Commodity Volatility Increases, Futures Company Should Avoid Risks

Updated on: April 5, 2016

Reported by Journalist Guan Ping

In recent years, steel prices continued to fall, the steel industry got into an overall loss predicament. Public information shows, Chongqing Iron and Steel’s loss in 2015 reaches 5. 987 billion yuan, and became the worst player; Maanshan Iron & Steel and Ansteel followed, respectively with loss of 4.804 billion yuan and 4.593 billion yuan. It is worth mentioning that the "futures investors" -- private enterprises Shagang Group bucked the trend to achieve profit of nearly 1.9 billion yuan that year.

"Futures are risky but more risky without futures." said Jiao Yonggang, Director of the Futures Division of Shandong Jinjing Technologies Inc. The group leaders said these words three years ago. As a state-owned enterprise engaged in production of glass, they started from tieing with futures to being mature in futures trading, then to high-frequency contact and combination, during which although it is bumpy, but gained a lot.

For state-owned enterprises, there is a vague concept in all rules - not to involve in futures. In fact, as the enterprise has practical obstacles in accounting principles for hedging restrictions and separate audit on futures and spot. So state-owned enterprises are indeed separated by a "glass door" to participate in the futures market. Insiders said that in the conditions that the commodity market go sharply up and down, both state-owned enterprises and private enterprises should learn and use futures well to manage risk, avoid the strike of the market brought to production.

Hedging can avoid operational risks

In 2012, Shandong Provincial Bureau of Securities and Supervision held Taishan Forum in Jinan. As the head of the largest glass enterprise in the province and Chairman of Jinjing Group, Wang Gang also attended the two-day meeting.

Jiao Yonggang revealed that after the meeting, the leaders from Shandong Provincial Bureau of Securities and Supervision reflect, on conference, Wang Gang is the most attentive, concentrate on taking notes, besides rest, basically did not leave the meeting room. When going back to the company, he specifically hold a meeting on futures market. In the company meeting, Wang Gang pointed out that it is risky to do futures trading, but if not, there are more risks.

"The tie of Jinjing and futures is like ‘falling in love’. It started in October 2011, when Zhengzhou Commodity Exchange organized a research on glass futures, and the first phase is to love futures “at first sight”; the second phase begins normal communication, such as discussing glass futures contract and the draft system; The third phase is formal uniting, and the agreement on establishing Jinjing Technology Delivery Warehouse was signed." said Jiao Yonggang.

In recent years, the glass industry has become increasingly competitive. In 2010, there were about 240 glass production lines in the country. By 2015, the number of glass production lines increased to 340. The excess capacity was serious, and the downstream processing enterprises also face similar difficulties. Profits of the industry are falling, and the average glass price is about half that of five years ago. Under such circumstances, the business risks faced by glass enterprises are increasing, but in the absence of glass futures, enterprises have little to do in the face of market risks. On December 3, 2012, Zhengzhou Commodity Exchange 's glass futures were listed. Glass companies are both happy and curious, and in cautious too. Industry insiders believe that it has sought another sales channel for glass entities, and has become a risk management tool for entities.

Jiao Yonggang believes that top leader of enterprises must understand futures, there must be a clear organizational structure, strict risk control system and operational processes. As an entity, there must be a scheme or pre-arranged plan before each futures transaction or every decision. For large enterprises, hedging transactions can avoid the risk of spot operation and make up for the loss of spot management. Jiao Yonggang pointed out that trading futures for a few years, as enterprises, what valued most is not how much money earned in futures transaction, but how much risk is avoided, how much loss of business it makes up for.

It is worth noting that industrial enterprises should recognize their own advantages and disadvantages when they participate in futures. As far as the glass industry is concerned, the upstream and downstream enterprises are well acquainted with the actual supply-demand in market. In addition, there are also spot sales channels, especially as glass delivery warehouse. The advantages are more important and obvious. but the disadvantage is that the glass enterprise has deep-rooted spot thinking, and lacks specialized knowledge of futures, the spot thinking cannot be reversed in short time, and ignore easily the market funds and trend strength.

Jiao Yonggang said, Jinjing Technology involved in the futures market, first, it is owing to "earliness"——early contact, early grasp, early participation, early benefited; second, owing to the "specialized" operation——a specialized-assigned person, full-time; third, owing to "strict" transaction control system——strict scheme and process; forth, owing to coordination of "diligence"——diligent in learning, communication, reflection; fifth, owing to the discipline and stopping where it should. Whether the enterprise is hedging or speculating, if excess operating, the risk is not controllable.

The insiders of the industry also said that in the process of participation in futures, violating the original intention, that is crazy, therefore, we can neither be a fool, nor be a madman .

Barriers for participation in futures

In fact, the state-owned enterprise participating in futures is nothing new. More than 10 years ago, "China Aviation Oil" incident, "National Copper Storage of SRB" incident, Hunan "Zhuzhou Smelter" incident, are typical cases of state-owned enterprises involving in futures and go astray. These events afford state-owned enterprises useful lessons.

For state-owned enterprises, futures is more like a rose with thorns. Although the futures transaction is conducive to risk management, but entering the market still exists "glass door".

Insiders said, although the state-owned enterprises have greater risk management requirements, due to some external factors such as policy, it is largely restricted, such as the evaluation and assessment for state-owned enterprises participating in futures and derivatives trading is not objective and complete; the current accounting principle for enterprises identification and treatment on hedging is too strict; part of the tax policy have a certain impact on enterprise involving in futures trading.

An director from a large state-owned enterprises said to Chinese Securities Journal journalist that early as 2002, the company began to actively enter the futures market hedging, futures accounts are profitable at first, and often praised by the superiors, but in 2006 as prices rose sharply, enterprises sold hedging, resulting in losses, but because the rival who did not participate in the future, its overall profit instead exceed the company, which was blamed and criticized by the higher authorities that year, while the rival was praised.

The situation is universal. Due to the high risk of futures trading, the state-owned assets management department has been cautious on state-owned enterprises involving in derivatives trading. In current assessment of state-owned enterprises to participate in futures hedging transactions, no loss is allowed but profit, and shall bear the responsibility when occurring loss, to some extent hinder the enthusiasm of state-owned enterprises using derivatives such as futures tools.

Since 2014, Ministry of Finance and Securities Regulatory Commission (CSRC) attache great importance to the problems of hedging accounting, formed a special group and have carried out many fruitful research work. State-owned Assets Supervision and Administration Commission of the State Council (SASAC) also actively support the qualified central enterprises under the condition of controllable risk to be engaged in hedging using futures market, but the problem hasn't been solved yet, it is still difficult for enterprises to participate in hedging transactions efficiently.

In addition, in the Accounting Standards for Enterprises No. 24—— Hedging, regarding the cognizance of the corporate hedging, the regulations such as hedging the actual offset of the results in the range of 80% to 125% is relatively rigid, and enterprise may exceed its limit in practice because the price fluctuation of futures and spots are inconsistent, and easily identified as speculative trading, and do not accord with the current corporate hedging demand.

On November 26, 2015, Interim Provisions on Commodity Futures Hedging Business Accounting issued by the Ministry of Finance caused much attention. General Manager Assistant of Beijing Huarong Qiming Risk Management Technology Co., Ltd., Chen Zhijun pointed out that the interim provisions is still not quite clear on the difference between spot business and risk exposure, cause confusion in hedging and accounting, brings certain difficulties to corporate hedging.

Use futures tool skillfully

It is not that difficulties cannot be overcome. The difficulty state-owned enterprises faced is that industry overcapacity is serious, product prices continue to fall, if skillfully using futures tools, they can reduce the loss to a certain extent, and even turn a profit.

In the case of steel companies, prices of ore, coal and scrap were down 39.4 %, 33.3% and 45 % respectively in 2015, leading to a sharp decline in the cost of steel production. However, the impact of steel price decline on sales revenue has far exceeded the impact on cost of raw material prices during the same period, and steel enterprises have suffered serious losses.

In 2015, according to the China Iron and Steel Association statistics, 101 large and medium-sized steel mills gained profit - 64.53 billion yuan, down 87.12 billion yuan compared with last year, yearly loss ratio is 50.5%, unprofitable enterprises increased to 34, loss amount up to 81.72 billion yuan, loss increased to 61.52billion yuan year-on-year.

It is worth noting that when the industry is large losses, it is better for steel companies with abundant experience in futures markets such as Shagang Group and Rizhao Steel. The relevant person in charge of a large domestic futures company, according to the reasonable reason is that they use the futures market to hedge risk, and part of state-owned enterprises due to the proper use of futures tools make the loss of momentum is contained. However, most of the surplus industry still do not value futures.

It is worth noting that when the steel industry is in loss in large scale, steel companies with abundant experience in futures markets such as Shagang steel group and Rizhao steel have good gains. The director of a large domestic futures company revealed that they reasonably use the futures market to hedge risk, and besides, part of state-owned enterprises through proper use of futures tools make the loss contained. However, most of SOEs in surplus industry still do not value futures.

In the steel futures market, Shagang Group has always played the role of participants. Compared with the relatively stable and conservative state-owned enterprises, Shagang Group has been very active in the futures market. Previously, the relevant person in charge of Shagang Group said that due to big volatility of the raw material price, the company has strong willing to hedge using futures market, for example, based on ratio of raw materials, buying iron ore futures and selling rebar futures to ensure processing profits.

"Some top leaders don't even know how to make money by selling short." Shi Jianjun, General Manager of Yongan Futures, said that the there will be no problem for the top leader (state-owned enterprises) to handle if they can really learn and understand it. COFCO and Jiangxi Copper Group are good examples.

Shi Jianjun points that debt is leverage. Once prices go down, it's a big risk. The accounting system is of no problem. Some people say that the futures losses should be held accountable, but COFCO is not held accountable, so the accounting system is not the main problem. The futures used as a crutch is better than nothing. For companies in glass industry, a futures department is to be set up separately, but if it is not linked to the supply and sale, the futures department will become a speculative part, which will not benefit the production and operation. The appraisal of futures department should set up an evaluation standard for production, sales and futures.

The insiders said the current commodities rise and drop suddenly and sharply, either state-owned enterprises or private companies, such as steel, coal industry with overcapacity pressure, at this time participate in hedging to better reduce losses, maintain the stability of the operating profit, evade the risk in the process of production and operation.