By Cindy Nana, Cargill Cotton
In March 2008 the Interncontinental Exchange (ICE) futures market experienced a historical price spike that was largely driven by speculation. It hurt many key merchant players who used the futures market to fully hedge their physical positions. Since then, it has become more challenging for merchants to fulfill their task of buying and selling whenever the mills or producers are in the market. The volatility visited upon the market has forced different industry players to change some of the rules of the trading game. In this article we will look at the key lessons learned and how they should be implemented for 2012 and beyond.
In March 2008, a historic record was achieved by ICE as more than 300,000 contracts were opened. This drove the market technically high forcing some reputable merchants to liquidate their hedged positions in order to meet the margin call requirements. The main lessons learned from this event is the need to work closely with banks or financial departments before working in physical positions and to have a market risk management strategy in place. When deciding to hedge positions by using ICE future market tools, users need to be aware that the market could potentially go up 700 points a day or even higher synthetically with options. Is there sufficient financing or cash flow to be able to hold the position in case the market is visited by speculators with a different market view? Answering this question through financial analysis will allow a business to define a position size that it can easily manage despite the volatility of the market.
Willing to take the risks
In the last three years, the main single-commodities merchants have exited the market leaving in their place several well financed multinational companies who seem more than willing to take the bigger risk provided by the volatility of the ICE market. However, as money is a finite resource, the multinationals still need to provide a competitive return on equity to ensure company funds are optimally employed. Given the margin call variable, it is making more sense for merchants to focus on the ongoing crop business rather than 12 month forward fixed price business. This will minimize the counterparty risk and maximize the annual return on equity.
From the ginnerΆs or producerΆs point of view the market has brought an opportunity over the past two seasons to sell above production cost. Therefore, some sold more than three quarters of their expected crop prior to harvest time. Unfortunately, they were not all able to deliver full quantities. As a result, the opportunity given by the market to sell the crop forward ended up as a financial disaster. The undelivered quantity was negotiated with an intercrop market and was at one stage more than 80 cents reverse. For 2012, ginners need to have the discipline not to commit more than one third to fixed contracts before harvest time. However, they can commit an additional share of their production using on call price contract with a minimum price guaranteed option. This would allow them to benefit from the upside of the market while limiting exposure to the downside. These contracts could be used as collateral to obtain financing from the banks for their production needs.
In this uncertain environment it is also essential to have trust in the principle of contract sanctity and the ability of the counterparty to execute. The performance of counterparties can no longer be measured on their historical performance as the high price range volatility of the market is changing the industry. With an incentive of 80 cents market difference, there is a very healthy incentive to default. It is vital for each trading entity to know their counterparty and define the amount of business that they are willing to do with them according to the most up to date financial and commercial analysis. If the counterparty fails to fulfill their contractual obligations the failure needs to be registered with the relevant cotton arbitration body which will provide protection through an opportunity to get an award. As Ray Butler said, “history shows that an increased number of disputes and consequently arbitrations are the inevitable results of market instability”.
Indeed in the last three years we have seen an increasing number of contract failures with 2011 likely to hit an upsetting and historical record. Unfortunately, the big price fluctuations have seen more parties who are no longer able to perform and thus lose their reputations. In 2012, all industry participants should register and support their cotton association which will provide them with some “protection”.
Within this volatile environment organisations such the International Cotton Association (ICA), China Cotton Association (CCA) and Association Française Cotonnière (AFCOT) continue to work together with the Committee for International Cotton Co-operation between Cotton Associations (CICCA) to protect the principle of “contract sanctity”, provide “good trading practices” and a harmonized framework of rules and by-laws. Last year, CCA and ICA signed a Memorandum of Understanding to formally acknowledge the cooperation between the two associations. This initiative should be encouraged as despite uncertainties, this will continue to be a people business in which reputations and trust will remain key success factors in the industry.
The other challenge will be for the merchants not only to buy or sell whenever producers, ginners or mills are in the market but also to use their knowledge of the ICE market and expertise to provide customers with value-adding solutions. For example, they could meet the millΆs need for a constant cotton price to make yarn production remain competitive, by providing an on call contract with a guaranteed maximum price.
This partnership will help to decrease the biggest threat to industry - counterparty risk. Indeed the more defaults, the greater the financial losses and risk, and the more conservative pricing becomes by merchants who need to get an acceptable return on their equity to survive.
