Game for agri-commodities?

The Dhaanya index of the NCDEX has delivered annualised return of 19.2 per cent since January 2008, pipping most other asset classes to the post. But the high returns come with high risks

Do you know which asset class delivered the best return since the beginning of 2008? The answer is agri-commodities. While not many investors or traders would have put money in coriander or cotton seed oil cake futures, they would have made more money there than in gold or even equity.

The sharp plunge in equity markets in 2008 and the period of stagnation since 2010 have resulted in the Indian benchmark, Nifty, delivering annualised return of just 4 per cent since January 2008. Gold had its moment in the sun in the fall of 2011 but it has been a downhill ride for the yellow metal since then; resulting in yearly return of 5 per cent. Crude oil has not had it good since July 2008, delivering negative annual growth of 8 per cent. Returns from real estate have also been not much to write home about in the recent past.

However, the benchmark index of NCDEX, the Dhaanya index that is constituted with the highly-traded agri-commodities of the exchange, has delivered annualised return of 19.2 per cent since January 2008, pipping most other asset classes to the post. Some of the constituents of this index, such as rape mustard seed have given annual growth of 33 per cent since January 2008, a feat that can be matched by very few stocks.

That said, agri-commodities are not suitable for investors because there is no instrument to ride on; unlike gold where ETFs are available for investors. Agri-commodity futures traded on the commexes mainly serve the needs of the commodity producers or users of the products to help hedge their price risk. There are some arbitrageurs and traders who do operate in these exchanges but they are few in number.

While lack of avenues is a drawback, not many investors would agree to bet on rape mustard seed or jeera even if ETFs or other similar instruments were offered to them. What is it that turns off traders and investors from agri-commodities? Are their fears justified? Here we examine some of the common misgivings about agri-commodities futures to see if they are valid.

Lack of liquidity

Liquidity is a concern, but it can be surmounted by trading only on exchanges that trade higher volumes, such as NCDEX and MCX and staying away from illiquid counters.

The three largest exchanges for agri-commodities, the NCDEX, MCX (agri-commodity segment) and the NMCE together transact contracts worth ₹3,000-4,000 crore every day. This is about 2 per cent of the value of equity futures and options (F&O) traded on the national exchanges and around a tenth the value of currency derivative contracts traded on exchanges.

Liquidity in individual contracts is not too much to write home about. For instance, the top-traded contracts on the NCDEX trade roughly between ₹200 crore and ₹500 crore every day but many contracts witness less than ₹100 crore of transaction per day.

Aurobindo Gayan, Vice-President-Research, Kotak Commodities, says that there are three factors that a person must keep in mind while selecting a commodity to trade in — the volume or participation level in that commodity, the sowing and harvesting pattern and his risk appetite. He says that of the total volume of agri-commodities traded every day, roughly 40 per cent comes from the edible oil cluster — soyabean, soyaoil, crude palm oil and mustard. These are followed by sugar, cotton and other spices.

But the sowing and harvesting pattern of a commodity affects seasonal liquidity, too. For instance, soyabean is harvested between October and December in India. The users of soyabean try to buy this commodity during this period making the contract very active in this period. On the other hand, in March or April, this contract could get quite inactive.

The trader’s risk appetite also needs to be considered as the exchange charges mark-to-market margin everyday on the outstanding positions. It is best to set aside a certain sum at the outset as the draw-down or (the reduction from your capital) that you are willing to take.

Sushil Sinha, Executive Director, Karvy Comtrade, says that it is possible that an investor might be aware of the factors affecting the price of a certain commodity as the commodity is grown in the region he resides in or because he is a user and hence follows it closely. It is best to stick to such commodities where familiarity is higher.

Price manipulation

Thin liquidity on many counters that enables price rigging is one of the main drawbacks of commexes. Instances of a few players, who are privy to price-sensitive information regarding a commodity, forming a cartel to rig up the price are quite common in the Indian agri-commodity market. That is one of the reasons why the history of this segment is strewn with suspensions and outright bans of commodities. The guar gum and guar seed episodes of 2011 and 2012, where prices rocketed high in a crazy manner was mainly due to low liquidity and lack of strong players to act as counter-party.

While the market is maturing, this threat has not entirely vanished, as is evidenced by the suspension of the castor seed contracts in January and the chana futures in June this year. Threat of excessive speculation affecting the spot prices was cited as a reason for these recent suspensions, too.

The market regulator has plans to increase participation in agri-commodities by allowing domestic financial institutions, mutual funds and foreign institutional investors to participate here. Once that happens and volumes increase, this issue can be addressed. Traders can, meanwhile, mitigate this risk somewhat by staying in the more liquid counters. But the threat of the contract getting suspended, if there is a sharp one-sided movement in the commodity, continues and remains one of the greatest risks in this segment.

Fragmented spot market

The absence of a unified spot market that can provide the underlying price for anchoring the futures price is considered another drawback for the Indian agri-commodity segment. But exchanges have a process in place to ensure that spot and future prices are not entirely out of whack.

This is done through a price polling mechanism that is followed by the agri-commodity exchanges. The NCDEX follows a pretty elaborate method under which spot prices of each commodity are collected from a set of empanelled dealers and stakeholders most relevant for that commodity from various spot markets and mandis. These prices are bootstrapped (removing the outlier prices) and subject to further smoothening through statistical means to arrive at the spot price that is flashed live on the exchange.

SEBI, in a circular issued this month, has laid down rules regarding the disclosure needed to be made by exchanges regarding the methodology followed, the centres and panellists used for each commodity.

Finding a spot price to anchor commodity prices will become a lot easier once the proposed National Agriculture Market is fully operational. This is a pan-India electronic platform that will connect all the APMC mandis to create a unified spot market for agricultural produce.

NCDEX puts out live data on both the spot and future prices of contracts; this can help you select the commodity with the least variance.

Fear of government intervention

This is also not too great a concern as, over the years, the agri market has realised that it is best not to show too much interest in commodities too prone to government control.

If we consider the weights in the CPI index, for the base year of 2012, cereals and products have weights of 12 per cent in the rural basket and 6.5 per cent in the urban basket. Of the main cereals consumed in the country, rice has already been suspended from trading. While wheat and maize are traded on agri-commexes, volumes are not too high on these counters.

Of the politically sensitive pulses cluster, tur, arhar, etc, have already been suspended from trading. Trading in chana was suspended in June. Sugar continues to be vulnerable to political risk and hence, traders here need to keep a tight watch on government policies as well.

Edible oils, such as mustard, and soy refined oil have higher weights in the CPI and hence, are exposed to risk from government intervention. So, traders need to tread cautiously here as well.

Information deficit

There is a perception that commodities are a black-box with information hard to come by. But this is far from the truth. Exchanges provide a wealth of information on factors governing the price of each commodity, its price patterns and so on. Brokers also issue reports on commodities that can be quite helpful. Apart from this, investors should track the harvesting and sowing periods of a commodity, says Sushil Sinha. It is also important to follow the monsoon, on the IMD website. Most commodities are internationally traded, too, so information can be obtained from international exchanges, and research reports. Sites such as USDA (US Department of Agriculture) and the Indian Ministry of Agriculture can also be tapped.

Keeping track of mandi prices is essential at present. This can be done by following these prices on exchange websites or from the daily reports issued by brokers.

Game for risk?

To sum up, liquidity is generally low in commodity exchanges but some counters (in certain seasons) show enough liquidity to enable trading. Information is also not too hard to come by for those interested in following the market. Also, exchanges are trying to make the futures price as close as possible to the price traded on the mandis.

But the risk of sharp price movements due to price manipulation by a few insiders remains open. With SEBI at the helm, these wrongdoers could be checked, and the system cleaned up eventually. But that could take years. Meanwhile, the regulators continue to remain jumpy and continue to suspend trading in contracts with excessive price movements, leaving the users of these contracts in the lurch. This is eroding the credibility of these exchanges.

So, while agri-commodities could be an alternate avenue for making some money, it is suited only for the risk-takers.