BMD Crude Palm Oil Vs DCE Palm Oil Futures: Feasibility

Article is contributed by Shen Guo Cheng, 3rd party content provider and translated into English.

Nearly 100% of palm oil supplies in China depends on imports, nearly half of the import is from Malaysia. Bursa Malaysia Derivatives Bhd (BMD) Crude Palm Oil Futures (symbol: FCPO) have significant pricing power in the global market, the cost transmission process from external to internal has tightened the trading relations between DCE and BMD, and as a result the cross market arbitrage becomes feasible. CME Group has 25% equity ownership in BMD.

Condition Analysis

Cross market arbitrage is an action that one enters into two exchanges simultaneously, in order to gain from the price spread. Firstly, this requires the products traded to be highly correlated, through the statistical analysis of BMD and DCE Palm Oil Futures (symbol: P) Contract Wenhua Index price, since DCE-P contract was launched in 29th October 2007, their correlation coefficient has been up to 0.9245, while the correlation between the cash price of the import and the domestic average spot trade price even reached 0.9771, indicating that the two have a consistent trend, the price factors for BMD would affects the DCE palm oil trend as well.

For arbitrage trade, typically, traders need to consider the degree of liquidity of the contract. From the market development of BMD-FCPO, its overall open interest—from around 50,000 lots in 2008; monthly trading volume around 200,000-300,000 lots, has expended recently to total open interest 200,000-300,000 lots; and monthly trading volume stabilized above 500,000-700,000 lots, even once rushed to 1 million lots. While the DCE palm oil’s trading heat is much higher than BMD market, in recent years, the total open interest of various contracts have mostly focused on 600,000-800,000 lots, the monthly trading volume has to be calculated by millions and hundreds of millions. Adequate liquidity determined that the two markets are highly active, providing the key conditions for cross market arbitrage.

Arbitrage Strategy

Given the underlying of DCE-P differs from the underlying of BMD-FCPO, the former is refined edible palm oil (24 degree palm oil in spot trading); the latter is crude palm oil, therefore, we have to calculate the spread implied by the two underlying products. Typically, the spread price between the 24 degree refined palm oil and crude palm oil fluctuate between $20-$40/ton, the relatively stable spread relationship makes the arbitrage pattern can be followed.

At times of cross market arbitrage, factors that traders need to pay attention to include: exchange rate; shipping cost; duties; handling charges and Malaysia palm oil basis quotation etc., the cost calculations by step (that is, import conversion) are as follows:

  • Convert Malaysia crude palm oil ringgit (RM) quotation into USD;
  • 24 degree palm oil FOB price (offshore price) is around $25, shipping is about $30;
  • Convert USD into RMB;
  • Import duties 9%, VAT 13%, incidental expenses of 120RMB.

Thus, we conclude imported palm oil theoretical price calculation formula, that is= {(Palm x RM/USD exchange rate) +FOB quote + shipping + ($20 or $40) contract underlying spread}x USD/RMB exchange rate x1.13×1.09+120.

Opportunity Identification

According to the formula above, if the current RM/USD exchange rate is 0.274; while the USD/RMB exchange rate is 6.1615, shipping the Malaysia palm oil priced at 2150RM/ton to China would cost 5160RMB/ton, the popular spot quote is around 5100RMB/ton, the basis is 5100-5160=60RMB/ton, there are slight upside down phenomena existing in the internal and external markets, to some extent, theoretically speaking, not much space for arbitrage. However, if we take into account the weak conversion of both markets, as well as the deep negative value of domestic futures premium, it may be appropriate to consider expending the price upside down spread trade, that is, short DCE September palm oil; and long BME-FCPO benchmark contract.

Of course, this kind of arbitrage has significant risk, after all, the theory is based on related cost structures, while the domestic spot price should be higher than the Malaysia palm oil price, in recent years, with the rising of palm oil import trade financing, the old spread arbitrage logic and range were broken, allows many uncertainties been brought into cross market arbitrage. Moreover, in the real arbitrage trading, we must also take into account if the total position value of the two markets are basically the same; whether the contract time corresponds to each other; as well as exchange rate risk, import & export policy changes etc.

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