A. A further look at the commodity chain

1
CLASS 2

• A. A further look at the commodity chain
• the production and processing chain - the
  example of cotton
• seasonality
• pricing at different levels of the chain
• the flow of goods
• the flow of documents
• marketing structure, and the role of traders
• integrating finance in the commodity chain
• B. Dealing with uncertainties

2
The cotton production and processing chain In
developing countries, more than 250 million
people depend for all or part of their cash
income on cotton production and processing.
Seed cotton
Standard cotton Extra-long staples (for
high-quality textiles)
Hand picking (70) or machine picking (30)
Ginnery
Farmers
Cotton seed
Cotton fibre
Oil mill
Produced in bales often transported by
container
Cotton spinner
Textile factory
Produced in rolls, sold on the basis of
length often, tailor-made to textile factorys
needs
Cotton seed oil (worlds 5th major edible oil)
Cotton seed cake (worlds 2nd major livestock
feed)
Cotton yarn
3
Most commodities are seasonal - e.g., cotton in
Uganda Seasons differ from country to country
Cotton lint Raw cotton
Exposure of ginnery
J F M A M J J A S
O N D
4
Remember the pricing environment is not
predictable.New York cotton futures, high low
prices (1980-1997)
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Exploration Production Transport Processing
Marketing/ distribution Information
Conditions do not remain the same. E.g.,
technological factors.
Falling production costs and competition from
new products
Increasing flexibility of processing equipment
Highly competitive pricing.
Easier identification of reserves has led to
geographical diversification
Drastic fall in international shipping costs
bulk transport
Just-in-time delivery electronic trading
6
Cotton pricing
Seed cotton
Generally, no formal price formation system.
Some auctions (e.g., India) and some local price
reporting.
Ginnery
Farmers
Textile factory
Cotton seed
Clothing
Cotton fibre
Oil mill
Price reporting US futures market
Standard cloths
Price reporting
Cotton spinner
Textile factory
Price reporting
Price reporting Japanese futures market
Cotton seed oil
Cotton seed cake
Cotton yarn
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Farmers
Illegal futures markets, raw cotton
Raw cotton mostly spot, some forward contracts
Ginners
Cotton lint spot, forward contracts (1-3 months)
arbitrage
Traders
Bombay futures market, cotton lint
Cotton lint much use of forward contracts (2-3
months)
Cotton lint forward contracts (up to 6 months)
Textile mills
Yarn/textiles forward contracts (up to 6 months)
Cotton pricing and marketing - the Indian example
Foreign buyers
8
Post-liberalization risk exposure, financing
costs and access to finance
Use of price risk management tools
Access to finance
Credit risk for a lender
Interest rate for a loan
Exposure to price risk
Exporters
Cooperative unions or large traders
Cooperatives/ small traders
Producers
9
If relevant futures markets exist, physical
commodities are often priced on the basis of
futures contracts. E.g., coffee
Quantity Origin Grade Shipment
Destination Futures Price Basis Dates
Month BIDS Arabica Washed 3600
bags India Plantation A Mar - Apr Open May Less
19c/lb Fob Robusta Unwashed 16
80 bags Cote d'Ivoire Grade 2 Apr Open May Less
100 CF 3360 bags Cote d'Ivoire Grade
2 May-Jun Open Jul Less 100
CF 3600 bags India Cherry ab Mar-Apr
(1800 each)Open May Less 40 Fob 1800
bags India Cherry ab May Open Jul Less 40
Fob 3600 bags India Cherry clean bulk Mar-Apr
(1800 each)Open May Less 80 Fob 1800
bags India Cherry clean bulk May Open Jul Less
80 Fob 3600 bags Indonesia EK1
gr4 80 def MayJun Open Jul Less 230
Fob 1280 bags Uganda Screen
15 Jun Open Jul Less 20 Fob 2560
bags Uganda Screen 15 Jul-Aug (1280
each)Open Sep Less 20 Fob OFFERS
Arabica Washed 3600 bags India
Plantation A Mar - Apr (1800 each) Open May Less
15c/lb Fob
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Seller
The flow of goods INCOTERMS
Domestic transport
EXW
Clearing at export port
FAS
FCA
FOB
International transport - who pays insurance?
CFR
CPT/
CIF
Clearing at import port
CIP
DAF
Domestic transport Are import duties
paid?
DES
DEQ
DDU
Buyer
DDP
11
Seller
The flow of documents
Perhaps need to add customs/consular invoice
Invoice
Perhaps consular visa needed
Certificate of origin
Independent verification?
Inspection certificate
Translated into language of importer?
Packing list
Bill of lading
Insurance certificate
Import certification
Buyer
12
Producer
The cotton trade
Private buyers
Central marketing co.
Cooperative
Broker/ agent
Agent
Merchant
Central buying co.
Agent
User
13

• Functions of international traders
• Overcome language barriers
• Overcome the problems of space land and sea
  transportation, logistics, documentation,
  coverage
• Provide financing
• Manage currency risks (including to the
  provision of risk management services)
• Take market risks (long/short positions offtake
  contracts supply deals price guarantee
  contracts)
• Provide direct or indirect access to futures
  exchanges
• Arrange countertrade
• Handle quality issues (provide information on
  quality standards assist in selection of
  required qualities and provide quality
  alternatives ensure procurement of proper
  quality)
• Provide information to buyers and sellers

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Farmer / middleman
Integrating finance into the commodity chain
Quality? Security of transport?
Warehouse / Warehouse receipt issued
Bank extends financing on basis of collateral
stock value
Reprocessing Facilities
Risk of loss of control over collateral
Graded Commodity
Export warehouses - finance relatively easy.
Bank extends financing on basis of collateral
stock value
Warehouse receipt issued
Export Export proceeds are remitted to
designated escrow account
Are there well-established buyers?
Financing secured through export receivables
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Integrating finance into the commodity chain (2)
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Can local traders still compete in the face of
high financing costs? - the example of Uganda
Licensed exporters end of 1996 200 early 1999
25
Interest rates charged on funds used by coffee
exporters, 1997
Interest rate Percentage charged
of exporters 10 or below 30.0
10.1-15 6.6 15.1-20 20.0 20.1-25
26.6 25.1-30 16.6
Foreign companies market share close to 60
Local companies also face problems with timing
of availability of funds (delays), and heavy
bureaucratic load.
Source Frederick Kawuma, Managing Director,
Uganda Coffee Trade Federation
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• Dealing with the uncertainties of physical trade
• Commodity trade and production are exposed to a
  large number of risks, not just price risk. The
  proper management of price risk assumes a proper
  understanding of other risks such as
• Counterparty risk what will happen with my
  hedge if my counterparty defaults?
• Timing risk will the hedge still be good if
  there is a delay in shipment?
• Quantity risk how do I do to hedge uncertain
  production/supply
• Competition risk how do I avoid that
  competitors take my market away?