge over others due to its presence over global
commodities like metals unlike others. This is a point of differentiation in this industry where
consumers have limited options of buying global commodities. Some major factors that can
act as points of differentiation for increasing diversity in the industry are:
Infrastructure: The markets are still considered inefficient due to lack of proper
warehousing system. Similarly, the requirement of labs for quality/grade check of products is
essential for standardization. This all require considerable investments in the front which
makes the entry of new player more competitive.
Technology: Although the national exchange trading are carried out through electronic
trading system, a number of the regional exchanges trade through over the counter system. A
large number of investors can be attracted through use of technology which will also improve
the transparency in the system
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Brokers Community: A large number of members are registered in the exchanges but still
the business involved is very less as compared to the equities market. The reason cited here is
that the profitability is low as compared to other trading options. In order to enhance their
participation capital adequacy norms can be imposed. Similarly setting up particular
standards for participation as well as qualification criteria can be added for trading purposes.
Although, there are certain impediments, Foreign Institutional Investors, Banks, Investor
funds may plan to become active participants of the future markets. The Reserve Bank of
India (RBI), in collaboration with finance ministry is planning to provide grant permission to
FIIs to hold stakes in the futures commodity market. Once this is implemented, the markets
will gain a wider reach and provide further growth opportunity to the incumbents.
The convergence of commodity futures markets with other derivatives markets will stimulate
prominent economies of scale. It would help in the utilization of capital and institution
building, which are already put to use for other derivatives market in the growth of agricommodities future markets. This will induce mutual benefit to both the financial as well as
commodity markets.

Figure 2: Regional distribution of commodity futures exchanges

Current Market Scenario:

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As per FY13 market results,

MCX is the leading player with
a share of 87% followed by
NCDEX
with
10%.
The
remaining 3% market is
captured by smaller firms.
The oligopolistic market can
be an opportunity for other
new entrants who can capture
from this industry which is

Figure 3: Market share split

Conclusion
The report studied the industry of commodity futures with the help of Porter five forces
model. The study focussed on the forces necessary to determine the competitiveness of the
industry. The commencement of commodity futures industry dates back to 1875 but still the
industry has not grown to its full potential. There are different commodities in which India is
among the top producers like tea which is famous all across the world. The trading of
commodity futures has faced lots of ups and down because of the conservative approach of
the government to satisfy the basic need of the population which was suffering from extreme
scarcity of resources after independence which ultimately resulted in the four decades ban on
the commodity trading. But, it seems to have finally arrived now. The availability of the
various commodities is also one of the major issues which dictates the trading environment.
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.

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