Questions answered here: - What is commodity exchange, what are some common types and its role in a country's economy? - How can commodity exchange solve some of the major problems facing Nigeria's agricultural sector?
I recently attended the Agric Summit Africa (ASA 2022), organised by Sterling Bank Plc, in Lagos in November 2022. The ASA 2022 was a two-day summit, resembling a caravanserai of the agricultural (agric) industry experts and stakeholders. They discussed some of the challenges dampening the outlook of the agric sector and actionable steps to address these issues.
One of the main discussions that caught my attention was exploring how a well-functioning commodity exchange can help set a path to a viable future for the agric sector.
Speaking at the ASA 2022, Mr Akeredolu Ale, the Managing Director of Lagos Commodities and Futures Exchange (LCFE), spotlighted how Nigeriaâs agric sector is lagging behind its peers.
He said that despite having fewer land masses and populations, Ethiopia and the Benin Republic see higher contributions of Agric to GDP at 60% and 40%, respectively, compared to about 25% in Nigeria.
He also added that some of the challenges holding Nigeria back include: underperforming value chains, insufficient infrastructure, limited access to agric finance, adverse agri-business environment etc. All issues that well-functioning commodities exchanges can fix.
Another speaker, Gbenga Awe, the Group Head of Agric Finance and Solid Minerals, Sterling Alternative Fund, mentioned that the key to building a trillion-dollar economy revolves around enabling the four factors of production.
These are capital (access), Land (yield), labour (productivity) and entrepreneurship (innovation)âagain, all things functioning and well-developed commodity exchanges can fix. Interesting right?
As such, as we head to the polls in a few weeks to elect a president, I thought itâll be befitting to explore the solutions a commodity exchange offers and why the next administration must give it its utmost attention.
To do this, we shall review the current condition of the agric sector and identify its impact on Nigerians and some of the challenges plaguing the sector. We will then explore how a commodity exchange fixes things.
But first, what is a commodity exchange?
Think of the stock market, but for commodities instead
A commodities exchange is a legal entity that determines and enforces rules and procedures for trading standardised commodity contracts and related investment products. A commodities exchange could also refer to a physical centre or an online platform where these transactions occur.
Commodities traded on the exchange are split into two: hard commodities (natural resources that must be mined or extracted), e.g. gold, crude oil etc., and soft commodities (agricultural products or livestock), e.g. corn, sorghum, pork etc.
Commodity trading typically occurs in two markets on an exchange, spot and derivative markets. Spot market trading refers to the exchange of cash for the immediate delivery of the product, i.e. buyers and sellers agree on a price now and immediately exchange cash and goods.
Derivate trading (further split into futures, options and forwards) involves the immediate exchange of cash for the right to future product delivery. Most commodity trades occur in the derivative market.
For instance, Nigeriaâs crude oil sold in the international market is usually done via forward/futures contracts. This involves selling a specific amount of crude oil at a set price and a specified date in the future.
Derivates involve standardised contracts that are highly regulated. Investors prefer trading in this market because it protects buyers and sellers from sudden price increases or shocks.
Say militant attacks in the Niger Delta resumed today and shut off half of Nigeriaâs oil production; the resulting supply shock will send crude oil prices skyrocketing at the spot market. Thus anyone looking to buy today will have to pay a higher priceâgood for Nigeria, bad for the buyer. However, if the inverse was the situation, like the Federal Government finally found oil in large commercial quantities in Lake Chad. The anticipated boost in supply would make oil prices drop so that spot buyers will buy at lower pricesâbad for Nigeria, suitable for the buyer.
This is where derivates come in. Since prices and volumes are predetermined, buyers and sellers are protected from sudden price changes.
Examples of commodity exchanges include the Chicago Board of Trade (CBOT), London Metal Exchange, Intercontinental Exchange (ICE) etc.
Locally, Nigeria has three commodity exchanges. The AFEX Commodities Exchange Limited, Lagos Commodities and Futures Exchange (both privately owned), and the Nigerian Commodity Exchange (NCX is government owned). The Securities and Exchange Commission (SEC) is the regulator of commodity exchanges in Nigeria.
So now that we understand what a commodity exchange is and how it works, let’s review the current state of the agric sector. When we do this, we see how commodity exchanges fit into the puzzle.
My people are suffering
We can all agree that most Nigerians are hungry! According to the NBS, 133 million Nigerians are multi-dimensionally poor, meaning they cannot afford basic life needs, including food.
In addition, Nigeria ranks 107 out of 113 countries in terms of food security in the Global Food Security Index (GSFI). Food security is the availability of good food at affordable prices and vice versa, so Nigeria is on the edge of food insecurity.
A closer look at the four pillars used by the GSFI to measure food security explains why. They are accessibility, affordability, utilisation (quality and safety) and stability (sustainability and adaptation).
As we can see, affordability and availability of food are Nigeriaâs biggest problems. Nigeria ranks 113 (last) in terms of affordability.
This isnât surprising given that as of 2019, almost half (93 million Nigerians) of the population lived under the poverty line (i.e. survived on less than â¦11,450 per month). Supply chain disruptions due to Covid-19 and the Russian-Ukraine war have only exacerbated this problem. Between 2020 and 2021, the World Bank estimates that higher food prices (inflation) pushed an additional eight million people into extreme poverty.
For context, Nigerians spend almost 60% of their income on food. With food inflation at 24.3% as of January 2023, it’s easy to see why people can afford food.
Compared to three years ago, Nigerians are almost paying double for food items due to structural issues (like insecurity and flooding) and external issues (like global food inflation and persistent naira devaluation).
These structural issues affect the availability of food and, in turn, affordability.
Persistent insecurity and herdsmen attacks have plagued food-producing states for the better part of the last decade. Thus, limiting output and increasing prices. For instance, in November 2020, 110 rice farmers were killed by Boko haram insurgents in Borno state. The recent flooding in Sep/Octâ22 that affected 92% of the entire country further serves to reduce food supply. Olam foods rice farm (Africaâs largest), reportedly worth $15 million, in Nasarawa state, alongside other farmlands, has been destroyed by this incident.
Also, Nigeria has a severe wastage problem. According to the World Bank, about 40% of goods are lost before they get to the final consumer due to issues around transportation and storage.
For instance, despite being Africaâs second-largest producer of tomatoes, with 3.8 million tons (mt) produced annually, Nigeria struggles to meet its domestic demand of 3.2 mt. They lose an estimated 45% of tomatoes harvested to poor storage infrastructure.
The aim of highlighting all of these isnât to scare you. Yes, weâre in trouble going into 2023, but as Americaâs second President, John Adams, once said, âevery problem is an opportunity in disguiseâ.
So how do commodity exchanges solve these problems?
Commodity exchange as a way out of hunger
Mr Akeredolu Ale (of LCFE) spotlighted six core functions of a commodity exchange. They are:
- Price discovery and transparency;
- Financing of the commodity;
- Competitive markets price risk management;
- Physical trade;
- Investment venue;
- Market development.
Today, we will analyse the top three functions, starting with price discovery.
Price discovery and transparency
Price discovery is the process by which market prices are determined, mainly by interactions between buyers and sellers. Simply, it is where a buyer and a seller agree on a price, and the transaction occurs.
Think of it this way. If a Brewer needs to purchase 20mt of wheat and calls farmers or suppliers in three different wheat-producing states in Nigeria (e.g. Kano, Plateau and Cross River), it would most likely get different price quotes due to a variety of reasons like price differences in input costs, transportation costs, and even insecurity costs.
However, since one of the main features of an exchange is that there are many buyers and sellers, price discovery occurs as both sellers and buyers agree on a price that works best for both parties.
Also, since the transactions are publicly settled (transparency), future transactions tend to occur around the same price until an equilibrium price is eventually found and settled.
Price discovery improves because the actual value of a commodity is revealed through the bidding of buyers and sellers that exchanges bring together at their floors.
Returning to the crude oil example, the price increase due to the militant attacks reflects less supply and high demand. Economics 101 says prices increase advertently when more money (demand) is chasing fewer goods (supply). And the inverse is the case when supply increases.
With this knowledge, traders and market participants can effectively tell whether buyers or sellers dominate the market and make informed decisions regarding their purchases/sales.
Next, we have competitive market price risk management.
Price risk management
As I alluded to earlier, Nigerians are experiencing high food inflation. In fact, between January and October 2022, food inflation averaged about 20%. However, the regional distribution of the price changes varied, with Kwara state recording a 33% year-on-year increase in food prices, compared to 19% witnessed in Sokoto.
This spotlights the vast price differences consumers and manufacturers are exposed to, called volatility.
2022 was the year of inflation (global and domestic), no thanks to the Eastern European war and its impact on commodity prices. According to the Food and Agriculture Organisation (FAO), the global food price index (which measures the monthly change in the international price of food items), food prices were up over 16% in 2022 alone.
Extending the timeline a bit further back, the index was up 49% since the start of 2021. Soberingly, this is the fourth-highest rise (over a two-year interval) since 1960. Again, this spotlights volatility or fluctuations in prices.
These sudden increases in commodity prices could also affect the profits of those involved. For instance, in the first half of 2016, steel prices jumped 36%, while natural rubber prices rebounded by 25% after declining for more than three years. This led many Wall Street financial analysts to conclude that the sudden price changes could negatively impact the profits of auto manufacturers and auto parts makers.
On the supply side, say a farmer bought â¦100 worth of input materials to produce a harvest yield worth â¦250, but post-harvest, their yield is now worth â¦80. The farmer will not be incentivised to plant next year, as they would feel their labour was in vain.
However, through standardised contracts like derivatives (e.g. futures, forwards etc.), stakeholders can efficiently utilise these financial instruments to hedge against volatility.
Lastly, we have financing of the commodity, a.k.a liquidity.
Liquidity
Despite the agric sector contributing 25% to Nigeriaâs GDP (as of Q3â22), total credit to the sector only takes up 6.35%. Juxtapose this against the oil sector, which contributes about 5% to GDP and about 30% of loans granted to the private sector.Â
The main reason for this is that most of the farming done in Nigeria is still subsistent and of low value. Consequently, farmers, especially resource-poor smallholders, are often unattractive credit candidates for financial institutions because of their unpredictable, fragmented and unstructured agricultural activities.
Liquidity constraints are eased through well-functioning warehouse receipt systems (WRS) or inventory credit systems, which are generally integral parts of commodity exchanges. WRS lets farmers deposit storable goods (typically grains) in exchange for a warehouse receipt (WR).
WRS reduces the pressure on the farmer to sell immediately after a harvest when prices are generally low. While the commodity is in the warehouse, the depositor can monitor the prices and sell when it is favourable, often resulting in a 35-40% increase in price. It allows sales to continue from one harvest to another, thus stabilising prices. Notably, the system drastically reduces post-harvest losses as the storage and care of the commodity is transferred to certified warehouses equipped with appropriate facilities and experts to ensure quality and quantity.
Based on all thatâs been said, we see a recurring theme of the function of a commodities exchange: price stability. Coordinating through a centralised exchange reduces the costs associated with identifying market outlets, physically inspecting product quality, and finding buyers or sellers.
However, three conditions must be considered for a commodity exchange to be successful. The first two are governance and market conditions, both external to the exchange itself. The third category consists of operational design conditions, which is internal to the exchange.
Governance means there should be as little government interference as possible in setting commodity market prices. If a government controls prices, for example, by suddenly restricting exports or releasing grain stocks, both of which moderate prices for the good of consumers at the expense of producers, then there is a disincentive for market actors to participate in the exchange. Sound and efficient regulation is also needed to enforce contracts and foster trust between market participants.
Additionally, market conditions refer to the participation of other financial services players, e.g. Pension Funds Administrators (PFAs), insurance and brokerage firms etc. If they are absent or present and unwilling to provide services to other exchange participants, it becomes less likely that a full-service exchange can succeed.
Finally, the operational design conditions of an exchange can lead to its failure or success. Providing these services can be costly (think about the technology, infrastructure, legal fees etc., involved), and the more services an exchange offers, the more its costs go up. However, to cover its operational costs and avoid passing them on to its participants, the exchange needs to generate sufficient volumes of transactions to maintain profitability.
Towards the end of the ASA 2022 event, Mr Ihua Elenwor, the Interim Coordinator at the NCX, urged individuals and institutions to get more actively involved in the agric ecosystem, given the role it plays in unlocking productivity in Nigeria.
As we head to the polls in 2023, your preferred candidate must have plans to boost participation in the commodity exchanges. Your survival may depend on it.
