What can help producers and users of base metals in India

By Joshy Jacob

Base metals, critical inputs to the manufacturing sector and prime indicators of economic activity, are often exposed to high price volatility due to perturbations in the global demand and supply. As a significant fraction of base metal users in India comprises of small and medium enterprises, which operate with narrow margins and financial constraints, the sector is highly vulnerable to commodity price volatility. Ideally, vulnerable exposure to price risk should be managed through hedging with traded commodity derivative contracts. But a study of the risk management practices of base metal firms in India indicates that risk management with traded derivatives is not widespread amongst small and medium firms.

Interestingly, most of the firms value the information revealed by the futures prices of base metals broadcast by the commodity exchanges. They actively follow the futures price of base metals to update their industry outlook, and take into account the futures prices in their budgeting, to manage cost and revenue fluctuations arising out of base metals price volatility. Given the widespread awareness about the commodity price risks, it is somewhat surprising that a sizeable fraction of firms does not actively recognise the benefits of hedging with derivatives to manage the price risk. The poor adoption is despite their heightened concern that the commodities price risk is a major factor that could adversely impact their profit margins, cash flows, and the ability to commit capital expenditure. Though small and medium firms are shy of hedging, they readily agree that a single large risk event in the base metals markets can induce several years of distress.

Given the concentrated ownership of small and medium firms, unlike the large listed firms with widely distributed risks across shareholders, it makes little sense for the promoters of small firms to hold the commodities risk with themselves.

The poor adoption of risk management by small firms does not amount to a financially prudent choice and does not improve their competitiveness.

Large firms, on the other hand, have both more exceptional ability to absorb the commodity price risks given their financial resources and pricing power, and greater access to the domestic and international hedging markets. Large firms with active risk management recognise the improvement in operational efficiency and financing costs through hedging of the price risk. The study finds that small and medium firms are heavily reliant on their large value chain partners to manage the metal price risks by providing them with a stable business scenario.

The low adoption of hedging is attributable primarily to the lack of awareness of the economic benefits of hedging, lack of recognition of technical skills to trade in the derivatives markets, as also the lack of financial resources to maintain hedging through the life-cycle of operations. The study also reveals that small and medium firms perceive difficulties such as cash settlement of the contracts (subsequent to the study, Indian exchanges have made the base metals derivatives contracts delivery-based), high cost of trading, and the absence of long-maturity futures contracts as the key deterrents in accessing the commodities derivative market for risk management. In fact, these concerns arise despite the fact the futures prices traded on Indian exchanges have high hedging efficiency as in international exchanges and, therefore, can support the risk management needs.

The participants in our survey raised the impediments that are leading to the ineffective use of derivatives for risk management; these merit serious attention by the exchanges and the market regulator.

In light of the findings, several initiatives could be undertaken to build greater awareness about the risk management role of the exchange-traded commodity derivatives. Firstly, elevate the beneficial aspects of commodity derivatives and on how to incorporate it into their product pricing strategy, through a structured education programme. For instance, surprisingly, a large number of firms regard commodity options as an esoteric and expensive product, despite its suitability for risk management. Better awareness about commodity options would enhance its adoption as an effective tool for price risk management for small and medium firms, faced with fund flow constraints to deal with the daily MTM requirements in the futures market.

Secondly, it should be emphasised that cash settlement of futures contracts does not make them less effective for risk management, as prices of all the base metals traded in India converge to the international markets. Moreover, all base metals futures contracts are now delivery-based and more suitable for entities keen to make use of delivery facilities. In fact, within a few months of changing the settlement style of its five base metals futures contracts into ‘compulsory delivery’ mode, MCX has delivered close to 16,000 MT of metals through its accredited warehouses until August 2019.

Finally, while long-dated futures would suit the long operating cycles of some firms, such contracts have poor liquidity. As institutional investors, particularly financial institutions like mutual funds and alternative investment funds, start to participate in commodity derivatives, one can expect an increase in the liquidity of long-dated futures contracts. Institutional participation will also generate unbiased research on commodities fundamentals, which can be accessed by small and medium firms, which are currently dependent on research reports from market intermediaries.

The study suggests the need for several policy initiatives. Hedging by small and medium firms in the base metals industry on domestic exchanges could be encouraged through incentives, such as interest rate subsidy to meet the margin costs in hedging. Besides, there is a need to educate the industry participants about the role and use of exchange-traded commodity futures and options contracts for hedging, and the comparable pricing efficiency of the futures contracts traded in India with those traded in international exchanges such as the London Metal Exchange and COMEX. Finally, there is a need for measures to bring adequate liquidity into longer maturity contracts.

Encouraging institutional participation in commodity derivatives markets and rationalising the commodity transaction tax can go a long way in bringing the benefits of risk management to the producers and users of base metals in the Indian market.

The author is associate professor, Accounting & Finance, IIM Ahmedabad. Views are personal