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RAJAT BHATIA

GLOBAL COMMODITY MARKETSwww.fea.com/resources/a_mean_reverting_processes.pdf

NEURAL CAPITALOutlinePage OVERVIEW OF COMMODITIES TRADINGAncient times: Rice Futures - 6000 Years ago in ChinaOptions known to Greece in 350 BCShortage of commodities sparked warsOversupply resulted in devaluing core commoditiesModern times: Japanese traded Futures in the 17th centuryOSAKA Rice Exchange 1730, first organized futures marketCBOT 1848, Evolution begins EVOLUTION OF COMMODITY TRADINGLocal Market InteractionComparative advantage of local marketEvolution of specialty marketsEvolution of commodity traderForward deals / derivativesCentralized location / Credit Risk minimizationFormation of Board of TradeExchange of deals before deliverySpeculation on commodity outlookPermitted commodity category / ListingModern day exchangeDerivatives / Exotics COMMODITIES UNIVERSE

The COMMODITIES RESEARCH BUREAU INDEX (Now the Thomson Reuters/Jefferies CRB Index)Data Source: Thomson Reuters

The Thomson Reuters/Jefferies CRB Index (TR/J CRB) is a commodity futures price index

First calculated by Commodity Research Bureau, Inc. in 1957 and made its inaugural appearance in the 1958 CRB Commodity Year Book SUBGROUPMARKETSWEIGHTEnergyCrude Oil, Heating Oil, Natural Gas17.6%GrainsWheat, Corn, Soybeans17.6%IndustrialsCopper, Cotton11.8%MeatsLive Cattle, Lean Hogs11.8%SoftsCoffee, Cocoa, Sugar, Orange Juice23.5%Precious MetalsGold, Silver, Platinum17.6%Components of the CRB IndexCurrently consists of commodities quoted on the NYMEX, CBOT LME, CME and COMEX

RATIONALE FOR INVESTING IN COMMODITIES

China has the worlds largest volume in commodity derivatives with a 51% global market shareSGFE = Shanghai Futures ExchangeDCE = Dalian Commodity ExchangeZCE = Zhengzhou Commodity Exchange (Estd. 1990)Source: Nomura Research Institute 91

THE CENTER OF GRAVITY OF GLOBAL COMMODITIES TRADING IS SHIFTING TO ASIA-PACIFIC

THREE OF THE TOP FIVE COMMODITY EXCHANGES ARE IN CHINA

RISING PER CAPITAL GDP IN INDIA AND CHINA WILL RESULT IN GREATER CONSUMPTION OF METALS Source: RIO TINTO

FINANCIALIZATION OF GLOBAL COMMODITY MARKETS EVOLUTION OF INDIAN COMMODITY MARKETBombay Cotton Trade Association Ltd. Established in 1875Commodity specific exchanges Gold, Jute, Pepper, Turmeric, Potatos, Sugar etc1940s: Price controlsForward Contract Regulation Act 1952Govt. Suspended cotton, jute, edible oilseeds trading in 1960s and 1970s During late 1970s, ban was removed on selected basis but contracts were mostly illiquidIn the early 1980s the government allowed forward trading in agricultural commodities (of lesser importance - castor seed and castor oil, jaggery, jute, pepper, potato and turmeric)Local exchanges National level exchanges established in 2003 CASH Versus FUTURESMarkets are separate but interrelatedCash MarketCommodities are physically bought or sold in the spot marketContracts requires actual delivery of commoditiesFutures MarketBuying and selling of standardized contractsdoes not involve immediate transfer of ownershipPossession of commodities not requiredOffers hedging and risk management platformMost contracts are squared off before actual deliveryCash and Futures prices converge as contracts approach maturity

PRECIOUS METALSGOLD Gold is primarily a monetary asset and partly a commodityMore than two thirds of total accumulated holdings of Gold are driven by Investment:Central Bank reservesPrivate High Net worth InvestorsHigh-carat jewelryLess than one third of golds total accumulated holdings is as a commodity for jewelry and industrial purposes

CHARACTERISTICS OF GOLD CHARACTERISTICS OF THE GOLD MARKETThe Gold market is highly liquid and gold held by central banks, other major institutions and retail jewelry keeps coming back into the marketDue to large stocks of Gold compared to its demand, the core driver of the real price of gold is stock equilibrium rather than flow equilibriumEconomic forces that determine the price of gold are different from, and in many cases opposed to the forces that influence most financial assetsThe factors determining the price of gold are fundamentally different from those of other commodities and assets. The price of gold is inversely related to its supply while it moves parallel to inflationReturns from gold and equity markets have a low correlationPrice of gold is inversely related to the value of the U.S. dollar Supply from sales by central banks, reclaimed scrap and official gold loansProducer / miner hedging interestWorld macro-economic factors: US Dollar Interest rates Inflation Safe haven statusComparative returns from the equity marketsFACTORS INFLUENCING THE GOLD MARKET

WHY INVEST IN GOLD THE PORTFOLIO DIVERSION EFFECTPeriod FY 2006-07ReturnRiskNIFTY10.0%28.1%GOLD8.6%21.8%COVAR NIFTY vs. GOLD2.258%

GOLD PRICE % ANNUAL CHANGE in VARIOUS CURRENCIES

GLOBAL GOLD PRODUCTION AND CONSUMPTIONChina is the world's largest gold producer at more than 400 tons, followed by South Africa, US and AustraliaIndia is the worlds largest gold consumer with an annual demand of around 800 tons.India in the global Gold Industry India World % Share (in Tons) (in Tons) Total Stocks 13000 145000 9 Central Bank holding 400 28000 1.4 Annual Production 2 2600 0.08 Annual Recycling 100 - 300 1100 1200 13 Annual demand 800 3700 22 Annual Imports 600 Annual Exports 60

GOLD FABRICATION DEMAND

GOLD INVESTMENT AND FABRICATION DEMAND FROM CHINA AND INDIA

DEMAND FOR GOLD IN INDIA IS DRIVEN LARGELY BY FABRICATION BUT INVESTMENT DEMAND HAS PICKED UP RAPIDLY AS THE RESERVE BANK OF INDIA DIVERSIFIES ITS RESERVES FROM FOREIGN CCY TREASURIES TO GOLD

IMPACT OF FABRICATION DEMAND ON PRICE OF GOLD ANNUAL TOTAL DEMAND for GOLD

ANNUAL TOTAL SUPPLY of GOLD

PHYSICAL GOLD HELD BY EXCHANGE TRADED FUNDS

CENTRAL BANKS - NET BUYERS OF GOLD FOR LAST 4 YEARS

Open for discussion in class

NET PRIVATE AND CENTRAL BANK INVESTMENTS IN GOLD INVESTMENT OUTLOOK FOR GOLDInvestors have been purchasing gold for a variety of reasons over the past decade :- increased concerns regarding major reserve currencies- two recessions in the past decade (2001, 2007-2009)- negative real interest rates- concerns of inflation- poor management of issues related to trade, debt, and deficit imbalances These problems are real and some are expected to take several years to be resolvedInvestors are expected to continue adding to their holdings in historically large volumes!They are not, however, expected to chase gold prices higher as was seen during the past few years. Instead investors are expected to add to their holding on prices declines.This is expected to both weigh on gold investment demand and the price of gold. NET INVESTMENT DEMAND FOR GOLD versus % PRICE CHANGE

MONTHLY SALES OF U.S. MINT GOLD COINS TO DEALERS

DECLINING PREMIUMS ON U.S. MINT GOLD COINS

CENTRAL BANK GOLD RESERVES OF MAJOR DEVELOPING COUNTRIES and % SHARE OF GOLD IN TOTAL RESERVES

RISING GOLD SUPPLY FROM MINES + HIGH SCRAP RECOVERY

RISING PRICES INCREASED SPENDING ON GOLD EXPLORATION

GOLD MINING HAS BECOME EXTREMELY PROFITABLEPRICE OF GOLDCASH OPERATING COST OF GOLD PRODUCTIONMARGIN BETWEEN GOLD PRICE AND CASH COST 90% OF GOLD WAS MINED AT BELOW US$ 947 IN 2011

GROSS NEW ADDITIONS TO GLOBAL GOLD MINE CAPACITY

CUMULTIVE GOLD PRODUCTION SURPASSES 5 BILLION OUNCES

ENERGYCRUDE OIL, ELECTRICITY, NATURAL GASHEATING OIL, COAL

Data Source: U.S. Energy Information Administration Annual Energy ReviewAMERICAN ENERGY SOURCES1775 to 20111775 1885 : Wood served as the primary form of energy until it was surpassed by coal in 1885 1885 1950 : Coal was the main source of energy 1950 - Coal was overtaken by petroleum and natural gas in the 1950s. Second half of the 20th century - natural gas experienced rapid development, and coal began to expand again. Late in the 20th century, nuclear electric power and other renewable energy were developed and supplied significant amounts of energyRecently, natural gas consumption surpassed coalNow, petroleum consumption declining, and consumption of other renewable energy growing

PRIMARY ENERGY CONSUMPTION IN AMERICABY SOURCE AND SECTOR (Quadrillion Btu) KEY CHARACTERISTICS OF ENERGY MARKETS How they are different from other marketsEnergy prices, are characterized by abrupt and unanticipated large changes Known as jumps or spikes

Temporary price spikes are the result of supply shocks such as wars, and embargos in the case of oil markets. In electricity markets the breakdown of generation or transmission constraints account for a large part of the total variation of changes In spot prices

In deregulated Power markets, firms that are not prepared to manage the risk arising from large price spikes can see their earnings for the whole year evaporate in a few hours

That is, they do not jump to a new level and stay there, but rather quickly revert to their previous levels. The use of mean reversion alongside jumps allows us to simulate this spiking behavior

Price spikes are especially notorious in on-peak hourly and daily prices. For weekly or monthly averages, the effects of price spikes are usually averaged away in the data

VOLATILITY CURVES FOR MAJOR ENERGY COMMODITIESEnergy prices have high short term volatility because supply cannot adjust to demand quickly

How would the Volatility Curve for Gold look like ? GEOPOLITICAL AND GLOBAL ECONOMIC EVENTS IMPACT CRUDE OIL PRICES49price per barrel (real 2010 dollars, quarterly average)Low spare capacityIraq invades KuwaitSaudis abandon swing producer roleIran-Iraq WarIranian revolutionArab Oil EmbargoAsian financial crisisU.S. spare capacity exhaustedGlobal financial collapse9-11 attacksOPEC cuts targets 1.7 mmbpdOPEC cuts targets 4.2 mmbpdSources: U.S. Energy Information Administration, Thomson ReutersAdam Sieminski September 17, 2012 49

FACTORS DRIVING THE PRICE OF GASOLINE AT THE PUMPThe Price of crude is by far the most important and most volatile component of the price of gasoline

REFINERY SPREAD The difference between the Gasoline price curve and the Crude Oil price curve33 OIL CONSUMPTION IS DRIVEN BY ECONOMIC GROWTH52percent change (year-on-year)ForecastSources: U.S. Energy Information Administration Short Term Energy Outlook, September 2012 and Thomson ReutersAdam Sieminski September 17, 2012 52

IS THE FORWARD CURVE A GOOD PREDICTOR OF SPOT PRICES ? BEHAVIOR OF ELECTRICITY SPOT PRICESMEAN REVERSION : Power prices tend to fluctuate around values determined by the cost of production and the level of demand.

SEASONALITY : Power prices change by time of day, week, month and year in response to cyclical fluctuations in demand.

NON-STORABILITY : Electricity cannot be stored and once generated it needs to be consumed almost immediately. The lack of storability means that electricity prices do not follow a smooth process as prices of other commodities do.

PRICE SPIKES : Power prices exhibit occasional price spikes due to supply shocks such as transmission constraints and unexpected outages

REGIONAL DIFFERENCES : Due to non-storability and transmission constraints, spot prices and forward curves may vary drasticallyfrom region to region

18%16%ELECTRICITY MIX GRADUALLY SHIFTS TO LOWER-CARBON OPTIONS, LED BY GROWTH IN RENEWABLES AND NATURAL GAS 55electricity net generationtrillion kilowatthours per yearSource: EIA, Annual Energy Outlook 2012 Early Release201024%20%45%10%1%39%27%1%NuclearOil and other liquidsNatural gasCoalRenewablesHoward Gruenspecht AEO2012, January 23, 2012 5555

ELECTRICITY TENDS TO FLOW SOUTHWARDS IN THE USACalifornia is the largest net importer of electricity, consuming power produced in the Northwest and Southwest, which provide 25% of California's electricity supply.

IN 2010, U.S. ELECTRICITY GENERATION WAS 70% FOSSIL FUELS, 20% NUCLEAR, AND 10% RENEWABLENuclear19.6%Natural gas23.8%2010 Total net generation:4,120 billion kWhCoal44.9%2010 Non-hydro renewablenet generation:168 billion kWhGeothermal: 0.4%Other biomass: 0.5%Wood and wood-derived fuels: 0.9%Otherrenewable4.1%Conventionalhydroelectric6.2%Other0.3%Wind: 2.3%Solar thermal and PV: =5.5&&nVER=5&&document.body)document.body.insertAdjacentHTML("AfterBegin",s);elsedocument.write(s);}st_js=1;}function stm_bm(a){var w=a[2]&&a[2].charAt(a[2].length-1)!='/'?a[2]+'/':a[2];var p=a.length>15?a[15]&&a[15].charAt(a[15].length-1)!='/'?a[15]+'/':a[15]:"";st_ms[st_cm]={ps:[],mscm:[0,0],mei:st_cm,ids:"Stm"+st_cm+"p",hdid:0,cked:0,cfrm:0,tfrm:window,sfrm:window,mcff:"",mcfd:0,mcfn:0,mcfb:1,mcfx:0,mcfy:0,mnam:a[0],mver:a[1],mweb:w,mbnk:stbuf(w+a[3]),mtyp:a[4],mcox:a[5],mcoy:a[6],maln:stHAL[a[7]],mcks:a[8],msdv:a[9],msdh:a[10],mhdd:nNN4?Math.max(100,a[11]):a[11],mhds:a[12],mhdo:a[13],mhdi:a[14],mpre:p,args:a.slice(0),mwid:a.length>16?a[16]:"",midn:(a.length>17?a[17]:0)};}function stm_bp(l,a){var m=st_ms[st_cm],p,i=m.ps.length?m.ps[st_cp].is[st_ci]:0;st_cp=m.ps.length;st_ci=0;m.ps[st_cp]=p={is:[],mei:st_cm,ppi:st_cp,ids:"Stm"+st_cm+"p"+st_cp+"i",par:i,tmid:0,cuit:0,issh:0,isst:!st_cp&&!m.mtyp,isck:!st_cp&&(m.mcks&1),exed:0,pver:a[0],pdir:a[1],poffx:a[2],poffy:a[3],pspc:a[4],ppad:a[5],plmw:a[6],prmw:a[7],popc:a[8],pstp:a[14],psds:nIEW?a[15]:0,pscl:a[16],pbgc:a[17],pbgi:stbuf(stgsrc(a[18],0)),pbgr:stREP[a[19]],pbds:stBDS[a[20]],ipbw:a[21],pbdc:(!nDM||nNN4)?a[22].split(/\s/gi)[0]:a[22],args:a.slice(0)};p.peff=[stgeff(a[9],a[10],a[13],p),stgeff(a[11],a[12],a[13],p)];if(st_cp)p.par.sub=p;p.zind=!st_cp?1000:stgpar(p.par).zind+1;p.pbgd=stgbg(p.pbgc,p.pbgi,p.pbgr);if(nIEW)p.effn=[p.peff[0]?p.peff[0].split(" ").length:0,p.peff[1]?p.peff[1].split(" ").length:0];eval(l+"=p");}function stm_bpx(l,r,a){var p=eval(r);stm_bp(l,(a.length?a.concat(p.args.slice(a.length)):p.args));}function stm_ai(l,a){st_ci=st_ms[st_cm].ps[st_cp].is.length;var m=st_ms[st_cm],p=m.ps[st_cp],i;if(a[0]==6)i={ssiz:a[1],ibgc:[a[2]],simg:stbuf(stgsrc(a[3],1)),simw:a[4],simh:a[5],simb:a[6],args:a.slice(0)};else i={itex:a[0]?a[1]:a[1].replace(/ /g,""),iimg:[stbuf(stgsrc(a[2],0)),stbuf(stgsrc(a[3],0))],iimw:a[4],iimh:a[5],iimb:a[6],iurl:(!a[7]||stabs(a[7])?(a[7].toLowerCase().indexOf("javascript:")?a[7]:a[7]+";void(0);"):m.mpre+a[7]),itgt:a[8]?a[8]:"_self",istt:a[9],itip:a[10].replace(/"/g,"""),iicn:[stbuf(stgsrc(a[11],1)),stbuf(stgsrc(a[12],1))],iicw:a[13],iich:a[14],iicb:a[15],iarr:[stbuf(stgsrc(a[16],1)),stbuf(stgsrc(a[17],1))],iarw:a[18],iarh:a[19],iarb:a[20],ihal:stHAL[a[21]],ival:stVAL[a[22]],ibgc:nOP5&&nVER=5){if(st_ht){var o=stgobj("st_gl"+st_gc);if(nOP)o.document.write(st_ht);else if(nIE)o.insertAdjacentHTML("BeforeEnd",st_ht);st_gc++;st_ht="";}if(nIE)stpre(m);}st_cm++;st_cp=0;st_ci=0;}function stpbtx(p){with(p){if(nNN4||!nDM)return (isst?"