Gain on commodities lure to Kiwi punters

By Peter O'Brien

Friday 11th June 2004

The lure of substantial gain on a low outlay has enticed many Kiwis to the delights of speculation in internationally traded commodities.

They may have short-term interests in 100oz of gold, 1000bb1 of crude sweet light oil (Brent), 2500kg of wool in the 36-40 microns range, tonnes of industrial metals, 15,000lb of frozen orange juice and quantities of other agricultural products ranging through the alphabet from beef to wheat.

There is no need to have an Arthur Daley lockup for storing the stuff. Deals are done through local brokers who either execute the transactions on the Sydney Futures Exchange (SFE), if that body has a contract on the commodity, or transmits them to operators in the US and London.

It is all done on paper.

End users are usually the only people in the deals who ever see the physical goods.

Most traders would have no idea about the appearance of crude oil or frozen orange juice.

Commodity futures are big operations among private investors. OMFinancial chief executive Colin Churchouse says his firm had more business than ever before and numbered private clients in the "many hundreds."

Tricom Futures Services Pty New Zealand associate director Bryn Griffiths had a similar experience. His firm had "hundreds of clients," of whom some 95% were private investors. Private dealers in commodity futures were about 35% of the total client base.

Both firms handled currency futures, which were separate from commodity contracts but often combined, with the currency side used as a hedge.

The mechanics of a commodity futures contract are relatively simple. Churchouse used a gold contract as an example.

A client would approach his firm and take a contract for delivery in a specified date, a deal done in June being an August contract.

The client would contract to buy (or sell) 100oz of gold in August at, say, $US400 an ounce, the contract thus having a face value of $US40, 000. A "good faith" margin is deposited with the broker.

The margin varies depending on the size of the contract and the commodity, but on $US40, 000 for 100oz of gold it would be $US2000. (US dollar amounts have their New Zealand dollar equivalents so a currency hedge could be appropriate for individual commodities with high price volatility if the currency is fluctuating.)

OMFinancial would take a commission of $US40 on a $US40,000 contract, passing part of it to the operator of the New York Metals Exchange or, alternatively, the London Metals Exchange. The contract is registered with the clearing house at the price the deal was done and documentation issued to the client.

Leverage is the essence of a futures contract.

If gold went to, say, $US410 an ounce, the client would have gained $US1000 (100 x $US10) on an outlay of $US2000, or 50%. Conversely, a drop to $US390 an ounce would require an additional margin of $US1000, although the contract could be closed out at any time.

Griffiths said oil and gold contracts were popular and there was interest in frozen orange juice futures, where the underlying prices were at historic lows. The "crude, sweet, light" oil contract, also known as "Brent futures," comprised 1000 barrels. It would have a $US41,000 value at a price of $US41 a barrel. The initial margin would be $US3375, based on calculations at the end of May. Griffiths said oil futures contracts had volatility-based margins.

Average price movements were examined over a period and plotted on a probability curve, the result, after taking account of deviations, being designed to capture 99% of price moves.

The margin varied up or down in line with volatility fluctuations.

Frozen orange juice was priced at about 55US¢ a lb at the end of May. A 15,000lb futures contract therefore had an underlying value of $US8250 and 1US¢ a lb movement in the base price would give the contract holder a gain of $US150 to be related to the initial margin of $US560.

Anyone who thinks a commodity futures contract is a pass to instant wealth should have a sedative and a lie down. Prices go up and down. An investor buying a contract (expecting the commodity's underlying price to rise) would either have to produce more margin or close out at a loss, albeit small, if the price fell.

Selling a contract on the assumption prices would fall could have the same effect if the market rose.

Commodity prices are always volatile, although they have risen overall in the past two to three years under buying pressure from China and a weak US dollar.

Some commodities are subject to "orderly pricing" strategies by manufacturers who are the end users of the raw materials.

You can be sure that chocolate manufacturers, for example, cover themselves against perceived movements in cocoa prices.

People thinking of a dabble in commodity futures should deal only with reputable brokers with solid histories. Complaints about some fringe operators are under Securities Commission and New Zealand stock exchange (NZX) investigation. NZX took over regulation of futures and options trading in New Zealand from April 1, after local brokers had earlier relationships with the Sydney Futures Exchange (SFE).

The New Zealand Futures and Options Exchange became a subsidiary of SFE 10 years ago but the latter body does not want to regulate New Zealand firms.

Local brokers have access to three wool futures contracts on the SFE, all in fine wool, a cattle contract and one in electricity. The New Zealand Futures and Options Exchange (NZFOX) is introducing a wool contract later this month, based on wool in the 36-40microns fibre range.

SFE contracts are on wool in the 19-23 microns range.

NZFOX chief executive Greg Boland says the new contract was the result of feedback from discussions with exporters, woolbrokers and farmers' organisations.

It was expected to attract exporters, carpet manufacturers and overseas wool buyers but private investors might take positions.

The contract would be for 2500kg of wool, with the price per kg being the average calculated at any given time from a new wool price index and the dollar margin set at a fixed amount of the resulting value.

A contract at an index price of $4 a kg, for example, would be valued at $10,000 and a rise of 10¢ a kg in the underlying market price would produce a profit of $250, which could be assessed as a percentage gain on the margin.

The new wool facility adds to the many commodity futures contracts available to Kiwi punters.

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