China Securities Journal: Futures Market Will Be A “Bumper” for Substantial Economy

Updated on: May 27, 2016

Reported by Zhang Lijing & Guan Ping, Journalists from China Securities Journal

Since the beginning of this year, the bulk commodity markets at home and abroad have seen drastic fluctuations. Some futures products experienced sharp rises and drops. As a result, enterprise risk management demands have increased rapidly.

On the 13th Shanghai Derivatives Market Forum held recently, according to some experts, under the background of supply-side structural reforms, the asset allocations have been accelerated and the preferences of capitals have been changing. By researching futures market price fluctuations, enterprises can improve their inventory management and raw material pricing management and implement medium and long-term development strategies such as production expansion and reduction. For bulk commodity industries, there are challenges as well as opportunities for transformation. The futures market shall grasp the historic opportunities to help enterprises properly utilize risk management tools and enhance its level of serving substantial economy.

Local refineries get nervous due to accelerated price fluctuations

Recently the moods of investors for bulk commodities can be compared with roller coasters. With the drastic changes of black futures products, the prices of the bulk commodities including rubber, nickel and pitch have experienced violent and sharp fluctuations. Compared with that in the second half of last year, the fluctuations of bulk commodities have increased considerably.

As a saying goes, the market index is fixed and capitals are flowing. According to some analysts, the current frequent commodity market fluctuations are related to three mismatchings in Chinese economy. Firstly, the return of substantial economy has dropped, but the expected rate of return from capitals is still high; secondly, the situation of social funds is “more short-term funds and less long-term ones as well as more tightened funds and less loose ones”; thirdly, the two engines (globalization + labor force) of global economic growth have decelerated, but capitals are still excessive. Under the circumstance, asset allocations usually repeatedly shift between pursuing high risks and “grabbing liquidity” to form the shifts of asset allocations.

The rise of Bloomberg CRB index tracking 22 bulk commodities since this year has surpassed that of USA treasury bond index and US dollar index during the same period and become one of the most profitable investment assets in the first half of the year. However, ordinary enterprises have been quite nervous when the performances of some private equities for futures are rising with the rise of fluctuations.

As recent new forces of domestic crude oil imports, some local refineries have been worried when facing international oil prices wandering at high levels. “Once the oil prices drop seriously again, those local refineries that imported a great number of crude oil in May and has weak capital reserve and regular production problems may go bankrupt at first.” Some insiders said.

Recently, according to the 2016 Annual Report of Early Warning for Petrochemical Industry Production Capacity, issued by China Petroleum and Chemical Industry Federation, the rate of capacity utilization for the oil refining industry in 2016 may level off or keep declining and the overcapacity has been increasingly prominent, which are worth being on alert. According to the report, in 2016, the newly added oil refining capacity of China will reach 30 million tons; 30 million tons of backward capacity will be eliminated; the oil refining capacity will be maintained at about 800 million tons, and the oil refining capacity is 120 million tons more than actual demands.

Furthermore, “major repairs” have been a theme for bulk commodities market since this year. Take nonferrous metal futures as an example, the rebounds of Shanghai Copper, Shanghai Aluminum, Shanghai Zinc, Shanghai Lead and Shanghai Tin have reached 7% - 25% since this year. Due to the continuous supply-side reforms in the nonferrous metals industry, the united reduced and restricted production measures of copper and aluminum enterprises have been constantly performed since last year. However, unlike local refineries lacking of crude oil futures tools, the enterprises in the nonferrous metals industry are not quite worried about price fluctuations for the most enterprises of the industry have formed the habit of hedging for a long term.

According to public data, Chinese imports of crude oil reached 336 million tons in 2015, with year-on-year growth of 8.8%, ranking the second place in the world. The degree of dependence on imports keeps rising to a record high level 60.8%, and the figure may be as high as 67% by 2020. By the end of the 12th Five-Year Plan, refined oil products (gasoline, diesel, kerosene), the main oil refining products of China, have displayed the market conditions of supplies exceeding demands. On January 13, 2016, NDRC announced its pricing mechanism for new refined oil products. A “floor price”, USD 40/barrel, was added. The prices for refined oil products would not be adjusted during the sluggish periods of international oil prices, which “protected” the profits of domestic refineries at the beginning of 2016.

According to the journalists, facing the enormous spot market scale, “authoritative” price signal guiding and risk management mechanism is still absent for the development of the industries related to crude oil. In addition, the inadequacy of market systems has made relevant industries really connect with global markets, and they have to rely on “policy-based protection”.

According to some insiders, the futures market has high transparency, strong liquidity and concentration of supply and demand. The commonly used two pricing modes for spot trading of domestic nonferrous metals industry, in particular the copper industry, are based on futures, namely average futures prices and futures quotation prices respectively to determine the base prices for purchasing and selling relevant products. As a result, the futures market can reflect actual supplies, demands and variation trends in an accurate and comprehensive manner, which makes a good guiding function for producers and operators.

At the 13th Shanghai Derivatives Market Forum held recently, Shang Fushan, Vice President of China Nonferrous Metals Industry Association, said that as a financial derivative, the futures margin system has the attributes of monetary lever, making it a double-edged sword. If hedging tools are well utilized, not only can enterprises enhance their risk management level and realize their operation objectives, but also the nonferrous metals industry can implement supply-side reforms and accelerate “cutting excessive productivity, inventories and deleveraging, lowering costs and improving weaknesses”, especially under the circumstances that the current nonferrous metals industry operation faces declining investment efficiency and imports and exports, the importance of enterprises to participate in market activities can be more prominent.

In the above forum, according to Teng Jiawei, Deputy General Manager of Shanghai Futures Exchange, hedging has been on an apparent increase. A great deal of practices show that enterprises can completely transfer their market risks through hedging. In addition, practices show that enterprises can completely transfer market risks through hedging. In addition, the correlation coefficient of future prices and spot prices for nonferrous metals maintains above 0.9 and that for copper futures prices and spot prices is above 0.93. The favorable price correlation of nickel futures has made it a pricing standard for its spot prices.

Providing guarantees for business operation by establishing virtual inventory

Since the end of last year, there have been constant reduced and restricted production measures in the nonferrous metals industry under the background of continuous supply-side reforms, causing large increases in prices, while the prices have been in adjustment recently. The upstream and downstream enterprises have reached an intensive and compact “honeymoon period” for futures.

“In the past, many people thought that it is gambling for an enterprise to participate in futures hedging. In my opinion, it is gambling if I don’t do so.” The owner of a trading enterprise of nonferrous metals in Guangdong Province told this to the journalists of China Securities Journal. In recent years, the nonferrous metals industry has great changes in terms of the understanding for the industry. Many of them have achieved stable profits by using futures tools during the periods with drastic price fluctuations.

According to insiders, in market operations, the prices of futures market are expected prices in the future. Such prices can directly reflect the expectations of spot supply and demand changes as well as the changes of macro economy, financial markets and relevant industries. In addition, the connection between delivery mechanism and spot prices makes futures prices effective references for the operation of spot goods.

As a leading company of Chinese copper industry and one of Fortune 500 enterprises, Jiangxi Copper was a small and medium-sized copper company more than 20 years ago. The leaders of the group recently expressed that the development of the group has been based on futures. According to Wu Yuneng, Deputy General Manager of Jiangxi Copper, both the purchasing and selling of the corporation are based on futures prices and it keeps using futures market for hedging purpose. The business performance of Jiangxi Copper has been stable and sustainable for more than two decades. During the course, it development is indispensable with futures market and hedging. The futures market has played an important role in safeguarding its development.

According to Wu Yuneng, Jiangxi Copper successfully avoided the risk of large-scale “debt chains”, occurred in the 1990s, by making futures as its marketing channel. For example, nowadays many downstream copper processors have fully utilized futures market to establish virtual refined copper material inventory to lower actual refined copper material inventory so as to reduce the occupation of funds and relevant costs. “After many years of development, the futures market has been an effective supplement for entity enterprises to realize purchasing, selling and operation. Such enterprises can change their business practices and operation modes by fully using the futures market.”

As for market price risks in supply-side reforms, Wu suggested that enterprises can use futures market to establish their virtual mines. The period of purchasing mines is long, the occupation of funds is large and there are many force majeure factors. And the above problems can be effectively avoided by establishing virtual mines. “Domestic enterprise shall research the possibility and operation strategy of establishing virtual mines by using futures market.” He said.

According to Cai Dongcheng, a professor at the School of Finance and Business of Shanghai Normal University, with the development of Chinese oil product futures market, the gradually enhanced liquidity of available products will provide standard sites for relevant enterprises to effectively avoid operational risks. Shanghai Futures Exchange can guide enterprises to constantly adapt to changing market requirements by gradually improving product arrays, cooperating with supply-side structural reforms, optimizing standards for refined oil products, and utilizing market-oriented measures. In addition, the gradual improvement of available oil arrays and the system design of forward standard contracts may make enterprises the dynamic relations among the supplies, demands and industry profits in foreseeable future, which is conducive to making enterprises properly arrange production and operation, avoid relevant risks and adjust product mixes successfully as well as the long-term sound development of energy industries related to crude oil.

Futures market has constant innovations and more risk tools can be expected

Generally speaking, price discovery and risk management are common ways for futures to serve spot goods.

According to Wu Yuneng, for serving the spot goods industry, the futures market plays its role by giving play to price discovery and risk management. As for price discovery, futures trading has high transparency, strong liquidity and concentrated market supplies and demands. In terms of risk management, based on hedging, enterprises can transfer spot price fluctuation risks through futures market so as to get fixed prices of raw materials, inventories and products, which are quite important to guarantee profits under the background of sluggish business environment.

With the innovations of the futures market, some enterprises have achieved some innovations for business models by utilizing the advantages of futures and spot markets.

According to Ma Wensheng, President of Xinhu Futures, based on the demands of entity enterprises on futures market, the innovations of derivatives market mainly include three aspects: Firstly, the innovation of pricing systems for bulk commodities. Enterprises shall integrate upstream and downstream industry chains and further optimize industry chain pricing systems during the process of utilizing futures market to make relevant bulk commodities adapt to downstream and upstream trade chains by increasing or decreasing premiums based on benchmark prices of futures. Secondly, the innovation of financing modes. Enterprises can use the futures market to manage the price, and use the third party warehouse to manage the spot goods, so the banks are willing to allocate funds to support enterprises needs for warehouse financing and order financing. For the security of capitals is guaranteed, banks can use such modes to support the development of enterprises. Thirdly, the innovation of risk management tools. Besides futures market, there are new risk management tools, such as swap, over-the-counter options and mid and long-term contracts of bulk commodities in the market. These diversified tools can provide risk management services for enterprises.

Ma Wensheng expressed that the operation patterns of some enterprises have great changes as well due to the above innovations. Some of them have started the transition toward price management and risk management; some enterprises have become traders of bulk commodities; some have transformed to industry fund operators and some others have transformed to asset managers. These transitions have appeared in the market, and its core is properly using derivatives.

In addition, the supply-side reforms of the energy industry are important components of the structural reforms in the heavy chemical industry, while correct market guidance will be an important factor determining the success of such reforms. Authoritative “price signals” and product benchmark guides may become focuses for mutual adaptation between supply and demand, while the places and measures for avoiding operational risks are key factors for the sound development of relevant industries.

According to some insiders, at present, nearly everything is ready for Chinese crude oil futures. After the approval is made by the regulator, crude oil futures will be listed and traded at the international energy trading center of Shanghai Futures Exchange so as to commence the crude oil and refined oil product futures market of China. The oil futures with RMB as trading currency will appear in global energy markets. The business rules act on international conventions, and worldwide investors and enterprises can participate in it. The authoritative price signals of oil markets will be mature gradually in the future, and they may become key guideposts leading the operation and development of relevant industries.