Why there is no perfect strategy for hedging in commodity markets

Inventories for storable commodities have always played a crucial role in price formation. It acts as a buffer that helps absorb shocks to demand and supply affecting spot prices.

However, there is a possibility of a stock-out implying that the basis can surge in times of shortages. In case of importable commodities, such situations are sometimes created by squeezing the supply lines for a time period.

On the other hand, larger processors of soyabean, mustard and maize hold commodities to reduce costs of adjusting production over time and also to reduce marketing costs by facilitating production and delivery scheduling and avoiding stock outs.

If marginal production costs increases with the rate of output and if the demand fluctuates, processors can reduce their costs over time by selling out inventory during high-demand periods and replenishing inventories during low-demand periods. Selling out of inventory during high-demand periods can reduce the adjustment costs.

Processors most often try to determine their own production levels with the expected inventory drawdown or build-ups. However, the information on the real stock and inventory level is never available from a reliable source in India.

It is mostly hearsay or a trade rumour. Prices and inventory level fluctuate considerably from time to time which may partly be predictable due to seasonal production and the unpredictability part is generally brought by the market players in response to demand expectations.

Very often the decisions are made in light of two prices – a spot price for sale of the commodity itself, and a price for storage.

Thus there are two inter-related markets for a commodity, the cash market for immediate, or “spot,” purchase and sale and the storage market for inventories held by both producers and consumers of the commodity. Because inventory holdings can change, the spot price does not equate production and consumption.

Instead, it characterises the cash market as a relationship between the spot price and “net demand,” i.e., the difference between production and consumption.

Total demand in the cash market is a function of the spot price and other variables such as weather, aggregate income and random shocks reflecting unpredictable changes.

Processors and consumers often seek ways of hedging in the markets in response to the price volatility. Whether this is done by way of financial instruments such as futures contracts or by physical instruments such as inventories depends on the appetite of entities in the value chain.

Rarely is there one perfect strategy, hence the key to optimal decision making is to understand the tradeoffs that are occurring in deciding on the actual strategy.

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