China's Commodity Futures On The Ascent

BMI View: Through launching a host of commodities futures contracts, Chinese authorities aim to empower domestic consumers with greater hedging tools and a larger say in the global pricing of major commodities . Despite fast development of the number of contracts and trading volumes, we do not believe China's futures markets pose any immediate threat to the giant benchmark exchanges in the US and the UK. In fact, the successful implementation of trading platforms in China is not without major roadblocks, as Chinese authorities maintain a tight grip on commodities production and pricing as well as on financial markets regulations.

In an effort to enhance China's pricing power in the commodities market, authorities have been making bold strides in the establishment of domestic-based commodities futures contracts in recent years. For decades, the London Metals Exchange (LME), Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT) and the IntercontinentalExchange (ICE) have dominated commodities pricing. Yet, in recent years, none of these global heavyweights can claim the top three spots for the most-actively traded commodity futures contracts. Instead, China's three futures commodities exchanges, Dalian, Zhengzhou and Shanghai top the global leader board. In fact, the 326mn soybean meal contracts that changed hands on the Dalian Commodity Exchange (Dalian CE) in 2012 made it the world's most-active commodity future, far ahead of the 73mn corn contracts traded on the CBOT, according to the Washington-based Futures Industry Association ( see table at end of article).

China's futures contracts cover a wide range of commodities, including metals such as aluminium, zinc, copper and lead, as well as soybean, corn, wheat, sugar and cotton for agriculture. However the total number of contract is still limited compared with the hundreds of contracts operated by the large exchanges in the US and the UK. Recently, China extended the futures coverage for five commodities:

  • Zhengzhou Commodity Exchange (ZCE) launched trading of China's first steam coal futures on September 26.

  • China Securities Regulatory Commission (CSRC) approved in September futures contracts for eggs on the Dalian CE. This will be China's first livestock contract.

  • Shanghai Futures Exchange (SHFE) started trading futures contracts for road-paving material bitumen on October 9.

  • China's first iron ore futures contract debuted on the Dalian CE on October 18.

  • CSRC approved futures contracts for short-grain rice (Japonica rice) and late Indica rice on October 18 on the ZCE.

Colossal Imports
Select Commodities - China Imports, 2012 (As % of global volume)

China's Commodity Futures On The Ascent

BMI View: Through launching a host of commodities futures contracts, Chinese authorities aim to empower domestic consumers with greater hedging tools and a larger say in the global pricing of major commodities . Despite fast development of the number of contracts and trading volumes, we do not believe China's futures markets pose any immediate threat to the giant benchmark exchanges in the US and the UK. In fact, the successful implementation of trading platforms in China is not without major roadblocks, as Chinese authorities maintain a tight grip on commodities production and pricing as well as on financial markets regulations.

In an effort to enhance China's pricing power in the commodities market, authorities have been making bold strides in the establishment of domestic-based commodities futures contracts in recent years. For decades, the London Metals Exchange (LME), Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT) and the IntercontinentalExchange (ICE) have dominated commodities pricing. Yet, in recent years, none of these global heavyweights can claim the top three spots for the most-actively traded commodity futures contracts. Instead, China's three futures commodities exchanges, Dalian, Zhengzhou and Shanghai top the global leader board. In fact, the 326mn soybean meal contracts that changed hands on the Dalian Commodity Exchange (Dalian CE) in 2012 made it the world's most-active commodity future, far ahead of the 73mn corn contracts traded on the CBOT, according to the Washington-based Futures Industry Association ( see table at end of article).

China's futures contracts cover a wide range of commodities, including metals such as aluminium, zinc, copper and lead, as well as soybean, corn, wheat, sugar and cotton for agriculture. However the total number of contract is still limited compared with the hundreds of contracts operated by the large exchanges in the US and the UK. Recently, China extended the futures coverage for five commodities:

  • Zhengzhou Commodity Exchange (ZCE) launched trading of China's first steam coal futures on September 26.

  • China Securities Regulatory Commission (CSRC) approved in September futures contracts for eggs on the Dalian CE. This will be China's first livestock contract.

  • Shanghai Futures Exchange (SHFE) started trading futures contracts for road-paving material bitumen on October 9.

  • China's first iron ore futures contract debuted on the Dalian CE on October 18.

  • CSRC approved futures contracts for short-grain rice (Japonica rice) and late Indica rice on October 18 on the ZCE.

Unsurprisingly, many of these contracts have been launched for commodities that China typically sources heavily from the seaborne market.

Colossal Imports
Select Commodities - China Imports, 2012 (As % of global volume)

Iron Ore: Diluting Big Three Dominance

In the case of iron ore, China's weight on the seaborne market has been growing rapidly over the past decade, from 27% of global imports in 2003 to 65% in 2012. This was mainly driven by the unparalleled expansion of the Chinese steel sector, which accounted for more than 75% of incremental global steel production over the same period.

Ore-Some Share
China - Iron Ore Imports & Crude Steel Production (% Share of Global Total)

Crucially, the consolidated nature of the seaborne trade in iron ore has long been a bone of contention for many Chinese steel mills. Chinese steelmakers have accused the big three iron ore miners - BHP Billiton, Rio Tinto and Vale, of pulling back supply in order to artificially push up international prices. While facts on this are thin on the ground, China is certainly keen to dilute the pricing power of the big three given that they secure more than two-thirds of the seaborne trade. The futures launched by the Dalian CE on October 18, 2013, would thus provides an alternative reference price for iron ore purchases that are currently based on index prices derived from a small proportion of China's spot transactions. Data providers Platts and Metal Bulletin also provide benchmark prices according to spot sale tenders held by global miners.

Major Chinese steelmakers such as Angang, Baosteel and Shagang have expressed interest in the Dalian Futures. The Dalian contract marked the world's first iron ore futures that is backed by physical delivery and should enable domestic steelmakers to draw on the massive untapped hedging potential in China as it is denominated in the local currency. Encouragingly, the physical delivery of iron ore would align futures prices closer to the spot market by more accurately reflecting the current supply and demand fundamentals in the spot market. In contrast, the Singapore Exchange's futures contract and swap contracts cleared by the SGX and CME Group are cash-settled against The Steel Index (TSI) price.

In Australia & Brazil's Hands
Global - Iron Ore Exports By Country (2012)

Coal: Garnering Significant Interest

In September, China's first steam coal futures contract was launched on the Zhengzhou Commodity Exchange as one of the most heavily-traded contracts. Only Chinese entities and China-registered wholly foreign-owned enterprises (WFOE) will be allowed to trade the contract, which will be denominated in yuan and based on coal with a calorific value of 5,500/kcal/kg.

We believe the Zhengzhou coal contract will garner significant interest over the coming quarters. The persistent fall in domestic coal prices this year should lock more consumers into the contract as China's appetite for coal-fired power generation continues to grow in absolute terms. Despite growing green initiatives, we expect coal to continue dominating the country's overall energy mix - from 76.8% of total electricity generation in 2013 to 71.7% in 2022 ( see 'Beijing Clears The Air, But Broader Impact To Be Limited', September 16).

Coal Dominates
China - Electricity Generation By Type (TWh)

Egg Futures: First Of Many Livestock Futures

China's livestock prices usually see large fluctuation and are cyclical, as periods of high prices lead to investment in capacity, which eventually leads to overproduction, pushing prices down. As such, the launch of the egg futures will help stabilise the cycle and is likely to help the financial health of the sector, which will now be able to hedge the entire supply chain, from feed to final product prices.

We believe more livestock futures contracts are likely to follow suit, especially in the poultry sector which is the most industrialised livestock segment and is the most in need of efficient pricing methods. A live hogs futures contract is also likely to be launched in the coming years, given China's aim to industrialise the pork sector and to smooth out the hog cycle.

More Than Gaining Pricing Power

While the growing number of futures contracts is indicative of Beijing's push to ink a larger presence in the pricing market, a clearer-eyed analysis of recent economic reforms in China suggests a broader trend at play. Specifically, the ascendancy of the futures market forms part of the Chinese government's move to liberalise its economy ( see 'Third Plenary Session To Focus On Moderate Economic Reforms', October 07).

With the Chinese economy on course for a sharp slowdown over the coming years, China is gradually embracing financial innovation to spur economic growth in the country. Amongst a slew of other measures, the Chinese government is encouraging domestic companies to rely less on state subsidies and bank loans to support their businesses. In this case, it is pushing Chinese companies to take up greater ownership of their businesses through more efficient cost management. The increasing number of commodities futures contracts should enable greater hedging activities by domestic companies, thereby greatly reducing their exposure to price fluctuations. Indeed, the ascendancy of China's futures market in recent months highlights the increasing hardline stance of Beijing's new leaders when it comes to ending the decade-long support for many Chinese companies.

More Economic Reforms As China Rebalances
China - Real GDP Growth (% chg y-o-y)

Not So Easy

Despite excitement over the new futures contracts, the successful implementation of these trading platforms is not without major roadblocks. Therefore, we do not believe China's futures markets pose any immediate threat to the giant exchanges in the US and the UK that set benchmark prices for most commodities. So far, the emergence of big futures exchanges in China is giving the country a role, but not control, in determining global prices.

For example, the Dalian contract for iron ore faces pronounced challenges. According to China Securities Regulatory Commission, the trading unit of the contract will be 100 tonnes per lot, with the standard quality for delivery at 62% iron. However, it will be difficult to ensure the quality of iron ore in the physical delivery as the grades of the mineral varies significantly within every shipload depending on the source. The iron ore contract could also struggle to gain traction over the near term as a large number of Chinese steelmakers usually source their input from certain suppliers and are thus unaccustomed to hedging future supply.

Moreover, Chinese authorities maintain a tight grip on its commodity exchanges as part of efforts to deter speculators from driving up food and resource prices. The three commodity futures exchanges only allow very limited foreign participation. Financial institutions are barred from participating, and brokers cannot take positions, while government-owned entities are among the biggest traders. China's regulation of its food production, via a rigid control over cultivated area and minimum prices also limits the efficiency gains and price discovery mechanism on the futures markets.

Finally, the Chinese yuan is not a fully convertible currency and China has a relatively closed capital account, which we see as a major obstacle to China's goal of developing international futures contracts and of having a larger say in the pricing of commodities. While we may have seen incipient financial reform and capital account liberalisation recently, given Beijing's preference for a gradual economic reform, a fully liberalised capital account is unlikely to materialise in the near-term ( see 'No Room For Change To Monetary Peg' September 30). As such, we believe China's local commodities exchanges will mainly focus on improving domestic supply and demand efficiency and hedging capabilities for now.

Global - Top Commodities Futures Contracts
Agriculture
Contract Exchange Country Of Exchange No. of contracts traded, 2011 ('000) No. of contracts traded, 2012 ('000)
1 Soy Meal Futures Dalian CE China 50,170 325,876
2 White Sugar Futures Zhengzhou CE China 128,193 148,290
3 Rubber Futures Shanghai FE China 104,286 75,176
4 Corn Futures CBOT US 79,004 73,184
5 Soy Oil Futures Dalian CE China 58,012 68,858
6 Soybean Futures CBOT US 45,153 52,041
7 No1 Soybean Futures Dalian CE China 25,239 45,475
8 Palm Oil Futures Dalian CE China 22,593 43,310
Metals
Contract Exchange Country Of Exchange No. of contracts traded, 2011 ('000) No. of contracts traded, 2012 '000)
1 Steel Rebar Futures Shanghai FE China 81,885 180,562
2 High Grade Primary Aluminum Futures LME UK 59,558 59,124
3 Copper Futures Shanghai FE China 48,961 57,285
4 SPDR Gold Shares ETF Options Multiple US exchanges US 74,967 54,568
5 Silver MIC Futures MCX India 46,865 51,442
6 Comex Gold Futures Nymex US 49,176 43,893
7 Silver M Futures MCX India 46,804 36,267
8 Gold Petal Futures MCX India 31,087 36,004
Source: Futures Industry Association
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