A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. It can be staple goods, food items, metals, natural resources, amongst others. They form an integral part of the most
basic aspects of our lives. Aside from being mere commodities, investors view them a bit differently. For them, commodities can be an important way to diversify their investment portfolios beyond traditional securities like stocks, shares and bonds. Since prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
Generally, the basic economic principles of demand and supply are the fundamental factors that drive the commodities markets. Any change in supply, no matter how insignificant, impact the demand; low supply equals higher prices. So, any major disruptions in the supply of a commodity, such as a widespread health issue that impacts sheep, the breach in supply chain of
wheat that resulted from the Russia/Ukraine war can lead to a spike in the generally stable and predictable demand for livestock, staple food and other commodities.
There is a broad spectrum of commodities, however, traded commodities are typically sorted into four categories which are metal, energy, livestock and meat, and agricultural. Most commodities exchange trade on these commodities. Metals commodities generally include gold, silver, platinum, copper and the likes. For energy commodities, they include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs from established oil wells around the world have historically led to rising oil prices. The face-off between Russia and OPEC on production output[1] for example, saw the price of crude oil crashing into a negative threshold. Also, the reduction in demand caused by the lock down measures for curbing the spread of COVID-19 worldwide led to reduction in price as supply surpassed demand. For agricultural commodities, they include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar amongst others.
How Futures contracts impact the commodity markets
Futures contracts are contracts between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price and at a specified date in future.
The payment and delivery of the asset is made on the future date termed as the delivery date. The buyer in the Futures contract is known as to hold a long position or simply long. The seller in the Futures contracts is said to be having short position or simply short.
The underlying asset in a Futures contract could be commodities, stocks, currencies, and interest rates, amongst others. It is in essence a type of derivatives.
What this basically means is that the buyer of a Futures contract is taking on the obligation to buy and receive the underlying commodity when the Futures contract expires. On the other hand, the seller of the Futures contract is taking on the obligation to provide and deliver the underlying commodity at the contract’s expiration date. Futures contracts are available for every category of commodity. Typically, there are two types of investors that participate in the Futures markets for commodities: commercial or institutional users of the commodities and speculative investors. For example, if someone buys a cocoa Futures contract for September, they are essentially saying they will buy 10 tonnes of cocoa for the agreed price upon the September expiration date, no matter what the market price is at that time. The seller is likewise agreeing to sell those 10 tonnes of cocoa at the agreed-upon price. Unless either trades their contract to another buyer or seller by that date, then the original seller will deliver 10 tonnes of cocoa to the original buyer.
In view of price volatility and the fact that prices of commodities are unpredictable, businesses and service providers use Futures contracts as part of their budgeting process to normalize expenses and reduce cash flow-related problems. The Futures contract helps stabilize pricing. Manufacturers and service providers that rely on commodities for their production process may take a position in the commodities markets as a way of reducing their risk of financial loss due to a change in price. For the seller of the Futures contract, he is assured of a guaranteed supply at a given time in the future and at a fixed price irrespective of whether the price drops due to intervening circumstances.
For the buyer, he is assured that at the agreed time in the future, he is guaranteed to have the quantity and quality of commodities agreed and at the agreed price irrespective of whether prices surge. Companies use Futures contracts to hedge against the risk of price fluctuation. Without the ability to hedge with Futures contracts, any volatility in the commodities market has the potential to bankrupt businesses that require a relative level of predictability in the prices of goods in order to manage their operating expenses. For example, a farmer, by entering into a Futures contract will be able to guarantee the sales of his yet-to-be-harvested crops.
The Lagos Commodities and Futures Exchange (LCFE) and the Future of Commodities Trading in Nigeria
On July 28, 2022, the LCFE, after obtaining its licence from the Securities
and Exchange Commission in 2019, officially went live and began trading in commodities targeting to leverage the potential of the commodity ecosystem worth about $1 trillion. The Exchange is to trade on four asset classes such as crude oil, solid minerals, currency, and agriculture. It is safe to say that prior to this development, the Nigerian Commodities Ecosystem was yet at infancy. There has been no significant structure in the buying and selling of commodities, no price discovery, and indeed, no transparency. The Exchange is the first Exchange in Nigeria licensed by the Securities and Exchange Commission to commence trading of gold contracts backed by physical gold and it intends to explore other key aspects of the Nigerian economy aside crude oil. This clearly shows that it will serve as a blueprint to other potential exchanges that may similarly spring up in Nigeria, and indeed West Africa. To achieve this, the Exchange must ensure it works with a solid legal framework amongst other core recommendations as set out below.
Reduction or elimination of Government’s Price Control interferences
Firstly, there must be a framework to reduce government policy interference in price fixing and control. Commodities traded must remain under the influence and control of the economic forces or demand and supply. If government controls prices, then there is a disincentive for market actors to participate on the exchange. In such a scenario, only well-connected actors may have inside information on government intentions that would influence prices, and this will impact the transparency intended.
Effective legal and regulatory framework
Also, there must be in place, an effective legal and regulatory framework to ensure the enforcements of Futures contracts in the Exchange. Since commodity exchanges trade commodity-backed contracts, commodity exchanges naturally will be less successful where the enforcement of contractual obligations is weak. Additionally, it is necessary to have a clear legal framework and strong institutional capacity for regulatory enforcements related to warehouse, brokerage, and clearinghouse operations. It is expected that the Exchange had explored the possibilities of these during its three years post licence incubation period.
Quality control mechanisms
It is also necessary to have an effectively administered system of quality standards in place that is clear and well-understood by stakeholders across the system. Commodity-based contracts are based on a mutually understood quality designation. Therefore, without clear, well-understood, and enforceable grades and standards for commodity quality, disputes are more likely to occur, and exchange-based trade becomes less likely to form. The adoption of technology can also be introduced in this regard.
Conclusion
The opportunities to be unleashed on the economy from the Exchange are boundless. Proper institutional framework and implementation are key to success. Whilst the opportunities are boundless, it is necessary to understand the underlying conditions for success, including conditions external to the exchange, such as governance and market conditions, as well as those internal to the exchange, such as operational design conditions.
Should you require professional advice on any of the foregoing please contact Peter-Cole Onele. We would be more than happy to assist.
Click here to download this article as a PDF.
