Pricing illiquid commodity markets -- white paper looking at the challenges of assessing prices in illiquid markets

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Published on February 17, 2014

Author: JustinPugsley



Market pricing for a range of financial instruments and commodities has run into considerable controversy in recent years with accusations of price manipulation to the detriment of consumers.

This has led to regulators and market participants making wholesale reviews of market practices.

This white paper entitled 'Challenges of Price Discovery in Illiquid Commodity Markets' argues that the practice of price reporting agencies assessing values of thinly traded commodities such as minor metals and rare earths remains the best approach for these markets.

But even for more bulk commodity markets such as ferro-alloys there are strong arguments for pricing to continue with price reporting agencies.

This white paper examines alternatives such as moving pricing of thinly traded commodities to exchanges. It even considers more radical approaches such as ceasing price assessment and the likely impact for these markets.

This paper was written by Justin Pugsley at JJPassociates ( on behalf of specialist publishing and price reporting agency Metal Pages.

Challenges of Price Discovery in Illiquid Commodity Markets A White Paper about Pricing Minor Metals, FerroAlloys and Rare Earths February 2014 Metal-Pages Market characteristics for minor metals, ferro-alloys and rare earths Price discovery for a commodity not traded on an exchange and where deals are largely struck in private is challenging. This is even more so when transactions are not that frequent due to factors such as low output and consumption volumes. In these markets price assessment, usually conducted by price reporting agencies, takes place in conditions where there is a lack of verifiable data. The transactions that take place in these markets are not officially recorded in a centralised location. The efforts of price reporting agencies in collecting these prices is the closest there is to a centralised collection point for prices. Transactions in these markets are either carried out directly between producers and consumers or via specialist traders. Occasionally brokers may bring buyers and sellers together for a commission. Traders help provide these markets with liquidity, assist with logistics, distribution and act as wholesalers. Traders are usually among the best informed about market conditions given the number of buyers and sellers they communicate with. Although producers, which hold dominant market positions, can be better informed than traders. Transactions tend to be negotiated over the phone, by email, fax or telex. They are typically confirmed via contract notes detailing prices and the terms and conditions of the contract. These commodities are either bought on a spot basis, that is for prompt delivery, or on long-term contacts. Long-term contracts are usually quarterly, semi-annual, annual and sometimes longer. Metal-Pages Ltd. 1

Spot market versus long-term contracts The spot market price – published by price reporting agencies – is typically used as a reference for long-term contracts. This is because spot market transactions tend to be more homogeneous, repeatable, comparable and therefore easier to use as a basis for market prices. Long-term contracts tend to contain clauses unique to the parties involved. This impacts pricing and therefore may not be representative of the wider market. A further issue is that the details of long-term contracts are rarely ever made public or even revealed to price reporting agencies. Though small the markets for minor metals and rare earths are very global in nature. Ferro-alloys are a bulk market that is also very globalised. A common characteristic of many minor metals and rare earths is that they are produced by a concentrated number of organisations in a small number of countries. They then tend to be consumed by a wider range of consumers. Rare earths are a case in point. As of early 2014, nearly all the production comes from China. Supply chains for these commodities have often formed over many years with the different participants possessing considerable knowledge of each other. Before finding their way into a vast array of end user applications ranging from smart phones, medicines through to turbine blades, minor metals and rare earths tend to go through several layers of transformation. Though critical to their functioning, rare earths and minor metals tend to only make up a fraction of the materials contained in these end products. They often account for only a small proportion of the overall material costs as well. Industry associations, such as the Minor Metals Trade Association, tend to act as a central forum for industry participants to address issues such as regulation and warehousing. However, they normally do not collect, assess and publish prices. Apart from supply and demand – there are a number of factors, which influence pricing. Influences on prices Quality – Higher purity commands higher prices due to the extra cost of processing. Form – There are price differences relating to ingot sizes/weight or whether they are briquettes or shot, for instance. There are also price differences between oxides and metals. Quantity – In a balanced or over-supplied market large volumes are generally transacted at lower prices than for smaller amounts, though it can be the opposite in a tight market. Delivery – Incorporates cost of freight, insurance, financing and warehousing. How prices of illiquid commodity markets are assessed Price discovery relies on canvassing a wide a range of market participants by telephone or via electronic communications such as email. Once prices have been collected it is a case of making some editorial judgements over the actual value of the commodity being assessed. Metal-Pages Ltd. 2

Prices are usually published in a range reflecting quantities traded and the form. Oxides, metals and the most commonly used grades are priced separately The main criticisms of using canvassing as a means of price discovery: 1. Lack of transparency as prices are typically collected from anonymous participants who might be inclined to 'talk their books.' Prices potentially open to manipulation to the benefit of those giving them. 2. Prices may not be representative because the sample canvassed might be too small. 3. Editorial judgement might be flawed. On the face of it these would appear to be serious flaws, but it must be remembered that these are illiquid and opaque markets. Price discovery in these circumstances will always be challenging and open to a certain level of subjectivity. Possible alternative approaches for discovering prices of illiquid commodities: 1. Place these commodities on exchanges to make price discovery transparent. 2. Assigning the collection of prices to industry associations. 3. A regulatory body collects and publishes prices on behalf of these markets. 4. Pass regulations forcing market participants to apply practices to make price discovery verifiable and accountable. 5. Simply cease the collection and publishing of prices. Though some of these approaches may appear attractive at first sight, they are on reflection subject to pitfalls as well. The first alternative – placing these commodities on an exchange appears to be the best solution. 1. Placing thinly traded commodities on exchanges This is a method of price discovery that has been favoured by EU regulators such as when they moved responsibility for LIBOR (London InterBank Offered Rate) interest rate benchmark pricing from the British Bankers Association to the Intercontinental exchange (ICE). The belief is that LIBOR will now be priced in a transparent fashion and be less open to manipulation. The market will also be more tightly regulated. For similar reasons there is a move by industry to make cobalt prices from the London Metal Exchange (LME) the main industry price benchmark rather than relying on those generated by price reporting agencies. However, this white paper argues that moving many rare earths and minor metals onto exchanges is simply not practicable. According to the US Geological Survey the annual production of germanium only came to 120 tonnes in 2012 and the refined production of indium was 670 tonnes. For many minor metals the volumes of production, consumption and trade are simply too small to justify being moved to an exchange. Metal-Pages Ltd. 3

By contrast 110,000 tonnes of cobalt was produced in 2012 according to the USGS, which is still considered a very small volume of production compared with more mainstream metals. For instance, for copper, which is a major non-ferrous metal, production was 19.8 million tonnes in 2011, according to the LME. The LME has had some success with its cobalt contract, but only after a great deal of effort. It's attempts at developing an exchange traded contract for molybdenum still had not gained much traction at the time of writing. This may dent the LME's enthusiasm for developing exchange traded contracts for other minor metals. However, not all minor metals produced in quantities of over 100,000 tonnes are exchange traded. Most aren't. In 2012 around 180,000 tonnes of antimony was produced, according to the USGS and price benchmarks for this metal come predominantly from price reporting agencies. Nonetheless, it is still a small volume and it is debatable whether enough trade could be generated on an exchange to produce more reliable prices than those published by price reporting agencies. Many buyers and sellers generally prefer to conduct their transactions in private and would not want to use an exchange and have the prices of their transactions made public. If regulators forced them to do so it would probably drive the trade to some other location. Also, it takes many years to establish new price benchmarks as contracts and industry norms have to be revised. If market participants saw an advantage in moving the trade of minor metals, ferroalloys and rare earths to an exchange they would probably have done so by now. Most exchanges welcome the addition of new contracts and actively search for new opportunities. Another issue is that the flow of trades that takes place on exchanges such as the London Metal Exchange are very small when compared with the business that takes place in private for the metals contracts it lists. From time to time this creates industry debates over how representative those prices are. For illiquid exchange traded markets from minor commodities, through to shares in very small companies and derivatives such as options, very wide price spreads and infrequent trades are quite normal. Often the prices quoted are based on those made by market makers, depending on the exchange, who can change them when faced with a real buyer or seller. Arguably prices are still open to manipulation. For instance, two parties could carry out a set of transactions at a price designed to meet their interests and to influence the rest of the market. In fact canvassing by price reporting agencies may well 'uncover' more trades and therefore more prices for an illiquid commodity than an exchange would generate. Market characteristics can also be a barrier It is not always just an issue of a commodity being thinly traded. Ferro-chrome, a 10 million tonnes-a- year market, was investigated by the LME for the purpose of developing a contract. It was eventually dropped due to issues over the practicality of warehousing large volumes of bulk material typically involved with this market. With commodity exchanges such as the LME much of the activity is driven by hedging, investing and price discovery rather than physical trading. Therefore much of the metal stored in LME warehouses will not be consumed for many years. Metal-Pages Ltd. 4

With minor metals the market is primarily driven by physical trade and industrial demand. Therefore convenient warehouse locations are very important. Some of the applications for minor metals are so particular that one parcel of metal cannot always be substituted for another due to slight variations in form, quality and metal composition. Impurity tolerances for base metals are generally higher. Still a role for PRAs with exchange generated pricing Even in cases where an exchange traded metal becomes the established benchmark for prices – there is still a role for price reporting agencies. Price premiums and discounts to the benchmark price can come about due to issues such as origin, physical form, metal content and any impurities present in the metal. For example, at the time of writing there was an active discussion in the cobalt industry about the need to quote premiums and discounts to the LME cobalt price for various physical forms of cobalt metal (e.g. cut cathode, ingot, broken cathode and briquettes) and reflecting variations in cobalt content and impurities, should the LME become the pricing benchmark for cobalt in the long term. Price reporting agencies already publish "physical" premiums to LME base metal prices to reflect the cost involved in processing material (e.g. cutting of nickel cathode) and taking the metal out of the exchange's bonded warehouses. The reason they do so is that the industry needs this information to establish the actual level of transacted prices for the material they buy or sell in the physical market. Speculative distortions Another point with exchange traded commodities is that it can attract speculative interest. An example of this phenomenon is the Kunming-based Fanya Metal Exchange. The exchange has listed contracts for a range of minor metals and has marketed them as investment products to retail investors in China. From 2013 an influx of investor money has driven up prices of indium and bismuth to levels that do not reflect fundamentals of production and industrial consumption. The higher prices on the exchange caused suppliers to deliver more metal to the exchange, diverting it from the physical market, and this in turn fuelled a rise in physical prices. From time to time minor metals are subject to speculative and investor interest. Often following some technological breakthrough, which will generate more demand. But the levels of speculative interest in indium are unprecedented. The Fanya Metal Exchange is acting as the main conduit for speculative funds into that market. In minor metal markets, where supply volumes are limited and prices can rise or fall on a small volume of trade, speculative interest can have a major distortionary impact on the market. This becomes a source of concern for the industries which produce and consume these metals. Consumers pay more than fundamentals justify as they compete with investors for material. It also potentially encourages over-production by producers. Then if those investors should decide to liquidate their holdings it could drive prices down to levels that are uncompetitive for producers. This could lead to them experiencing financial difficulties and create issues of under-supply further down the line, which could take years to resolve. Metal-Pages Ltd. 5

2. Price assessment by industry associations One of the main reasons why price reporting agencies have evolved is because of their neutrality. Publishing companies do not trade or invest in the commodities they assess for price purposes. Most of them have in place policies banning their employees from having a financial interest in the markets they assess for price purposes. Trade associations have tended to steer clear from getting involved in price assessment due to anti-trust laws in the US. Also, trade association members depending on whether they are producers or consumers have very strong biases on where prices should be. Arguments over pricing could potentially create bitter divisions within an association. It is therefore convenient to leave price assessment to neutral third parties, such as specialist publishing companies. 3. Price assessment by regulators Apart from not possessing the set-up to assess the prices of various metals and rare earths they would also be playing an active role in the markets they're regulating, potentially leaving them open to accusations of bias and conflicts of interest. This could result in reputational damage and call into question their ability to properly regulate the markets. 4. Make participants liable for the prices they give to price reporting agencies Many market participants give prices to price reporting agencies on an informal basis, but on the understanding that this information is given anonymously. Usually, these individuals are not named in market reports explaining price levels. The European Commission has suggested that price collection and assessment should be formalised. However, the idea of making market participants legally liable for the prices they give out would almost certainly guarantee that most would refuse to cooperate. This would make price collection and assessment by price reporting agencies almost impossible leaving the market devoid of any price benchmarks to guide transactions. Another suggestion is to make price reporting agencies legally liable for the prices they publish. This could have one of two outcomes. Some could cease publishing prices altogether or simply pass on the costs of potential fines etc.. to subscribers. Both outcomes would be bad for the market. 5. Ceasing price assessment One radical alternative could be to cease all price assessment leaving it to individual participants to discover prices for themselves. This would certainly suit some industry players, particularly those with more in-depth and up to date market knowledge. Less market information would give these participants a strong negotiating advantage. Typically, large traders, which have a view of buyers' and sellers' intentions, a knowledge of stock levels and where they are located have a commercial advantage. The same can be said for leading producers. The real losers would be consumers from the component manufacturers all the way up to the retail customer buying the end products. Metal-Pages Ltd. 6

Manufacturers, which use these materials, are often among the participants with the least market knowledge. Many purchasing departments procure a vast array of raw materials and are unable to closely follow all the different markets. For this reason many purchasing managers subscribe to specialist publications and price reporting agencies to enhance their market knowledge. In that sense price reporting agencies, which publish prices and articles about these markets, help level the playing field for consumers. Armed with better information they are more able to negotiate prices, which better reflect true supply and demand fundamentals. Therefore any regulatory move, which would make it difficult or impossible for price reporting agencies to operate would be to the detriment of consumers. It could also be detrimental to western economies and their efforts to promote high-tech industries which rely heavily on minor metals and rare earths. Best practices for assessing prices of illiquid commodity markets: 1. Employ experienced reporters who are familiar with the markets they are assessing. 2. Ensuring as many market participants as reasonably possible are contacted for price information. 3. Implementing a code of conduct for staff ensuring they have no personal interest in actual price levels and do not collude with industry participants. There should also be disciplinary procedures for breaches of conduct. 4. Carry out internal audits ensuring prices are being correctly collected and assessed. 5. A complaints procedure for industry participants if they believe prices to be incorrect. 6. Banning market participants from holding shares in price reporting agencies and vice versa. Conclusion Collecting prices from market participants and working out an average price, which sometimes includes making editorial judgements as to their true levels, may be far from perfect. This potentially leads to the criticism that price reporting agencies in general do not use precise pricing methodologies and algorithms, which would create greater market transparency and predictability. However, a precise pricing methodology is vulnerable to being gamed by market participants. This was shown to be the case with the LIBOR scandal where participants were able to manipulate interest rates to their advantage because they worked out how to play the rules. In the case of price discovery for commodities traded in illiquid and opaque markets the current approach used by most price reporting agencies of employing journalists to apply an editorial filter is still the most effective approach. By their very nature illiquid and opaque markets are challenging for price assessment purposes. Metal-Pages Ltd. 7

Moving them on to exchanges is unlikely to make the process of price discovery much clearer. There is also the issue of getting the industry to transact via an exchange. The vast majority of commodity business is still conducted privately. Nonetheless, price reporting agencies themselves are subject to market pressures, which impose their own discipline. Most minor metals, ferro-alloys and rare earths markets are covered by two or more price reporting agencies. Those which become 'captive' to certain market interests or fail to assess prices properly soon lose credibility. That in turn leads to losing subscribers. This in itself places a strong onus on price reporting agencies to try and publish prices, which are as accurate as possible. Generally industry participants appreciate having a number of price reporting agencies. Some for instance chose to collect prices from all of them and average them out to obtain what they believe is a clearer picture of the market. Whilst some may argue that an individual price on a particular day may be wrong, over time the prices published by price reporting agencies tend to be broadly accurate. For that reason contracts by industry tend to be signed on average prices over a period of time. Prices usually end up being corrected due to complaints from users and investigations by the price reporting agencies. In practice prices published by price reporting agencies do tend to be quite close to each other. For many metals and rare earths there are often substitutes. If prices of these commodities rise to the point of challenging profit margins of manufacturers then they quickly seek to first optimise their usage and then to introduce cheaper substitutes. There has been a revolution in recycling and it is steadily becoming more viable to extract smaller and smaller amounts of minor metals and rare earths from spent products. There are a raft of industry initiatives in countries such as Germany and state sponsored programmes by the European Commission and the Japanese government to make recycling even more effective. In effect high prices encourage more recycling and once this becomes more established it can have a smoothing effect on pricing. In both cases the extra transparency provided by price reporting agencies can make these natural market cycles work more effectively allowing participants to make better judgements in terms of making investments and planning their R&D. For further information please contact: Justin Pugsley, Markets Data Manager at Metal-Pages Ltd. 8

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