Getting the global price right
Source: www.chinamining.org Citation: China Daily Date: August 18, 2015
Chinese companies are increasingly trading in global commodities to secure long-term supplies and exert more influence over pricing mechanisms.
As one of the world`s largest consumers of commodities such as agricultural products, metals, minerals, oil and gas, China has historically purchased these commodities from international markets at unfavorable prices due to lack of participation in international commodity exchanges, which set commodity prices.
But that is now changing as increasingly, Chinese banks, securities firms and commodity trading firms are joining international commodity exchanges, mainly to buy and sell commodities on behalf of their clients in China. This in turn helps them hedge against future price fluctuations.
For example, if a Chinese oil refinery knows the quantity of crude it requires in a year`s time to meet production targets, it can purchase Brent Crude on the US-listed Intercontinental Exchange, or ICE, at a price determined by the futures market. By receiving a locked-in price, the firm is able to accurately determine its business model and be certain of profit margins.
Before such trading activity became possible, the same company would have needed to either buy crude oil in bulk for storage, or wait a year until the oil is required, facing the risk of increased prices.
"It is natural for Chinese companies to take a more dominant position in the global commodity trading space, both physically and financially, because China is one of the biggest commodity consumers in the world," said Bjarne Schieldrop, chief analyst of commodities at SEB, a Nordic bank.
He said that in the commodity markets, the fundamentals of supply and demand determine the long-term price, but in the short-term, on the day when a trade is made, the price is set by financial markets because sentiment can move prices up and down.
"At the moment I think China is huge on the physical side while the rest of the world has dominance in the financial markets," Schieldrop said.
One of the reasons that China has historically not engaged in commodity trading on financial markets was because it was highly focused on securing actual supplies.
In addition, China`s capital account restrictions, which limit the amount and type of financial flows into and out of China, also has been a factor behind its limited involvement in international commodity trading. The liberalization of the capital account in recent years is allowing more Chinese banks to trade on international exchanges, Schieldrop said.
Chinese companies` increased trade in commodities in foreign exchange is also a natural continuation of rising Chinese investment and financing activities in the international commodity markets, said Josh Clarke, counsel in the Perth office of the law firm Squire Patton Boggs.
For example, in Australia, as Chinese companies have bought shares in natural resources firms, more of those Australian companies` activities are financed by Chinese banks that already have a working relationship with their shareholders.
This trend has led Chinese banks into the commodity financing sector, and as a result of such involvement, participation in the commodity trading and hedging space became a natural progression, Clarke said.
This increasing commodity trading by Chinese banks will benefit the global commodity trading markets by increasing liquidity. It will benefit the clients of the Chinese banks, for example, through making available to those clients the means to hedge their forward price risks.
In 2012, Bank of China`s commodities trading arm, BOCI Global Commodities (UK) Ltd, became a member of the world`s biggest metals bourse, the London Metal Exchange, giving it the right to trade by phone and electronically. This was followed by China Merchants Securities, one of China`s largest securities companies, and GF Financial Markets, a Chinese derivatives broker, which also started trading on the LME.
Earlier this year, Bank of China became the first Chinese bank to join the auction process that sets gold prices in the London market, run by ICE Benchmark Administration.
These initiatives by Chinese banks are happening at a time when Western banks are retreating from the commodity trading sector due to declining profitability in the sector and increasingly stringent financial regulations following the 2008 financial crisis.
Most of these financial regulations demand stricter capital requirements for banks, such as Dodd-Frank, EMIR, and Basel III, and limits on proprietary trading by banks, such as the Volcker Rule.
Last year, Barclays said it would give up most of its metals trading, and JPMorgan agreed to sell its physical commodities business to Mercuria, a Swiss commodities trading firm.
Chinese banks` bigger balance sheets mean on average they have more capacity for commodity trading while still meeting the requirements, Clarke said.
"Chinese banks trading in this space have bigger balance sheets to start with than other banks, so the overall risk from such activities may be lower. Potentially, the returns for Chinese banks may be higher, or pricing keener, if the cost of capital used for such trading activities is lower than other banks," Clarke said.
Meanwhile, China is also setting up its own commodity exchanges to allow Chinese buyers and sellers to trade on a platform in their own time zone, and in a market which they are more familiar with.
Because commodity exchanges in China have trades denominated in yuan, Chinese participants are not subject to exchange risks or capital controls that they would face by participating in overseas exchanges.
China has three key commodity exchanges, the Shanghai Futures Exchange, established in 1999; the Dalian Commodity Exchange, established in 1993; and the Zhengzhou Commodity Exchange, established in 1990. None allows foreign participation because of China`s capital controls.
Fang Jian, a partner at the London-based law firm Linklaters, said that China`s three biggest domestic exchanges are all exploring how they can best open up to foreign trading. It is possible that the government will eventually allow foreign traders, who meet certain criteria, to take part.
"What the Chinese regulators are doing is realistic. The process of liberalization for commodity trading in China may be quite similar to the process of gradually allowing qualified foreign institutional investors to participate in China`s stock market," Fang said.
Despite the Chinese commodity exchanges being relatively young, they have already gained significant influence in the commodity industry because of the massive volume of trade in the country.
They are also increasingly providing benchmark prices for commodities in their respective sectors, according to Daniel Morgan, global commodity analyst at UBS.
For example, iron ore traders now look to the Dalian Commodity Exchange for iron ore prices as a reference point, due to the large volume of trade on the exchange, Morgan said.
"As many iron ore buyers use the Dalian Commodity Exchange to hedge their risks, the exchange quickly received significant liquidity. When it first started trading, we and other people in the market were surprised by how quickly this liquidity came. Given its status now, it`s hard for anyone else to try to wrest it away," he said.
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