1. 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 CLASS 2

2. Seed cotton Cotton yarn Cotton seed Cotton fibre Ginnery Oil mill Cotton spinner Textile factory Hand picking (70%) or machine picking (30%) 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. * “Standard” cotton * Extra-long staples (for high-quality textiles) Farmers Cotton seed oil (world’s 5th major edible oil) Cotton seed cake (world’s 2nd major livestock feed) Produced in “bales”; often transported by container Produced in “rolls”, sold on the basis of length; often, tailor-made to textile factory’s needs

3. Most commodities are seasonal - e.g., cotton in Uganda Seasons differ from country to country “Exposure” of ginnery J F M A M J J A S O N D Cotton lint Raw cotton

4. Remember: the pricing environment is not predictable. New York cotton futures, high & low prices (1980-1997)

5. Conditions do not remain the same. E.g., technological factors. Exploration Production Transport Processing Marketing/ distribution Information Easier identification of reserves has led to geographical diversification Falling production costs; and competition from new products Drastic fall in international shipping costs; bulk transport Increasing flexibility of processing equipment Just-in-time delivery; electronic trading Highly competitive pricing.

6. Seed cotton Cotton yarn Cotton seed Cotton fibre Ginnery Oil mill Cotton spinner Textile factory Generally, no “formal” price formation system. Some auctions (e.g., India); and some local price reporting. Cotton pricing Farmers Cotton seed oil Cotton seed cake * Price reporting * US futures market * Price reporting * Japanese futures market Price reporting Standard cloths Price reporting Clothing Textile factory

7. Farmers Ginners Traders Textile mills Foreign buyers Raw cotton: mostly spot, some forward contracts Cotton lint: spot, forward contracts (1-3 months) Cotton lint: much use of forward contracts (2-3 months) Yarn/textiles: forward contracts (up to 6 months) Cotton lint: forward contracts (up to 6 months) Illegal futures markets, raw cotton Bombay futures market, cotton lint arbitrage Cotton pricing and marketing - the Indian example

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 Very strong Strong Weak Strong LIBOR + 2- 10 % LIBOR + 2- 10 % + 50 % or no loans + 50 % or no loans Variable Difficult Rare Non-existent Variable Cooperative unions or large traders Cooperatives/ small traders Producers Exporters

9. QuantityOrigin Grade Shipment DestinationFuturesPriceBasis DatesMonth BIDS Arabica Washed 3600 bagsIndia Plantation AMar - AprOpenMayLess 19c/lb Fob Robusta Unwashed 1680 bagsCote d'Ivoire Grade 2AprOpenMayLess $100 C&F 3360 bagsCote d'Ivoire Grade 2May-Jun OpenJulLess $100 C&F 3600 bagsIndia Cherry abMar-Apr (1800 each)OpenMayLess $40 Fob 1800 bagsIndia Cherry abMayOpenJulLess $40 Fob 3600 bagsIndia Cherry clean bulkMar-Apr (1800 each)OpenMayLess $80 Fob 1800 bagsIndia Cherry clean bulkMayOpenJulLess $80 Fob 3600 bagsIndonesia EK1 gr4 80 defMay&Jun OpenJulLess $230 Fob 1280 bagsUganda Screen 15JunOpenJulLess $20 Fob 2560 bagsUganda Screen 15Jul-Aug (1280 each)OpenSepLess $20 Fob OFFERS Arabica Washed 3600 bagsIndia Plantation AMar - Apr (1800 each) OpenMayLess 15c/lb Fob If relevant futures markets exist, physical commodities are often priced on the basis of futures contracts. E.g., coffee:

10. Seller Buyer EXW FAS FCA FOB CFR CIF CIP CPT/ DAF DDU DDP DEQ DES Domestic transport Clearing at export port International transport - who pays insurance? Clearing at import port Domestic transport Are import duties paid? The flow of goods: INCOTERMS

11. Seller Buyer Invoice Certificate of origin Inspection certificate Packing list Bill of lading Perhaps need to add customs/consular invoice Perhaps consular visa needed Independent verification? The flow of documents Translated into language of importer? Insurance certificate Import certification

12. Producer Private buyers Central marketing co. Cooperative Agent Broker/ agent User Agent Central buying co. Merchant The cotton trade

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

14. Farmer / middleman Quality? Security of transport? Risk of loss of control over collateral Export warehouses - finance relatively easy. Reprocessing Facilities Warehouse / Warehouse receipt issued Graded Commodity Warehouse receipt issued Bank extends financing on basis of collateral stock value Export Export proceeds are remitted to designated escrow account Financing secured through export receivables Are there well- established buyers? Integrating finance into the commodity chain

15. Integrating finance into the commodity chain (2)

16. Can local traders still compete in the face of high financing costs? - the example of Uganda Interest rates charged on funds used by coffee exporters, 1997 Interest rate Percentage charged of exporters 10 % or below30.0 % 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 Licensed exporters: end of 1996: 200 early 1999: 25

17. 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?