Commodity Markets – a traders viewpoint

The commodity cycle and food’s part in it

A bull market in commodities in the 40’s was followed by sideways markets through the 50’s and 60’s. The markets went on another bull run in the 70’s with gold peaking in February 1980. Soya beans hit $12 in this period, which was followed by another sideways market up until 1999. Now we have entered a new bull cycle – and depending on which planet one follows the cycle could be part of a 29 or 84 year cycle. This has been led by metals and then crude oil. It is now the turn of Food and especially Grain as the next component of the cycle to move. This will be followed by livestock.

The market has been driven in this cycle by large hedge fund and index fund participation. The Fund interest in commodities has been driven by investment objective elements such as inflation hedging and alternative asset allocation, but also by a basic reading of this cycle. Grain is the current target of their attention. Oilseeds will follow.

Many market players are uncomfortable with the scale of the positions being taken by the Funds, but their participation is set to grow substantially. The demand for commodities as an alternative asset and inflation hedge is on a huge growth path, and there are relatively few products on the market currently to meet investor demand. As the banks and large financial institutions develop new commodity investment products, they bring more and more cash to the market.

Do the Fundamentals support the interest in Grains?

The first part of the rally in grains was caused factors which are well understood now:-

• Economic growth especially in Asia and the Far East. Expanding GDP means diet upgrade, higher per capita food consumption and more demand for protein.
• China the main engine with 7-10% GDP growth, changing their diet to oil/fat/meat instead of rice, and contracting forward for energy and minerals, as well as investing billions of dollars in African infrastructure to secure access to raw materials.
• Population growth.
• Global rundown of stocks, a legacy of low prices.

This year’s rally has been led by wheat, and when the headline global supply/demand features are summarized, it’s not surprising.

On the demand side the main feature was India who sourced 7 million tonnes of imports when the world was expecting zero to 1.5 million

In the midst of the balancing of this demand versus supply equation a dynamic new entrant to the market has now turned corn into the driver of the cycle – Energy.

Effect of Ethanol as grain demand driver world-wide

George Bush set a target of 7.5 billion gallons of ethanol production for transport fuel by 2012, reflecting about 5% of projected U.S. fuel consumption. Current U.S. capacity is 5.4 billion gallons with another 6.2 billion gallons of capacity under construction!. This total capacity when operative will consume almost 40% of projected US corn production.

To meet this supplemental demand the market estimates another 8 million acres of corn must be sown this spring, taken largely from soya beans – the next cycle driver. Then yield must hit trend levels, all of which translates potentially into unacceptably tight year-end stocks.

In order to bring this situation under control corn has rallied 52% last year. Wheat stands a good chance of rebuilding stocks next year with this year’s rally having expanded acreage all around the globe. However wheat will now have to be fed in style to livestock to take the pressure off corn, which will help to absorb that surplus.

Although some are starting to question the economics of ethanol in the U.S. with the recent collapse in crude oil prices, one has to remember the political driver behind the ethanol project – self-sufficiency and independence from oil produced in politically unpredictable regimes.

Effect of Ethanol as grain demand driver – EU

The EU main feedstock will be wheat. The economics of ethanol, are different in the EU. Wheat has less starch and the EU supply/demand is far more balanced – in fact the EU is deficit in maize and has only a surplus of some 10% of its 120 million tonnes of wheat production. In contrast the US is surplus 40% of its 250 million tonne corn production before ethanol demand is taken into account. Higher feedstock prices in the EU have to be met by even more generous government tax subsidy. This is administered under a loose but committed protocol to achieve 5.75% of transport fuel requirements to be met by ethanol by 2010, which the EU will keep trying to make mandatory. However there will be the inevitable lag in application, which is left to the discretion of the individual member states.

In many ways the effects of the new player in EU markets will be no less dynamic.

1. Trade flows will change. The large compound feed industries in Holland and Belgium were fed by France, Germany, Scandinavia, Belgium and the UK. The UK and Belgian surpluses will be taken out, with resultant higher prices. A significant proportion of the surplus areas in France will also be diverted to ethanol. There will be an increasing reliance on the surpluses in Central and Eastern Europe, as well as the Black Sea producers, all of which have difficult, uncertain and expensive logistics.
2. The ethanol producer can hedge 2-3 years forward, and will be driven to do so by the banks in order to lock in margins on high-cost investments, and due to the imperative for a speedy amortization of their investment. The feed and food producers margin horizon is 12 months in the case of food and 2-3 months in the case of feed. How are these industries to compete with the dynamic buying power of the ethanol producer?
3. The EU will remain surplus grains due to the slow rhythm of construction of the ethanol plants. However since the supply/demand equation is far more balanced, and with the purchasing dynamics mentioned above, the market will behave deficit for large periods of the campaign, resulting in big price swings and increase in volatility.
4. Liquidity will also become a major problem. There will be times when prices will make exaggerated moves on limited volume. Cool heads will be required to keep one’s eye on the ball of real value – but even then end-users may find it hard to maintain the flow of supplies to the plants at that perceived number.
5. It gives the opportunity to kick away some of the corner-stones of the original CAP. For example maize intervention is set to disappear.

Next year’s grain prospects

On the world front, as already mentioned, there will be an opportunity to rebuild wheat stocks. World production is set to recover some 40-45 million tones, and wheat will narrow its spread on corn to induce wheat feeding, and spend much of the year as a follower, leaving corn to drive the market

Inside the EU, Brussels has launched a programme this year to liquidate all the intervention stocks they are holding. They will be largely successful in this, with only Hungary still carrying a substantial unsold quantity of some 4-5 million tonnes of maize in a year which will end on bare boards in terms of carry-out stocks. The EU wheat surplus will run between 12-13 million tonnes including Rumania and Bulgaria, and while the EU will have strong competition from the Black Sea, they should ultimately be able to dispose of this. The picture is therefore balanced, but the lack of government-owned stock together with the overall bullish global outlook will make for a steady and well-supported market.

Barley however will be in over-supply. Aggressive competition from Ukraine in early season export markets, even without Australia, will keep feed barley discounts to wheat very wide to enforce maximum take-up in compound rations, and one can’t exclude prices having to trade at intervention levels in Eastern Germany, again if all the crops come though well. Malting barley is a different matter and will continue to make substantial premiums as maltster’s struggle to rebuild stocks until well into harvest. However a large crop is in the making given normal weather, and if quality is good those premiums will come down.

Maize prices should maintain healthy premiums to wheat, not least because if prices stay above $4 on corn one can expect exports ex Hungary, Bulgaria and Rumania to third country Mediterranean destinations.

As to where price levels work out, that will largely depend on corn world-prices, and this is something we are not used to in the EU. Taken on its own, wheat would not be able to achieve the lofty levels we have seen this year, and benchmark values would be nearer $160 FOB EU for the last quarter compared to the $185 trading now. However the corn market cannot relax until the required acreage is in and successfully negotiated the critical pollination period in July/August. For the moment sentiment and the trend is bullish.

Is the ethanol demand situation irreversible?

Politically this demand bandwagon will not be stopped in the short term. However the market is reacting already with substantial increases in wheat and corn acreage. Seed technology will no doubt follow on and pick up the challenge.

Both the government and the EU have acreage in reserve programmes which can eventually be released, and new land can be commissioned in South America and areas like Russia and the Ukraine.

Some sectors will suffer – notably the livestock sector. Inefficient producers with no access to substitutes such as the by-product of ethanol, DDGs, will be forced out of business, and it is commonly recognized that, although increased use of DDGs and also wheat, hay and pasture will help it reduce demand for corn, the livestock industry will have to cut back in terms of size to make way for the new player.

Longer term, technology will bring on second-generation feedstocks such as switchgrass, miscanthus, straw and other cellulose based crops to take over from ethanol, which, though it satisfies current political imperatives, is an economically and ecologically flawed project. Hence the requirement of ethanol producers to write off their investments as soon as they can.

Commodity cycle – enjoy the ride but recognize the risks

The risks will come from violent price swings hitting constantly higher peaks over the next few years – especially if weather takes a hand.

However corrections could be equally violent and run very deep. Take corn at $4 per bushel now in the U.S which many are touting to hit $5. The CEO of a leading international consultant said in a speech only days ago that if the acreage they project gets planted in good conditions and survives the summer, they expect corn back at $3 in the autumn.

Several large industrials have already felt the effects of the swings we have had this year. One large U.S. industrial announced recently that they were ceasing using the futures market as a hedging medium.

The price swings will be even more dangerous to the extent that view the huge fund participation, unexpected outside events will at times put the market into a state of panic. Crop failures are something the Trade have learned to anticipate. They can be very disruptive and can certainly wreak serious damage, but market liquidity can generally handle them.

How about a global systemic event such as bird flu however? The mere fear of that can have a dramatic effect on sentiment given the current structure of the fund positions. What about Government, who can be every bit as dangerous? President Carter’s grain export embargo against Russia in 1980 comes to mind. This was recognized as a bad mistake, but there is no doubt that ethanol will have a seriously inflationary effect on food, and although current attitudes may seem cavalier in this regard, Government will act unpredictably if food supplies become seriously threatened by a series of crop failures. How about a government-prompted order for the U.S. grains futures to trade on a liquidation-only basis?. Index funds are currently long some 400,000 corn contracts, equal to the entire U.S. annual export demand. It is not a concern for now, nor is it too likely in the immediate future, but it has happened!

This volatility will play havoc with the Trade as a whole. Merchants and shippers will have to live with the fact that there will be the inevitable defaults and bankruptcies, and it will be important to diversify one’s commercial distribution across the industrial sector, and monitor exposure to individual trading firms, both in terms of credit risk and market price differences. Farmers will have to exercise the same rigour.

One should not over-dramatise, because the remedies are simple and boring. Although this will at times be scary, the Trade will naturally assume the basic counter-strategy which will have hugely beneficial effects on the industry and on market organisation as a whole. It will be very important to :

1. Know the customer.
2. Diversify sources of supply, and spread sales activity across several industrial sectors.
3. Build a network of individuals and firms in whom one can have confidence, and whose market role can be understood and trusted.
4. Use that network not only to develop mutually acceptable supply chains, but also to operate in relative transparency and with an understanding of each other’s business imperatives.

Finally let´s not ignore or become complacent about the commodity cycle theory. It maybe telling us things we don´t and can´t know.