A

Joint Endeavour

CommoditY insights
Yearbook 2010
A bAnk of ExCLuSIvE knowLEdgE And InforMAtIon on CoMModItIES ECoSyStEM

Global Products
Global Practices
Sponsors

experts views

Emerging Commodities
pankaj Chandak |
VP, CoMMoDity sAles, MF GloBAl CoMMoDities inDiA

Managing Price Risk for India Inc

recent developments in standardising of key attributes such as quality and port (for coal and iron ore), and vessel size and trunk routes (for freight) have resulted in creating indexes widely followed by industry participants. these indexes have lent themselves to designing easily tradable futures/swaps. Using derivatives on these indexes, it is now possible to transfer the risk from hedgers to speculators.

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lectricity consumption in India is estimated to double from 600 TWh by the next decade. To supply this additional requirement, the generation capacity will have to increase by 90 GW to 241 GW. Although the capacity for other sources of power (nuclear, hydro, solar, wind, etc.) is being augmented, coal accounts for 70% of power generated in India. The country has the third largest coal reserves in the world. However, in order to meet this rising demand for power, India is expected to import in the range of 80-90 million tonnes of coal in 2010-2011, an increase of 33-50% from last year. The country imports coal primarily from Indonesia, South Africa, and Australia. Dry bulk cargo vessels are used to transport coal parcels to one of the ports in India. After discharging coal, most of these vessels take iron ore to China, Japan, South Korea or they simply backhaul. India has emerged as one of the key suppliers of iron ore to the far-east nations. During January-May 2010, India exported 56 million tonnes of iron ore to China. Since the financial crisis of 2008, all the markets including those of coal, iron ore and freight have been fraught with extreme volatility. Baltic Dry Index touched an alltime high of 11793 in May 2008. By December 2008, the index hit a low of 671 a meteoric fall of 94% in eight months. Similarly, iron ore scaled to an all-time high of $176 a tonne on SGX AsiaClear in April and, in July, it fell to $114 a fall of 35% in three months. API4 (the benchmark for South Africa coal) peaked at $121 a tonne in October 2008 and then fell by 55% to a low of $53.75 a tonne in 2009. The volatility in prices affects all participants in the trade

whether they are miners, traders, ship-owners or charterers, bankers, and any other key player involved. Therefore, a critical question that arises is: Is there a platform available for the participants to manage and mitigate the price risk arising out of the volatile price movements of these commodities? The answer is a resounding yes! The recent developments in standardising of key attributes such as quality and port (for coal and iron ore), and vessel size and trunk routes (for freight) have resulted in creating indexes that are widely followed by industry participants. These indexes have lent themselves to designing futures/swaps that can be easily traded. Thus, using the derivatives on these indexes, it is now possible to transfer the risk from hedgers to speculators. The Forward Contracts (Regulation) Act, 1952 recognises only deliverable commodities as underlying for a forward contract and, as a result, Indian commodity derivative markets cannot trade commodity contracts that are non-deliverable or are cash-settled. Without amendments to the FCRA

bill, such contracts whose settlement necessarily has to be based on an internationally recognised benchmark cannot be listed or traded in India. Although some Indian commodity exchanges have launched a coal contract and some are working on the feasibility of an iron ore contract, the interest among participants is not very high. Nonetheless, given Indias strong reliance on imports of coal and its growing market share in iron ore exports, there is a pertinent need to understand and use the hedging instruments currently available only offshore, to insure against adverse price movement.

products available
Coal swaps based on the cost of thermal coal are becoming instruments of choice for coal miners, traders, and investors. Coal price risk can be managed using one of these three contracts: ICE Richards Bay Coal Futures: The Richards Bay Coal Futures contracts are financially settled based on coal loading at Richards Bay in South Africa. It is cash settled against the API 4 index as published in the Argus/ McCloskey Coal Price Index Report. For Indian importers of coal from South Africa, Richards Bay Coal swaps contract offers an excellent platform to hedge their coal price risk. ICE Rotterdam Coal Futures: The Rotterdam Coal swaps contracts are financially settled based on delivery of coal to Rotterdam in the Netherlands. It is cash settled against the API 2 index as published in the Argus/ McCloskey Coal Price Index Report. ICE globalCOAL Newcastle Coal Futures: The globalCOAL

indexes helped design futures/ swaps that can be easily traded. Using the derivatives on indexes, it is now possible to transfer the risk from hedgers to speculators.

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experts views

table #1: some commonly traded dry bulk contracts

routE Cs4tC C4 Pm4tC sm6tC sEgmEnt dry Capesize dry Capesize dry Panamax dry supramax tradE average of 4 time Charter (tC) routes C8, 9, 10 and 11 richards bay - rotterdam (aPI2- aPI4) average of 4 time Charter (tC) routes P1a, P2a, P3a and P4 average of 6 time Charter (tC) routes s1a/b, s2, s3, s4/b sIzE (mt) 172,000 150,000 74,000 54,000 tradIng unIt 1 day 1000 mt 1 day 1 day PrICE QuotatIon usd/day usd/ton usd/day usd/day IndEX baltic baltic baltic baltic

ICE Newcastle Futures contract is financially settled on the globalCOAL NEWC Index. Newcastle coal futures can be used to hedge the exposure for coal imported from Australia and also as a proxy to coal imported from Indonesia. Iron ore price risk can be managed by using the Iron Ore Swap (IOS) cleared by SGX AsiaClear and LCH. IOS is a standardised contract based on 62% iron ore fines CFR (cost and freight) basis China. IOS is cashsettled at the end of the month using the arithmetic average of all The Steel Index (TSI) iron ore reference prices in the expiring month. Like coal and IOS, Forward Freight Agreements (FFAs) are also financially settled contracts which fix the price of a particular freight index at a specific future period. The freight indices in question are built on the most common trade routes for each vessel type and correlate to a very high degree (mostly 90%+) with physical freight rates. As there are wet and dry cargoes to be shipped, FFA contracts are available for both types of cargoes. In this discussion, we will focus on the bulk cargo carriers. Some of the commonly traded dry bulk contracts are as shown in Table 1.

and calendar years are divided into their component months for example, Q1 (first quarter of a calendar year) is divided into three monthly contracts of January, February, and March. Each month is then settled on the last day of that month and then subtracted from the quarter or the calendar contract. ICE Europe offers coal contracts as far as six years in the future. IOS contracts can be traded for the next two years. FFAs are also available for three years in futures. However, like most other futures markets, the bulk of the liquidity is always concentrated in the nearby maturities.

grown for all these commodities, the market has flocked to clearing. Cleared trades for coal, IOS and FFAs now account for a substantial volume traded on a daily basis. In the case of OTC transactions, counterparties take a direct risk on each other. Also, to unwind an existing trade, they have to go back to the same counterparty. This causes an added layer of liquidity risk in an already exceptionally volatile market. In case the transactions are cleared, then the counterparty risk is transferred to the clearinghouse. In case any party wants to exit the trade, it is not bound to go back to its original counterparty and can unwind with any other player. Cleared trades also give anonymity to participants. Liquidity issues abound in the OTC market as traders need credit lines with a substantial number of participants in order to be able to execute derivative transactions whenever required with each of them. Clearinghouses such as LCH and SGX AsiaClear offer clearing services for iron ore and FFAs, where as ICE Europe clears the coal contracts.

exchange cleared versus Bilateral

Initially, the markets for coal, iron ore, and FFA were dominated by over-the-counter (OTC) contracts entered into by principals on a bilateral basis. With tightening credit, record commodity prices and some notable defaults (Bear Sterns, Lehman Brothers, etc.) solving potential credit issues across all jurisdictions had become an almost insurmountable task. As the number of market participants has

table #2: participants long physical commodities

Coal Coal mine owners trading companies with excess tonnage Iron orE Iron ore mine owners trading companies with excess tonnage frEIgHt ship owners trading companies with excess tonnage CIf buyers of cargo

Contract tenure available

Monthly, quarterly, and yearly (or calendar) contracts are available for coal, iron ore, and FFAs. Contracts for longer periods such as quarters

88 | Commodity insights Yearbook 2010

Hedge mathematics
Coal, iron ore and FFA contracts are settled as Asian style contracts, where the average of all spot (cash market) prices in a month is the eventual settlement price of a contract. The number of days depends on the holiday calendar of the pertinent exchange where the products are cleared. Let us see this with an example: let us assume a cement company buys 1 lot of September 2010 API4 contract for $90.5 a tonne and holds this contract till expiry. The contract will be settled using the monthly average price of September API4 as published by Argus/McCloskey. Let us say this price is $92 a tonne. As the settlement price is more than the entry price, the cement company will make a profit of $1.5 a tonne in the paper market. On the contrary, if the settlement price falls to $89 a tonne, then the cement company will make a loss of $1.5 a tonne in the paper market.

Cleared settlement cash flow

For contracts that are cleared at any of the participating clearinghouses, all settlements are done daily based on the daily closing price of each contract. Daily settlement of contracts allow for instant profits and losses for traders, with no possibility to build up future cash flow commitments that cannot be met. In the example above, the buyer will receive the difference between his purchase price and the closing price of the contract the following day, less margins applied. This daily mark-to-market methodology enables market participants to realise profits and losses early, being able to cash in or stop-loss positions at their convenience. The participating clearinghouses apply different models for margining of various commodities contracts. Given the current volatility levels, margins in the range of 10-20% are collected, directly or via

general clearing members such as banks and clearing brokers for the contracts traded.

Basic principles of a physical commodity hedge using cleared contracts

Participants be they miners, ship owners, charterers, traders or bankers make use of the following basic principles when hedging the physical commodity requirements: Direction long, short or neutral physical commodity? The long/short direction of a physical commodity position depends, as in other markets, on whether the controller of a physical asset in this case, coal or iron ore or ship stands to profit on a rising or a falling market. As a hedge using commodity derivatives, the controller of the asset will take an opposite paper position to the physical position to protect against the market moving in the

A pwC & MCx Joint endeavour | 89

experts views

wrong direction. See Table 2 and Table 3 for an illustrative list of participants who are long physical commodities and who are short physical commodities, respectively. Let us say an iron ore miner is worried about the falling prices of iron ore for the next three months. As a miner, the participant is long iron ore. Therefore, to hedge himself, the miner will sell iron ore swaps for the next three months, thus protecting himself from any downward price movement in iron ore for the next three months. Whereas a utility company that has coal-fired power plants will buy coal futures to hedge itself against any increase in the price of coal.

About the expert

pankaj Chandak, vice president - Commodity sales at MF Global Commodities india pvt Ltd, advises institutional and corporate clients in india and overseas on their commodity hedging and risk management needs. Mr. Chandak, a Master in industrial engineering from Georgia institute of technology, Atlanta UsA and a Bachelor in Mechanical engineering from sardar patel College of engineering, Mumbai, has also completed a risk Certification course from New York institute of Finance. He was one of the first in india to complete the academic requirements for Chartered Market technician (CMt) programme. Mr. Chandak may be reached at pchandak@mfglobal.com of exposure per month for October, November and December. Therefore, it will buy 60 days of SM6TC contract for each month. When a proxy contract is used for hedging, then the quantity of the proxy contract should be adjusted accordingly to match the real notional exposure as much as possible. For instance, in the above example, if a Panamax contract (PM4TC) is used to hedge the freight instead of a Supramax contract, then the power producer will require to buy 41 days of each month to hedge its freight exposure instead of 60 days (100,000/74,000*30 = 41). Regardless of physical exposure, most market participants agree that a degree of under-hedging is for the most part more beneficial in the long term than an exact hedge or an over-hedge. consumers crystallise their input price. The uncertainty prevailing in a marketplace is thus minimised for both the categories of participants. It is imperative to understand that hedging does not eliminate price risk but minimises the same. Another common issue is basis risk, which can arise from lack of availability of direct contracts for hedging. For example, though India imports a huge amount of coal from Indonesia, there is no contract available to hedge this import. Therefore, one has to use Newcastle coal contract as a proxy, thereby introducing basis risk. It is possible that at expiry the difference between the settlement price of Newcastle coal contract and the physical Indonesian coal can increase or decrease, thereby increasing the risk exposure. Further, it is important to understand that even though the potential for coal, IOS and freight is enormous, the markets for these commodities are still relatively nascent compared to the ones for other widely traded commodities such as crude oil, gold, and copper. However, as new participants enter, liquidity has increased over the past two years and will continue to improve going forward

How much to hedge?

The number of contracts to be bought or sold will depend on the actual or forecasted shipment/requirement of the commodity during a given period of time. For example, a power producer estimates that it will require 1,00,000 tonnes of imported coal per month for three months from October to December. The coal will be shipped from South Africa using a Supramax vessel (capacity 50,000 dwt). To protect itself against rising coal and freight prices, the power producer will hedge the above transaction as follows: Buy 1,00,000 tonnes of API4 contract per month expiring in October, November and December. Assuming it takes 30 days to get the shipment from South Africa to India, the power producer will require60days(1,00,000/50,000*30)

Benefits and shortcomings of hedging

Hedging helps producers crystallise their sell price, and it helps

table #3: participants short physical commodities

Coal Coal consumers (power plants, cement companies etc) trading companies Iron orE Iron ore consumers (steel mills etc.) trading companies frEIgHt Charterers /oil refiners trading companies fob buyers of cargo

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PricewaterhouseCoopers Pvt. Ltd. 2nd Floor, 252, Veer Savarkar Marg, Shivaji Park, Dadar, Mumbai 400 028 (India) Phone: +91-22-6669 1000; Fax: +91-22-6654 7800 Website: www.pwc.corn

Multi Commodity Exchange of India Ltd. Exchange Square, CTS No. 255, Suren Road, Chakala, Andheri (East), Mumbai 400 093 (India) Tel: +91-22-6731 8888; Fax: +91-22-6649 4151 Website: www.mcxindia.com