What can be learnt from China’s commodity futures markets?

Chinese commodity markets have become an increasingly important indicator for other sectors of the global economy, especially dry bulk commodities such as iron ore, steel, coal and grains. For example, iron ore and steel rebar futures increased by 120% and 86% respectively in the twelve months to mid-May 2021, the latter seeing prices spike by 50% in the in the first two weeks of May alone. Other futures markets such as that for coking coal have also seen strong gains.

Chinese commodity investors have piled into these markets on speculation that demand for infrastructure commodities post COVID will surge and that supply will remain constrained. For example, environmental and safety inspections have affected domestic coal output.

The surge in commodity prices resulted in Chinese factory gate prices leaping by 6.8% in April, the fastest pace for three years. The surge in prices pressured margins for those downstream businesses, including consumer goods industries yet to recover from COVID induced shutdowns.

China’s leadership face a delicate balancing act between competing economic interests, further financial liberalization, and broader social concerns. First, it wants to have more control over the pricing of the raw materials the Chinese economy so depends upon. Second, increasing the role of the yuan in global trade requires a higher degree of openness. At the same time it must balance the risk that speculative booms get out of hand and lead to social unrest.

Those concerns are unlikely to go away and should be borne in mind by anyone looking to China’s commodity markets for price signals to underlying supply and demand. This article delves into the background of commodity speculation in China and some of the things foreign investors need to factor in when observing Chinese commodity futures markets.

Speculative commodity booms lead to crackdowns

As commodity prices surged in May authorities eventually sought to crackdown on the speculation. The commodity exchanges introduced higher margin requirements and higher transaction fees in a bid to reduce speculation. Meanwhile, China’s National Development and Reform Commission (NDRC) promised “zero tolerance” for illegal activities, such as “reaching agreements to implement monopoly, spreading false information, driving up prices” and hoarding.

Chinese commodity investors have charged into commodities futures markets before. In early 2016 investors threw money into iron ore, rebar, cotton, and more esoteric markets such as egg futures. Futures markets became so frenzied that they became unusable for industrial companies seeking to hedge their commodity risk.

Crackdowns on speculative activity tends to follow a ‘whack-a-mole’ pattern. Stocks, bonds, property typically see cycles of speculative activity as investors jump from one momentum trade to the next momentum. In recent years crypto has been added to the list of speculative instruments favoured by retail investors. As the price of bitcoin and other digital assets dropped sharply over the past month, speculation in commodities and to an extent property, have became the only games in town.

Retail investors dominate Chinese commodity markets

As of February 2021 there were 63 commodity futures markets listed across the three Chinese commodity exchanges (Dalian Commodity Exchange, Shanghai Futures Exchange and the Zhengzhou Commodity Exchange). The chart below shows a selection of the most traded Chinese commodity markets (yellow bars) versus global commodity markets (blue bars). In 2020, the top five traded commodity futures markets in the world were Chinese commodities with steel rebar seeing the highest trading volume. Chinese commodity markets includes many unique futures markets that do not exist elsewhere, for example apple, bitumen and egg futures. The latter sees almost as much trading volume as the gold market.

Source: Man Institute

Although high trading volume is good for liquidity, if there is too much volume relative to the underlying market it can be a sign of excessive speculation. For example, apple futures trading volume on one single day in May 2018 was equivalent to half global apple production.

Evidence of excessive speculation is evident in the make-up of Chinese commodity futures markets. According to data from the China Futures Association around 98% of commodity futures trading accounts are individual investors, 94% of trading accounts have less than 100 thousand RMB and 90% of trading volume is carried out by individual retail investors (this compares with less than 15% in the US where institutions dominate trading volumes).

The high proportion of retail investors has a number of impacts. First, retail dominance means there may be an insufficient amount of hedging activity. This skews the risk preference for both short and long dated futures contracts.

Second, a large proportion of trading activity by individuals tends to result in a high degree of positive feedback trading. This means that price momentum is typically stronger than in commodity markets where there is more institutional activity.

Finally, individual investors are typically more emotional than institutional investors which leads to higher volatility. For example, the typical holding period for China’s commodity futures contracts is less than four hours.

Overall this leads to poorer price discovery than is evident in other major global commodity futures markets. The effect can be seen in the relationship between Chinese commodity futures contracts and their global competitors. For example, the monthly correlation between Chinese corn futures prices and US corn futures in the period 2015-2020 was just 0.24. Although transport and local growing conditions may have played some part the markets should be significantly more correlated than that.

Some of the issues are made worse by the unique way that Chinese commodity futures markets are set up. Time-varying margins and strict position limits means that speculators are involuntarily pushed away from the front end of the futures curve. For example, retail investors are prohibited from holding positions in the delivery month.

Unlike the US commodity futures markets where nearby contracts are most active, the nearest to maturity contracts in China account for less than 10% of total volume traded on the futures curve. This means that inferences drawn from the nearest contracts are virtually useless.

Government want to shield investors from losses

In late May 2021 the the China Banking and Insurance Regulatory Commission (CBIRC) asked lenders to stop selling commodity futures related products, as well as unwind any current holdings of such products which may otherwise be sold to individual investors.

The authorities do not want a repeat of 2020 when many retail investors lost their life savings betting on a structured crude oil investment product marketed by Bank of China (BoC). The product, called ‘Crude Oil Treasure’ promised riches to retail investors. It came with the slogan, “Oil is cheaper than water”, followed by the strap-line, “You can make money no matter if the price rises or falls.”

The crude oil product was linked to both domestic and global crude oil benchmarks, including WTI crude oil benchmark. When WTI crude oil prices went sharply negative in May 2020 investors found those promises weren’t quite true. At least 60,000 individual investors are thought to have suffered losses estimated to be at least $1.27 billion.

Investors took to online forums to complain and threatened to take their protest to Beijing. The bank responded by offering to return 20% of their investment, but only on the condition that they stopped any legal action. The bank very helpfully sent a message to investors via its app, offering to share in their pain, “You have suffered losses for investing in the Crude Oil Treasure product. For this, we feel for you and are willing to make an effort to go through this hard time with you.”

While the financialisation of the system has enabled everyone to have a stake, authorities do not want protests in the streets. In the BoC case the offer of a small refund was backed up by a visit from the local police, especially to those investors making the most noise about their losses online.

Implications for global commodity investors

In November 2020 new rules came into force making it easier for foreign institutional investors to access China’s commodity futures markets. China has so far internationalised six commodity futures contracts. The first was a yuan-denominated crude oil contract, launched in March 2018. Despite attracting interest from foreign traders, volumes are still well below those of Brent and West Texas Intermediate. Next China opened up its existing iron ore contract. Other contracts to follow included TSR 20 rubber, low-sulphur fuel oil, and purified terephthalic acid. Most recently, foreign investors are now able to trade palm oil futures. Other contracts are also open to foreign investors but require a local company to be set up to access them.

Although China’s commodity futures markets are in the process of being opened up to allow foreign institutional investors to access them, they remain closed for everyone else. That lack of access doesn’t mean that foreign retail investors can’t trade on the basis of China’s commodity futures markets. For example, the boom in coal, iron ore and steel prices in China helps drives speculation in related instruments elsewhere in the world, such as the share price of coal and iron ore producers and dry bulk shipping companies.

Remember though that Chinese commodity futures markets are very poor at fundamental price discovery – momentum base trading can take prices significantly further away from fundamentals than other global commodity markets. The government is prone to frequent crackdowns should trading activity threaten economic, financial or social stability. Global investors need to be aware that futures prices are prone to sharp reversals should the authorities crackdown on market movements that threaten these underlying objectives.

Related article: 3 reasons why commodity investors need to pay attention to China in 2021

Related article: China’s credit impulse a headwind for further commodity price gains

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