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CHAPTER 12
Procurement of commodities
Objectives of this chapter
• To identify the different soft and hard commodities and their impact on the material
costs of producers incorporating them
• To evaluate the different short-term and long-term price stabilisation techniques
• To consider the risks of speculation and measures undertaken to reduce them
• To appreciate that modern futures markets trade only in titles or rights to commodities
rather than actual goods
• To consider various procurement techniques
• To demonstrate the ‘price of indifference’
• To show how to insure against fluctuating prices by placing call and put options
List of Cases, Research Boxes and Figures in this chapter
Mini Case Studies
• Nestle
Research Boxes
Nil
Figures
• Figure 12.1 Commodity prices, 2002 and 2003 (Source: Barclays)
• Figure 12.2 A simple ‘buyer’s hedge’: the two transactions made on 1 January
compensate each other
• Figure 12.3 Indifference prices
Teaching Notes
The primary commodities are natural products rather than manufactured products. This affects
the prices at which they are sold even though they normally enter into trade in processed or
partly manufactured form rather than just as harvested or mined. Cocoa, coffee and sugar, for
instance, are processed before they reach the market. Many primary commodities are bought
and sold locally without entering into world trade. This chapter is mainly concerned with those
primary commodities that are in worldwide demand, and are traded worldwide, so that
organised commodity markets have developed to facilitate that trade.
Instructor’s Manual
The principal commodities
Aluminium
This metal has been traded as a commodity since 1978 when the London Metal Exchange
(LME) introduced aluminium contracts. The rather recent introduction of aluminium contracts is
probably due to the fact that production is controlled by a few companies – Alcan, Kaiser,
Reynolds and Alcoa. The tonnage of aluminium produced overtook the production of copper by
the late 1970s.
Cocoa
A very volatile commodity, with frosts, disease and other factors having a fairly unpredictable
effect on the supply and hence prices. Main producing countries are Brazil, Ivory Coast and
Ghana. The main cocoa markets are in New York and London, though Ivory Coast cocoa is
traded in Paris.
Coffee
Produced in many tropical countries, though Brazil is by far the biggest producer, with
Colombia some way behind. As with cocoa, the two main markets are in New York and
London.
Copper
The London Metal Exchange is the most important copper market, and its prices adopted as the
world reference price. Only a very small proportion of the world’s copper is handled through
LME trading, but producers and consumers often use the LME price as their basis for direct
contracts. The Commodity Exchange (COMEX) in New York is the major pricing influence in
the United States though in practice prices on all exchanges are closely related.
Cotton
Provides half of the world’s textile requirements, and is traded in Hong Kong, Liverpool,
London and New York.
Gas oil
A generic term covering a fraction of the products resulting from refining crude oil. In the
United States it is often called heating oil, and in Europe diesel is the usual name. Traded on the
New York Mineral Exchange (NYMEX) and the International Petroleum Exchange (IPE) in
London.
Gold
Until the 1960s gold prices were fixed by governments on an international basis. This practice
was abandoned in the 1960s and in 1982 the London gold futures market was established.
Instructor’s Manual
Grains
Wheat, barley, corn (maize), rye and oats are the important cereals, and the trade in these
commodities is dominated by North America. The main exchanges are in Kansas City,
Minneapolis, Winnepeg and Chicago.
Lead
Today the main application of lead is in the manufacture of batteries, and, to a lesser extent, it is
used in the construction industry. Former important applications, such as plumbing, in pigments
(as an oxide) and as a fuel additive, are all declining. Supplies are relatively plentiful, and much
lead is recycled. Because of this, price movements tend to be limited.
Nickel
Introduced on the London Metal Exchange in 1979, nickel is mainly used in the production of
stainless steel. Prices have changed dramatically in recent years.
Rubber
An interesting commodity, in that there is a synthetic substitute interchangeable with natural
rubber for most applications. By far the greatest market is for the manufacture of tyres. Traded
in several places, the most important market for rubber is the Malaysian Rubber Exchange in
Kuala Lumpur.
Silver
The price of silver can be erratic because it is both an industrial metal and a medium for
investment. Industrial materials tend to attract fewer buyers when the price is rising, but the
opposite is true if the purchase is for investment. The London Metal Exchange is a market for
silver, but the COMEX in New York occupies the key position.
Soya beans
There has been a good deal of speculation in this commodity in the past, though by the early
1980s the market had become rather more stable. The main markets are as foodstuffs (soya bean
oil for cooking and margarine manufacture) and as animal feeds (soya bean meal). Soya bean
meal is 47 per cent protein, and hence a very high-value commodity.
Glossary
Arbitrage Buying in one market, e.g. London, and selling in another, e.g. New York, in order to
profit from price anomalies. This in fact smoothes out the anomalies.
Backwardation Exists when the futures price is lower than the spot price.
Basis Difference between cash price and futures price.
Bear One who speculates for a fall in price.
Bear market A market in which the price is falling.
Broker One who buys or sells for others in return for a commission.
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Bull One who speculates for a rise in price.
Bull market One in which the price is rising.
Call option An option which confers the right to purchase a particular futures contract at a
specific price.
Commission Charge made by a broker for buying or selling contracts; rates of commission are
fixed by market authorities, and brokers are not allowed to depart from them.
Contango When the spot price is lower than the futures price.
Forwardation Same as contango.
Long Owning physical commodities or futures contracts which are not fully hedged. Put option
An option which confers the right to sell a particular futures contract at a specific price.
Premium The ‘price’ of the option; the amount of money transferred between buyer and seller
for the benefits and rights conferred by the option. The premium represents the maximum
amount that the option buyer can lose.
Prompt date The day on which delivery against a declared option contract must be made. Short
Selling physical commodities or futures in excess of what is owned.