Hong Kong is about to get a commodities exchange that the backers say will allow end-users and traders to more efficiently hedge their price risks in China and across the rest of Asia û something that has become more and more important with the sharp increase in commodity prices in recent years.

The exchange has the support of several international investment banks, including Barclays Capital, Cantor Fitzgerald, Lehman Brothers, Merrill Lynch and Morgan Stanley, and also of the Hong Kong government which advocated the establishment of a commodities trading platform here more than two years ago.

The commodity futures contracts currently available inside China and elsewhere in Asia arenÆt enough to meet the needs of both the global trading community and Chinese customers, and the new exchange û named the Hong Kong Mercantile Exchange (HKMEx) û will fill that gap, says Barry Cheung, a former deputy chairman of Hong Kong-based oil trader Titan Petrochemicals who will be the first chairman of the new exchange.

Chinese commodity users have the option of hedging their exposure on one of the three domestic commodities exchanges in Shanghai, Dalian and Zhengzhou, but these arenÆt open to international investors and the contracts are traded in renminbi and deliverable on a post-import basis. The other alternative in this time zone is Singapore where commodities are traded over the counter, a less transparent and less efficient process that typically leads to higher costs.

ôThe (new) exchange will provide more price relevancy that better reflects mainland ChinaÆs underlying supply and demand and enable Chinese traders to have more pricing power in the worldÆs commodities markets,ö Cheung says.

When it opens for trading in the first quarter of 2009, HKMEx will offer trading in just one product û fuel oil û which is used both by power plants as fuel and by refiners to produce diesel. However, this type of oil, which is known as ôNew York Harbour No. 2 oilö in the US and ôgas oilö in Europe, is often also used as a hedge for other types of fuel, including jet fuel and shipping fuel. In Asia, the fuel is known as ôRegular 180 CTSö.

The choice of product is quite obvious given the surge in oil prices over the past 12 months and the fact that ChinaÆs crude oil consumption has increased at a compound annual growth rate of 7.3% over the past seven years. But many other commodities show similar demand and price characteristics and Cheung says the HKMEx plans to introduce contracts for other products ôshortly after the first one is launched.ö At a press conference yesterday, the involved parties were unwilling to name any likely candidates, saying only that the exchange will be looking at various possibilities across a broad range of commodities. It will set up an advisory board of industry specialists to guide it in on issues like these.

In a written comment, Lehman BrothersÆ head of Asia-Pacific commodities trading, refers to his firms ôpotential involvementö in HKMEx and says: ôOur focus will be on expanding our footprint in other asset classes such as coal, metals, agriculture and carbon credits, and this new exchange will be one of the key partners for Lehman in this effort.ö

On a direct question of whether rice may be a possibility, given this yearÆs hefty price increases and the current supply and demand imbalances in certain geographies, HKMEx president Thomas McMahon says that would be ôa logical contract to bring into this regionö but adds that no decisions have been made. McMahon is a former vice president and director of Nymex Asia, the Asian arm of the New York Mercantile Exchange.

The location of the exchange in Hong Kong means that the participants will be in close proximity to the end-users of the commodities in China, but will be able to benefit from Hong KongÆs free market system, sound regulatory environment û the exchange will be regulated by the Securities and Futures Commission û and lack of foreign exchange controls. The delivery of the fuel oil will be to storage facilities owned by Titan in China, but while at the storage it will be treated as not yet having been imported. This means that the contracts can be traded in US dollars and that the customers are free to move the oil outside of China should they wish to do so.

ôThis will allow us to set a benchmark price for fuel oil import into China,ö says Cheung.

The delivery of the oil at ChinaÆs doorstep will be a key advantage over the fuel oil contracts available in Singapore that are traded on the basis of physical delivery in Singapore.

McMahon adds that the transparency surrounding the warehousing facilities will also give the banks that are lending against these commodity cargos better certainty that the products actually exists in the claimed amounts. ôThis will raise the standards for the industry as a whole and will help it grow further,ö he says.

The new exchange is being set up by private individuals, including Cheung who has been working on this project for about two years, and despite its similar name it has no connection to the Hong Kong Exchanges and Clearing (HKEx) which operates Hong KongÆs stock and futures exchanges. CheungÆs former employer Titan Petrochemicals also appears to be a driving force as it has, according to Cheung, provided some of the start-up capital.

The exchange has lined up a number of strategic investors who will provide an initial round of funding of $50 million that should cover some of the early start-up costs, including the recent move into its headquarters in Hong KongÆs new International Commerce Centre. The final shareholding structure will be worked out over the coming few months and is expected to be in place by the end of the third quarter.

Cheung was vague about which companies and banks were likely to become shareholders and which would join as trading members, but the pool of supporters who were listed as potential strategic investors/members include numerous high-profile names divided into three categories: international institutions, including the earlier mentioned investment banks; end users; and large Chinese enterprises. Some of the names on the list are China Galaxy Securities, China International Futures Corp, China Resources, Citic Group, Noble Group, Titan and Warburg Pincus.

HKMEx will provide the futures contracts on a standard 30-day delivery cycle, meaning there will be 12 contracts expiring every year. Cheung and McMahon argue that there are a lot of players in the commodities markets who have a need to hedge their China pricing risk more efficiently and who can be expected to start using this new platform.

ôThere is a lot of liquidity here that is being forced to non-Asian exchanges,ö McMahon says.

However, to ensure there will be sufficient liquidity, the HKMEx will implement a market-making system and at the moment expects 15 yet-to-be-disclosed firms will take on the role as market makers for the first fuel oil contract.

Other partners in the project include Nasdaq OMX, which is developing the design of the trading engine; Patsystems, which is developing the front-end trading model and the risk management system; Trayport, which will provide the software; and LCH.Clearnet which is set to become the clearing house.

Given that a successful commodities exchange is expected to enhance Hong KongÆs status as a financial centre and the fact that it has the support of the government, there should be no problem in obtaining the final license and approvals from the SFC. These are expected in the fourth quarter, which should allow for trading to start in the first quarter of 2009.