Research Paper

Relation between Commodity Futures & Spot Prices, and Inflation

Semester IV PGDM Batch 2011-13

Submitted by: Avishek Singh Roll 113 PGDM Finance

Abstract
Commodity futures have increasingly come under attack from various quarters for their supposed role in stoking up inflationary pressures. Persistent inflationary pressures in global commodity prices in the recent past sparked a debate over its nature with speculation in commodity markets being singled out as the primary factor behind rising prices, even leading to a demand for a ban on futures trading for several important commodities. Commodity futures market has developed at a phenomenal rate in India ever since its introduction in 2002. Indian commodity futures markets have registered a CAGR of 90% from 2004 to 2011. Despite this growth rate, there is skepticism about the effect of commodity futures on its underlying assets in India. The Forwards Market Commission (or the FMC-regulator of forward& futures market in India) temporarily suspended the trading in guar seed and guar gum futures and directed exchanges not to launch new contracts, imposed higher margin and reduced position limits in several agri-commodities. It may be recalled that in 2008 and 2009, several agricultural commodities including rubber, urad, tur, rice and wheat were banned by the government as the inflation was running high. However, futures trading in some of the banned commodities were restored subsequently as market conditions stabilized. FMC is yet to reintroduce futures in urad, tur and rice. Thus, we see that atleast the authorities in India believe that curbing futures trading in these commodities can help reduce inflationary trends. However, the findings of this research paper suggest that there is little empirical evidence to support such an idea. Rather than stoke inflation, futures trading has reduced the price volatility and improved price discovery. The persistent inflation in such commodities in fact point to a more structural problem on the supply side rather than speculation in the commodities market.

Introduction
While there is a viewpoint that Futures Trading has existed in India for thousands of years, the first organized futures market was established only in 1875 by the Bombay Cotton Trade Association to trade in cotton contracts. Post-independence, the subject of futures trading was placed in the Union list, and Forward Contracts (Regulation) Act, 1952 was enacted. Futures trading in commodities, particularly, cotton, oilseeds and bullion was at its peak during this period. However, following the scarcity in various commodities, futures trading in most commodities were again prohibited in midsixties. There was a time when trading was permitted only two minor commodities, viz., pepper and turmeric. By 1996 there was almost a complete ban on Futures Trading. In the early 1990s the Forex Crisis and liberalization of the economy lead to policy changes in India. These led to the re-introduction of futures trading in commodities. With a view to protect Farmers, Traders & Exporters from Price fluctuations of Commodities and to serve as an efficient Price Discovery mechanism, Government of India took the landmark decision in April 1999 to remove all the commodities from the restrictive list for Futures Trading. Government also allowed setting up of new, modern, demutualised, Nation-wide multi-commodity Exchanges with investment support from public and private institutions. National Multi Commodity Exchange of India Limited (NMCE) was the first such exchanges to be granted permanent recognition by the Government. NMCE commenced futures trading in 24 commodities on 26th November 2002 on a national scale. Commodity futures can be looked upon as an option for those who want to diversify their portfolios beyond equities, interest bearing securities or investments and real estate. For Traders & Exporters, it is an efficient mechanism to protect themselves against price fluctuations. Last but definitely not the least, for the farmers; Commodity Futures is a very efficient Price discovery as well as Price recovery mechanism. Capital inflows into the commodity futures market all over the world have increased manifold in the past few years, with several institutional investors entering the market in a big way. This paper will primarily focus on the Indian futures market, and seek to discover if there are linkages between futures market and inflation.

Literature Review
Plenty of literature exists in this field. Futures trading has evoked considerable interest in the academic fraternity and a lot of work has been done by various scholars. However, research with respect to Indian Futures market is still limited as the market is still in its nascent stage. Literature review of these research papers have suggested that the authors have failed to identify any empirical relationship between futures trading and inflation in a particular commodity. The full list of research papers referenced is available in the References section of the paper. Here, some of the key points from relevant papers have been presented in a concise manner. The Role of Futures Market in Aggravating Commodity Price Inflation and the Future of Commodity Futures in India: Sushismita Bose This paper by Sushismita Bose explores the role and behavior of different types of market participants in the futures market. Some of the key points of the paper can be summarized as under:

The overall assets under management (AUM) of commodity indices have risen from negligible size in 2003 to an estimated $76.7 billion in January 2006 and ballooned to $297 billion by June 2008, according to an estimate by Lehman Brothers. However, of this $219.3 billion increase since 2006, $98.1 billion has been new financial inflow, with the remainder due to the appreciation of the underlying commodities. Herding of investors has been observed to deviate asset prices from the fundamentals in the short term. The paper has cited Murphy & Krugman, 2008 to argue that since there has been no increase in physical hoarding of the commodities in question, it cannot be concluded that speculation has led to an increase in prices. If speculators really have driven up the world price of oil above the level justified by the fundamentals, then world output should be exceeding world consumption leading to physical hoarding in the longer run. On the other hand, if there is no hoarding, meaning that commercial consumers are purchasing all the output, then the higher price is justified by the fundamentals. In effect, if speculative activity drives market prices above the level at which supply and conventional demand are matched, then the data should indicate a growing stockpile of excess supply (or restricted output). For this kind of situation to occur, the markets have to be in contango or futures price above spot and sufficiently so to make storage worthwhile. The paper has denounced the theory that passive investors have also played a part in spurt in commodity prices. Even for passive investors the needs of portfolio management require that a fund adjust its allocation on the commodity futures as and when price changes occur (Murphy, 2008). For example, if a fund has decided on, say, a 5 per cent allocation in oil futures, according to its portfolio needs, when the price of oil rises, the funds total value increases, but the share of oil futures rises disproportionately, so that the allocation is now higher than the desired 5 per cent. If the price hike has not changed the funds underlying views about the future of the market, then during the next rebalancing the fund will reduce its holdings of commodity futures, i.e. it will become a net seller.

The Role of Institutional Investors in Rising Commodity Prices: Keith H. Black Some important observations of the author: Over the 45-year period analyzed by the author, commodity futures have earned returns similar to stocks with comparable risks Commodities have low, or sometimes negative correlation with the stock prices During the inflationary periods, commodities have outperformed the stocks This increases the attractiveness of commodities as an asset class especially with pension funds Institutional investors dont employ margin in their commodity portfolio; most institutional investors are fully collateralized Should institutions be regulated out of the futures markets, it is likely that they would simply move their positions to the unregulated over-the-counter markets, where their trading activity may be relatively unchanged from its current level Statistics tell us that institutional investments in energy products total about 3.7% of worldwide production, while coming in at 8.1% of food and fiber production

Commodity markets are inelastic: demand does not decline significantly during times of rising prices. Ideally, we would hope that prices would increase commodity supply while lowering the demand. Even in the face of doubling energy prices, demand in North America fell less than 1% in the one year period ending 2008.

Commodity prices will decline only when: - Supply increases significantly (such as discovery of a large oil field) - Demand drops sharply (such as recession in the emerging market)

Demand for all types of commodities has soared due to increased income in emerging markets, as well as the trend toward biofuels. In many markets, consumption of commodities exceeds supply, and consumption growth has exceeded supply growth for many years, which has caused declines in the inventory of many commodities to record low levels. When supply closely matches consumption, markets become vulnerable to supply shocks. Supplies can decline quickly due to adverse weather conditions or political changes that make it illegal or dangerous to engage in commodity export activity. Supply and demand for physical commodities determine prices. No amount of institutional investment in commodity markets can support the current level of prices if supply increases and demand declines. Conversely, the trend toward higher prices is directly related to rising demand and constrained supply. If supply continues to be tight, with falling exports and dwindling inventories, and demand from emerging markets continues to rise, restrictions on the structure of institutional

investment in commodity markets will not be effective in meeting the goal of reducing commodity prices. Examining the CRB index as a leading indicator for US inflation: Ram N. Acharya, Paul F. Gentle and Krishna P. Paudel The price change signaling role for commodities rests on the fact that commodity prices are set in auction or flexi-price markets. Because of this, these commodity prices can dash ahead quickly in response to actual or expected changes in supply or demand. By contrast, prices of most final goods and services are restrained by contractual arrangements and other market frictions. So they respond gradually and steadily to supply and demand pressures, slowly gaining ground on commodity prices Linkages between commodity prices and broad inflation: 1. Commodity prices may give forewarning signals of an inflationary swell in aggregate demand. Higher demand for final goods increases the demand for commodity inputs. Even though the inflation momentum may start in final goods markets, the first visible increase in prices may be in the flexi-price commodity markets. 2. Commodity prices and broad inflation may be directly connected because commodities are an important input to production, representing about one-tenth of the value of output in the United States. Thus, all else being equal, an increase in commodity prices should sooner or later be passed through to final goods prices. 3. Because commodity prices respond quickly to wide-ranging inflation pressures, investors may see them as a useful inflation hedge. This view tends to be self-fulfilling. The more the commodities are seen as an effective hedge, the more likely the investors are to turn to them in anticipation of inflation. Usually, precious metals have been signaled out as the most convenient commodities for hedging inflation The relationship between commodity price and inflation is still significant. In particular, the model results show that there is one-way relationship between commodity price index and inflation. Moreover, the results from the impulse response function show that an increase in commodity price index by 1 SD would increase inflation nearly by one unit in the second year. This implies that the CRB index can still be used as an early indicator of inflation. The Expert Committee to Study the Impact of Futures Trading On Agricultural Commodity Prices: Abhijit Sen 2008 Contribution of Agricultural Commodities in WPI & CPI Inflation There are 12 food grain items in the basket of WPI index, with 5.01% weight. Among these, rice and wheat have significant weight while weight of other items is individually very small. The weight of food items, particularly of foodgrains, is much higher in the Consumer Price Indices. The CPI-AL assigns a weight of 69.15% to food items, of which the weight of cereals is 40.94% and pulses 3.39%. Food & foodgrains contribution to inflation varies widely depending on weights assigned, being highest in CPI-AL which is pertinent for the poor and lowest in the WPI. In particular, the contribution of foodgrains to overall WPI inflation is relatively small and much less than to CPI inflation. This is because, unlike the CPIs, the WPI also includes intermediate and capital goods which do not enter directly into consumption. However, because of this, the WPI permits a wider

look at agricultural goods since many of these do not directly enter the food basket but are used as intermediates. Important points from the analysis: 43 agricultural commodities notified for futures trading 24 of them accounted for 98.7% of the total value of futures trading of agricultural commodities in 2006-07 Top 8 agro-commodities account for 84% of the total value of trade However, among these 24 commodities with preponderant trade share in volume of futures trade, 3 DO NOT feature in the WPI basket at all. Guar gum, guar seed and menthe oil accounted for 29.6% of the traded value, but not represented in the WPI This shows that a very significant share of futures trading in agricultural commodities is accounted for by commodities that are insignificant for the overall price level in the economy Even the remaining 21 commodities have a weight of only 11.73% in the WPI basket and account for less than half the weight of the processed and unprocessed agricultural commodities included in the WPI

Price Increase The author has divided the analysis into pre-trade and post-trade basis. Some of the significant excerpts of his observations are: Annual trend growth rate was HIGHER in the post-futures period in 14 commodities, viz. chana, pepper, jeera, urad, chillies, wheat, sugar, tur, raw cotton, rubber, cardamom, maize, raw jute and rice These commodities account for 48.2% of the total futures trading volume and have a weight of 10.1% in the WPI 10 of these commodities had suffered negative inflation in the pre-futures period Annual trend growth rate was LOWER in 7 commodities in the post-futures period, viz. soy oil, soy bean, rape seed/mustard seed, potato, turmeric, castor seed and gur These commodities account for 21.3% of the total futures trading volume and have a weight of 1.7% in the WPI 6 of these commodities had suffered unusually high inflation in the pre-futures period

The author concludes that what is being observed is simply reversion to a more normal level of inflation. In both the cases, the problem is that period during which futures markets have been in operation is much too short to discriminate adequately between the effects of opening up futures market and what might simply be normal cyclical adjustments. Volatility Anticipated benefits of futures trading in agro-commodities are: Reduction in price volatility(i.e., extent of fluctuations in price around trend) Better price discovery

NCDEX data for 19 of the 24 traded commodities selected earlier clearly shows that: Volatility was LOWER in 15 the commodities Higher in 3 commodities Remained the same in one

However, this decrease in volatility was not reflected in the WPI data for the 21 selected commodities. Price volatility had increased in 10 commodities, remained untouched in two and declined in 9 after the introduction of futures trading. Thus little conclusions can be drawn because of conflicting results. Concern for farmers

Introduction of futures trading should reduce price volatility along a relatively longer period of time. Mechanisms of price discovery and arbitrage should reduce the ratio between the highest and lowest (i.e. harvest) price observed during a crop year. But in several cases (especially chana, chillies, urad and wheat), this ratio increased after the introduction of futures trading, returning partially towards normal only after the inflation subsided in 2007. Thus, the efficiency of futures market in addressing this concern of farmers is very limited in this respect.

Underlying fundamentals and price behavior: The delisting experience

Urad: Tur: rd Delisted on 23 January 2007 Futures prices in backwardation indicating a future fall in spot prices Spot prices in fact declined as predicted Wheat: Rice: Delisted on 27th February 2007 Futures prices in backwardation Spot prices followed the predicted pattern

Delisted on 23rd January 2007 Futures prices in contango except for 1month forward price Spot prices followed the predicted behavior Delisted on 27th February 2007 Futures prices in backwardation Spot prices followed the predicted pattern

Conclusions: Futures prices in all these commodities successfully predicted the future spot prices Thus the price rise in all these commodities can be explained by the supply-side factors, i.e. domestic production and foreign trade

Tur: Supply & Inflation data 2003-04 2004-05 2005-06 2006-07 Production (in million 2.36 2.35 2.74 2.31 tonnes) Imports ranged between 0.23 to 0.34 million tonnes throughout the period Inflation of WPI tur (yoy 10.2% 9.5% -4.9% 6.6% in December) Real WPI of tur (1993-93 96.7 98.5 87.8 87.2 = 100) 2007(Delisted)

15.2% 94.1

Thus the price movements are largely in line with movements in supply. In particular, real prices of tur were lower during 2005 and 2006(when futures trading was significant) than in 2003(before futures) or 2007(after delisting). Rice: Supply & Inflation data 2003-04 Production (in million 88.53 tonnes) Exports (in million 3.4 tonnes) Government Rice 11.7 Stocks(in mn tonnes) as on January Inflation of WPI tur (yoy -1.3% in December) Real WPI of rice (1993-94 97.7 = 100) 2004-05 83.13 4.8 12.8 2005-06 91.79 4.1 12.6 2006-07 93.35 4.7 12 11.5 2007(Delisted)

1.7% 90.3

2.8% 89.6

4.4% 87.4

7.1% 88.3

Since the real WPI of rice declined throughout the period when futures trading was allowed, and increased only after de-listing, speculation in futures market cannot be said to have exerted any strong upward pressure on spot prices of rice. Urad: Supply & Inflation data 2003-04 Production (in million 1.47 tonnes) Imports (in million 0.21 tonnes) Inflation of WPI tur (yoy -10.2% in December) Real WPI of urad (1993- 126.6 94 = 100) 2004-05 1.33 0.08 -4.1% 116.9 2005-06 1.25 0.08 35.8% 124.7 2006-07 1.42 0.33 41.5% 190.8 -28.5% 169.9 2007(Delisted)

Thus, urad inflation did flare up very unusually in the period when futures trading was active. But this was a period of below normal production and although imports cushioned supply, import unit values rose 48.7% and 37.7% in 2005-06 and 2006-07. FMC had commissioned a study by the Indian Institute of Management, Bangalore (IIMB) to study the impact of futures trading in some important agricultural commodities. It concluded that changes in fundamentals (mainly from the supply side) were primarily responsible for the higher post-futures price rise, with government policies also contributing to it. It also found that in all the futures contracts traded (with the exception of tur), the basis risk was significantly high and in a number of them, it was higher than the price risk. Thus, Indian commodity exchanges have been offering contracts that are highly unsuitable for hedging purposes and thus prone to purely speculative activity. Variance in spot prices is much larger than that of futures(gur, potato, sugar and sacking) implying low efficiency of futures in price discovery; or variance of futures price is much higher than of spot(rubber and wheat) implying too much speculation in futures market.

Thus there is poor integration between the spot and futures market in all the commodities studied and therefore concludes that futures may not have served the purpose of risk management.

Key Reports
Several researches have been carried out by regulatory bodies all over the world to determine the effect of futures trading on inflation. In this respect, two key reports have been summarized here: Enquiry by US Commodity Futures Trading Commission There is little economic evidence to demonstrate that prices are being systematically driven by speculators in either oil or agricultural commodity markets. Generally, the data shows that: Prices have risen sharply for many commodities that have neither developed futures markets (e.g. Durham wheat, steel, iron ore, coal, etc.) nor institutional fund investments (Minneapolis wheat and Chicago rice). Markets where index trading is greatest as a percentage of total open interest (live cattle and hog futures) have actually suffered from falling prices during the past year. The level of speculation in the agriculture commodity and the crude oil markets has remained relatively constant in percentage terms as prices have risen. Studies in agriculture and crude oil markets have found that speculators tend to follow trends in prices rather than set them. Speculators such as managed money traders are both buyers and sellers in these markets. For example, data shows that there are almost as many bearish funds as bullish funds in wheat and crude oil.

The CFTC maintained that much of the increased inflow is speculative, in the sense that it is in anticipation of future supply constraints and robust demand. Both have been very much in evidence in recent years, and to the extent that speculation is driven by such factors it is playing a proper and indeed important role; that is, signaling the need to expand investment in production capacity, and

providing liquidity to hedgers. There is very little evidence that this inflow is manipulative. Low and declining levels of inventory for major food crops, for example, indicate no potentially manipulative hoarding going on in that sector. Enquiry by Indian Expert Committee on Futures Trading The Indian investigations were mainly based on comparison of commodity price trends and volatility pre- and post-futures and also took into consideration the production and supply of the crucial commodities in the relevant years. The terms of reference of the ECFT were as follows: i) To study the extent of impact, if any, of futures trading on wholesale and retail prices of agricultural commodities; and ii) Depending on (i), to suggest ways to minimize such an impact; iii) Make such other recommendations as the Committee may consider appropriate regarding increased association of farmers in the futures market/trading so that farmers are able to get the benefit of price discovery through Commodity Exchanges.

Thus in early 2007, both food and all agricultural commodities show higher inflation than overall WPI inflation (Exhibit 2). The ECFT opined that although this supports the view that the inflation in early 2007 was led by agricultural commodities, it is not possible to conclude that factors particular to these commodities were the only, or even major, reason behind the spurt in inflation, as manufactured products with a weight of 63.75 per cent in WPI also recorded inflation of around 6 per cent.

ECFT points out that a revealing feature of this data is that of the 14 commodities in which price acceleration took place in the post-futures period, 10 had suffered negative inflation during the prefutures period (Exhibit 3). It is possible in such cases that the acceleration in the growth rate of WPI in these commodities is simply rebound and catch-up with the trend, which in turn could have been aided by more efficient price discovery. Similarly, of the 7 commodities in which WPI growth was lower post-futures, 6 had unusually high pre-futures inflation at over 10 per cent. In these cases, too, it is possible that what is being observed is simply reversion to a more normal level of inflation. In both cases, there is the problem that the period during which futures markets have been in operation is much too short to discriminate adequately between the effect of opening up futures markets and what might simply be normal cyclical adjustments. Although inflation clearly increased post-futures in some sensitive commodities that have a higher weight in consumer prices indices, it is not possible to make any general claim that inflation accelerated more in commodities with futures trading.

More definitive is the ECFTs analysis of daily volatilities pre-and post-futures, which shows that daily price volatility in wheat less than halved post-futures; that of soy oil was exactly half; and for urad it had come down by more than 10 percentage points, while it remained same for chana (Exhibit 4). The most dramatic result was for a crucial perishable crop like potatoes; the 441 price observations pre-futures showed price volatility of 245.9 per cent, while the same number of observations postfutures showed volatility of 68.4 per cent.

The ECFT, notably, found that futures prices were in fact indicating price movements in the correct direction. Futures trading in urad and tur, which were quite liquid on the NCDEX platform, were delisted on January 23, 2007. On the date of delisting, four delivery-month contracts, February, March, April and May 2007 were running. The urad futures prices as on January 23, 2007 were in backwardation, predicting a future fall in spot prices. In fact, spot prices did fall after delisting from Rs. 3,551 on January 23, 2007 to Rs. 2,553 on August 4, 2007. As regards tur, except the February 2007 contract, futures prices at the time of delisting were in contango, predicting a rise in spot prices. In fact, spot prices continued their upward trend even after delisting. In the case of rice, futures prices in all contracts were in backwardation at the point of delisting, with the extent of backwardation lower in further contracts, indicating that spot prices were predicted to fall on the arrival of the new harvest in April-May and rise moderately thereafter. The post-delisting spot prices recorded by the NCDEX show that after a brief decline in prices in the post-harvest period of April and May prices started firming up to above Rs. 1,000 per quintal in July and August even though there were no new futures trade in this commodity. In contrast with the view of critics of futures markets who argue that speculative activity increased with the introduction of such markets and that this in turn led to unusual price movements, the Commodity Exchanges have argued that the price rise that occurred in these commodities before delisting can largely be explained by supply-side factors, involving domestic production and foreign trade. The ECFT also found that price movements are broadly in line with the movements in supply. Finally, the ECFT report concluded that the Committee has been unable to determine any conclusive causal relationship (between futures trading and inflation) in view of the short time period during which futures markets have functioned and the complexities that arise because a large number of variables impact spot prices. Ban on Futures Trading in select commodities in India

The ban has been quite ineffective in consistently softening prices in some commodities like wheat and rubber (Exhibit 6). The ban may have in fact deprived Indian consumers of the benefit of global price declines (rice and soy oil) as it has blocked the global price signals. Hence the ban has also underplayed the need to respond to supply constraints or increased demand by adjusting production. In India, neither the volumes of turnover in particular commodities nor their returns are such that one may suspect abnormal levels or directions of speculative activities bordering on market

manipulation in them. Post-futures, the movement of prices also does not seem to justify the move. In fact, in the absence of liquid futures markets, prices may give the wrong signals and lead to further misallocation of resources and intensify the supply side constraints that have already been pointed out as a very important cause of the present spate of wide and persistent inflation.

Conclusion
The current evidence available does not provide any conclusive evidence about whether there is any causal relationship between futures trading and rise in prices of the agricultural commodities. In fact, all the research papers have concluded that the futures trading has led to a better price discovery and decreased volatility in prices, as well as reduced information asymmetry. Thus it would be erroneous to blame futures trading for inflation. Despite the ban on trading of urad and tur, these commodities witnessed another round of high inflation since 2011. These conclusions suggest some other factor behind the persistent inflation. As argued by Sushismita Bose, if speculation was the reason behind inflation, physical hoarding of such commodities would be inevitable. However, there is no such instance in reality. Thus, supply has not been able to match the demand and that has been the root cause of persistent high inflation in these commodities.

References
Sushimita Bose (2009), The Role of Futures Market in Aggravating Commodity Price Inflation and the Future of Commodity Futures in India, ICRA Bulletin, Money & Finance. Keith H. Black (2009), The Role of Institutional Investors in Rising Commodity Prices, The Journal of Investing. Ram N. Acharya, Paul F. Gentle and Krishna P. Paudel (2010), Examining the CRB index as the leading indicator for US inflation, Applied Economics Letters. Peter A. McKay (1999), Commodities' Role as Inflation Harbinger Ebbs, Wall Street Journal (New York, NY), 06 Oct 1999. Elyse Tanouye (1991), Commodities: Are Indexes Flashing Alert on Inflation?, Wall Street Journal (New York, NY), 21 Oct 1991. Abhijit Sen led Expert Committee Report (2008), The Impact of Futures Trading on Agricultural Commodity Prices, Ministry of Consumer Affairs, Food & Public Distribution, Government of India, 2008. UN Report (1996), Managing Price Risks in Indias Liberalized Agriculture: Can Futures Market Help?, November 1996. Mantu Kumar Mahalik, Debashis Acharya and M. Suresh Babu (2009), Price Discovery and Volatility Spillovers in Futures and Spot Commodity Markets: Some Empirical evidence from India, Fourth Annual International Conference on Public Policy and Management, Indian Institute of Management, Bangalore, 9-12 August 2009. Jatinder Bir Singh, Futures Market and Price Stabilization: Evidence from Indian Hessian Market. David S. Jacks (2005), Populists versus theorists: Futures markets and the volatility of Prices, Science Direct, 6 June 2006. David A. Reichsfeld and Shaun K. Roache (2011), Do Commodity Futures Help Forecast Spot Prices?, IMF Working Paper, November 2011. Jian Yang,R. Brian Balyeat and David J. Leatham (2005), Futures Trading Activity and Commodity Cash Price Volatility, Journal of Business Finance & Accounting, January/March 2005.