Stretching the Limits: How Arbitrage in China is Disrupting the Natural Rubber Supply Chain
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:
- Composite rubber is widely purchased by downstream users and has a large supply base; which gives it a high degree of liquidity, as there are many buyers and sellers in the market.
- Composite rubber can often evade customs duties with a bit of “creative accounting.” Although the tariff for composite rubber is the same as that of standard rubber, traders often import composite rubber in the name of ‘mixed rubber,’ which enjoys zero tariffs. Thus, rather than having to find a buyer or having to find storage in a bonded warehouse in advance, the goods can pass through customs directly; saving the trader time and trouble and avoiding foreign exchange risks.
- The price of composite rubber is closely correlated with prices on the futures market and has a larger spread expansion and convergence. This makes it a favorable target for looking to arbitrage; the spread expansion offers price differences to exploit, while the convergence could allow investors and speculators to close out futures positions profitably.
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:
- From 2017 to the present, supply and demand seems to have little effect on the price of natural rubber. The constant decline in natural rubber prices has not inhibited the increase in supply nor has it stimulated demand. This is mainly due to the presence of arbitrage.
- On the supply side, traders are no longer sticking to absolute prices but are instead turning to spot-futures spreads. If the difference is large enough, traders will make the purchases.
- On the demand side; despite low prices, downstream procurement enthusiasm has not been significantly boosted. There is poor terminal demand caused by arbitrageurs importing vast quantities of composite rubber, regardless of downstream demand and market prices. This has led to high domestic stock levels, ensuring that supply is almost always enough and downstream users can adopt hand-to-mouth purchasing without having to stock up in advance.
- Traders' inventory liquidity is affected by the spot-futures spread, as it determines when arbitrageurs open and close their positions. When the spot-futures spread for rubber is ironically inelastic, neither fully converging nor expanding, arbitrageurs will be unwilling to close their positions on a loss (or insufficient profit). Thus, even though there might be a lot of inventory, it does not necessarily indicate oversupply. In cases when the spread does not converge, traders will hold on to their inventory and wait for the price difference to narrow, which hampers circulation and liquidity.
- Most of the natural rubber imported into China is either composite rubber or standard rubber. Composite rubber is used for manufacturing tires for domestic use, while standard rubber is used for export-grade tires, mainly due to tariff issues. As traders prefer composite rubber for arbitrage, there has been a surge in domestic composite rubber stocks. Meanwhile, inventory levels for standard rubber remain normal and reflect real downstream demands.
- Traders will often go in the same direction within a short window of time as arbitrage opportunities reveal themselves. The popularity and sheer volume of arbitrage orders is now affecting the price of natural rubber and will make a significant impact on the prices of futures and spot goods.
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.