June 24, 2019 | Chemicals
Arbitrage, the practice of taking advantage of price differences between two markets to earn a profit, is one of the oldest financial tricks in the book. In the modern commodities market, arbitrage makes use of the difference in prices between the futures and spot markets. In recent years, a favorable price difference has emerged in natural rubber and arbitrage is increasingly gaining popularity among commodity traders.
Unlike most other futures products, the goods marked for delivery in rubber futures contracts are not typically the same variety as the spot goods purchased by downstream users. Therefore, the arbitrage of natural rubber is frequently referred to as non-standard arbitrage. The widespread application of the arbitrage has significantly impacted all aspects of the domestic natural rubber market; from supply to demand, inventory level, and price.
At the core of arbitrage is the price difference between the spot and futures markets. When the price difference is large enough to cover the cost of the transaction, arbitrageurs will buy on the spot market and sell on the futures. Consequently, the price difference between spot and futures will start to narrow and arbitrageurs will stand to make profits by reversing their positions; selling their spot and closing their futures positions. In the process of arbitrage, the most important costs traders incur are spot storage cost and the cost of capital.
Profits in the Price Difference: Composite Rubber
The arbitrage of natural rubber mainly involves three varieties: ribbed smoke sheet rubber, domestic-produced pure latex, and imported composite rubber. This final variant, composite rubber, is the most widely used for arbitrage as it possesses some unique advantages:
The Situation in China
China possesses a unique advantage in composite rubber arbitrage, as composite rubber is not an item marked for delivery in futures contracts in the Chinese commodities market. According to the current arbitrage cost; traders begin to build their positions when the price difference between the spot and futures market is over 2,000 CNY per ton. At this point, the spread would most likely be enough to coverage storage and capital costs on the imported composite rubber. When the price difference reaches 3,000 CNY per ton, arbitrageurs flood the import market.
As arbitrageurs continue to make high-volume purchases of composite rubber in the spot market while shorting it on the futures market, the spot-futures spread begins to narrow. If convergence doesn’t happen immediately, traders will move their positions towards longer contracts. Eventually, the spread narrows, and arbitrageurs massively sell-off their composite rubber inventory on the spot market while closing their positions on the futures market. After factoring in the capital cost, storage cost for the spot goods, and the various transaction costs that come with trading in commodities; arbitrageurs pocket the difference as profit.
The size and prominence of composite rubber arbitrage in the Chinese commodities market has disrupted the supply and demand patterns in the natural rubber market, both upstream and downstream. Four of its major effects are:
Arbitrageurs are neither perma-bulls nor perma-bears. Their behavior and their potential impact on natural rubber prices are determined by spot-futures price differences at various points in time.
Non-standard composite rubber arbitrage has had wide-ranging changes in the supply and demand patterns of the domestic rubber market, affecting inventory levels and the structure of futures positions. These disruptions in supply chain ultimately impact market prices. Indeed, arbitrage activities can, to some extent, be held responsible for the current bear run in rubber prices.
There are a few regulatory changes in the works that could become game changers to arbitrage activities. China’s General Administration of Customs is revising their regulation policies, reclassifying composite rubber as natural rubber, closing the loophole traders have been utilizing to avoid customs duties, while the Shanghai Futures Exchange (SHFE) is currently promoting the listing of Technically Specified Rubber grade 20 (for example, ISNR 20, STR20, SIR 20), a process that is expected to be completed sometime in 2019. As TSR 20 is widely used by the downstream, its listing on SHFE may drastically change the behavior of arbitrage activities.
Nevertheless, severe oversupply in the rubber market and an imperfect delivery system of rubber futures contracts (where the subject of the delivery contract is not the mainstream variety of rubber used in the market) means that one can expect natural rubber prices to remain in the grip of a bear market for the foreseeable future. It appears that composite rubber arbitrage will continue to exert its influence on the supply chain.