Analysis: Agricultural commodities - boom, bubble or both?

Analysis: Agricultural commodities - boom, bubble or both?

What did you have for breakfast this morning? If the answer is Weetabix, you might be in trouble. Come to that, if you had eggs on toast, the same applies. Or even a hamburger (the cornerstone of any nutritious breakfast). And I hope you didn’t drink orange juice with it. How much did that set you back?

If you’re wondering, here are some clues. Front month arabica coffee futures are at $1.76/lb, 41% higher than a year ago. Live cattle are up 14% on last August, orange juice 40%, cocoa 19%, wheat 41%, lean hogs 75%. At least white sugar is only up 1% – but in March it was at $750/tonne, 36% above today’s price.NYSE Liffe's Ian Dudden

This is not to say all these prices are at record levels – they aren’t. But sugar, arabica coffee, cocoa and pork bellies are all more expensive now than they have been for the past five years.

And most of the other foods that are widely traded on futures exchanges had steep price peaks early in 2007 (cattle, orange juice) or in March 2008 (robusta coffee, wheat) or June-July 2008 (corn, cattle).

The chances are that if you’re sitting in the northern hemisphere reading FOi, the price of your breakfast is not a pressing concern. But think about your last business trip to Shanghai, Dubai or Mumbai. You’ll have seen people there for whom 20% and 40% price rises matter keenly.

Derivative markets, their participants say, exist to deal with these risks. They make price volatility more bearable – perhaps even less severe – for producers and consumers alike.

But somehow, despite the growth of derivatives trading, that volatility just won’t go away.

Food prices and agriculture in general, driven from the headlines in 2008 by the collapse of Lehman Brothers, are back in the news.

As this article went to press, Ukraine was contemplating a quota system to cut its exports of wheat from 9.3m tonnes last year to 1.5m tonnes. Exports of barley, of which Ukraine is the largest source, could shrink from 6.2m tonnes to 1m. European barley prices had already jumped 130% in six weeks in response to the east European drought, before that news.

On the same day, BHP Billiton, synonymous with the hardest of commodities, offered $39bn for PotashCorp of Canada, the biggest listed fertiliser maker.

And in its review of the first half of 2010, ETF Securities wrote: “Agriculture exchange-traded commodities have seen amongst the steadiest inflows overall since the credit crisis in late 2008, with net purchases in most of the trading weeks since the start of 2009.” The company ought to know – it is the largest ETC and commodity ETF provider.

At the beginning of August, Barclays Capital estimated that commodity assets under management topped $300bn for the first time.

Three kinds of news: supply disruptions, demand growth and investment growth. All are bullish for agricultural commodity prices.

But what kind of agricultural derivative markets are emerging? Are they havens of sanity, where real world risks get minimised and shared out safely – or a lawless gold rush for speculative investors – or a maelstrom, in which fundamental and investment factors wage an endless, chaotic war?

Deep roots

In one way, the excitement about farm produce is no big deal. Time was, the only contracts traded on exchanges were corn, wheat and other grains. Perhaps the real surprise is that it’s taken so long for ags to muscle their way back to centre stage.

The towering CME Group was originally the Chicago Butter and Egg Board, spun out from the Chicago Board of Trade in 1898. The CBoT and Nymex have still more obvious edible roots.

It’s the same in Europe. After the repeal of protectionist Corn Laws in 1846, regional corn exchanges sprang up in cities across Britain, as trade bodies sought to bring transparency to a shady and rampantly speculative forward market.

These bourses were gradually assimilated into one London Commodities Market, itself absorbed by Liffe in 1996. Nearly 10 years after the last trading pit closed, the LiffeConnect platform – catalysed by the Euronext takeover of 2001 – constitutes a vast e-network of European exchanges, offering hundreds of physical delivery points for the group’s commodities. Regional trade has been centralised for good.

“We’ve had a decade of growth, very consistently year on year, driven by the move to LiffeConnect,” says Ian Dudden, NYSE Liffe’s head of commodities (pictured above). “We haven’t looked back since.”

How important are agricultural derivatives to what is above all a financial futures exchange? Absolutely integral, replies Dudden – now more than ever.

Rival Eurex joined the fray last summer, listing cash-settled futures on potatoes, hogs and piglets – another financial exchange keen not to be left out of the ags boom.

“We’re facing customers who’ve never traded Eurex products before,” says agriculture product manager Sascha Siegel, his excitement at the prospect palpable.

Users are increasingly diverse too, says Dudden, from investment funds and proprietary traders right the way down the chain to farming cooperatives, passing through “feed compounders and flour millers through to starch manufacturers – and obviously the major merchants and trading companies”.

The Midas touch

Therein lie the headlines. Anthony Ward, co-founder of commodities trading firm Armajaro, had been famous for years in the cocoa market, but became globally renowned under the nickname of Chocfinger in July when he took delivery of 241,000 tonnes of cocoa beans, bought with Liffe futures.

This was the largest physical delivery for 14 years (since a similar, though reportedly loss-making, trade by Ward in 1996). It equalled 7% of the world’s cocoa supply and may have helped push cocoa prices to a 33 year high of £2,732 a tonne. Ward is reported to have bought the futures at about £2,100 to £2,200 a tonne.

No one outside Armajaro knows yet how much money Ward made on the trade, but if it were as much as £500 a tonne it could be £120m. Even a quarter of that amount would be a huge win.

The manoeuvre prompted angry mutterings from Liffe members and consumers alike.

“He’s going to have upset a lot of mothers,” chuckles Gavin Lavelle, CEO of Brady, which provides software for commodity trading. “But it’s as old as the hills: taking a big position in the market because you think prices are going to go up. The fact that someone can take 7% of the market shows how easy it is to become a major player.”

Did Ward do anything wrong? Buying a commodity on an exchange which sets no position limits because you think the price is going to rise is perfectly legitimate.

Liffe does, however, practice what it calls rigorous position management. It has the right to instruct a trader to reduce or liquidate a position if it sees fit.

On July 27, Liffe released a statement saying: “Today, NYSE Liffe met a number of its cocoa customers and listened to their views regarding the cocoa futures market. NYSE Liffe will take these views into consideration and consult further with its broader customer base and its regulator before determining whether any further changes are required to the market’s operation or procedures.”

Whether Liffe did intervene in the market, we may never find out. But the signs are that it is at least taking market grumblings seriously – especially those that hint at moving business elsewhere.

Last year, the bourse finished a long consultative review with its members on regulatory philosophy, discussing, among other issues, position limits. No consensus was achieved, leaving the introduction of stricter position rules any time soon unlikely.

What did emerge was a drive for transparency, something many argue is done better on the other side of the Atlantic. Well before the ‘Big Bang’ of deregulation in 1980s London, the US Commodity Futures Trading Commission began publishing its Commitments of Traders reports, giving weekly updates on the largest long and short positions in commodities. In fact, the Department of Agriculture’s Grain Futures Administration started doing this in 1924.

Liffe looks set to try something similar, pre-empting any move from the newly Bank of England-wrapped Financial Services Authority (though sources suggest Hector Sants and colleagues will be given a two year stay of execution, while the Bank tries to figure out the more serious business of keeping the country afloat).

Raising margins would be an obvious way to deter anyone from trying to corner the market – but you can bet not many of Liffe’s members have been clamouring for that.

Scarcity strikes

As so often, it’s taken a crisis to drive agricultural derivatives into the limelight once again.

There’s a reason James Bond author Ian Fleming never wrote Chocfinger or Soybeans are Forever. But when Egyptians, Indians or Bangladeshis start rioting about the price of a loaf, as they did in 2007-8, people take notice.

This year, Russia’s worst drought since the 1970s, coupled with raging wildfires which have caused hundreds of premature deaths, are believed to have destroyed up to a third of Russia’s wheat crop. The government has banned grain exports until the end of the year – sending prices spiralling upwards.

Ags traders’ eyes have been glued to Euronext Paris’s benchmark European Milling Wheat Futures. The November contract leapt from €135/tonne at the start of July to €236 a few days after the ban was announced on August 5.

The rise in trading volume was still more dramatic (see graph), a quadrupling of the monthly average to nearly 600,000 contracts.

US Department of Agriculture figures are still the best barometer of supply levels, says Jaime Miralles, a wheat specialist at commodity trading firm FC Stone in Dublin. “There was real fear and panic spreading in the market about the Russian wheat crop,” he says, “but the USDA have now eased the bull run on both sides of the Atlantic by putting out a new forecast, with production cut from 53m tonnes to 45m. The outlook is more quantifiable now and the last few days’ trading have been calmer.”

“It’s one of the worst droughts I’ve seen in 30 years,” says David Stein, co-founder of US consultancy the Commodity Weather Group. “The most comparable I can see is ’75. This is a once-in-a-few decades event. It’s not only done a significant amount of damage this season, but also for the next. They need to start prepping winter grains, which are important in Russia.”

Market participants are already wondering whether Russia will extend its export ban into next year.

‘Keep your eye on the open interest’

How worried should wheat eaters be? Fears of a repeat of the ‘Great Grain Robbery’ of 1972 – when the Soviet Union bought up vast stocks of cheap American wheat after a terrible harvest – are largely unfounded, says Stein.

Prices are nowhere near those days – or even the last supply and demand scare of 2008, when CBoT prices almost touched $12 a bushel ($441/tonne).

“There’s never been as much linkage between global markets as there is now,” says Stein. “Now there’s so much more data sharing. There are shocks to the market, but they’re much more short lived.”

Wheat futures trading has broken volume records – on Friday August 6, 316,000 CBoT Wheat Futures changed hands, eclipsing February 27, 2008’s mark of 263,000 – but although prices grazed their limit up levels, at no stage did the contracts close limit up. For that to happen, at least two delivery months would have to rise by more than 60¢ in a day, allowing a new maximum rise of 90¢ the following day.

The causes of this price spike seem clear enough – the drought. But could commodity investors be exacerbating the problem – blowing a bubble?

Some think so. “Just keep your eye on the open interest in November NYSE Liffe milling wheat,” says Miralles. “That is telling us much of the story about the European bull run in wheat. For much of the year, European prices usually follow those in Chicago. But with new speculative interest in NYSE Liffe milling wheat these past seven to eight weeks, the beginning of August was a perfect example of fund money hitting the market.”

So, much of the record volumes and open interest in Liffe wheat futures have been driven by fund buying? “Absolutely,” says Miralles. “Open interest for November milling wheat was around 67,000 contracts at the end of June. Since then it has ballooned to above 130,000. Who is behind that? When one analyses the use of futures by commercial hedgers and takes into account anecdotal information, one can make a realistic assumption that a large percentage is speculative.”

So to what extent is price being driven by the raw economics of speculation: more demand equals higher prices? “One would like to think it was fairly even ,” Stein reflects. “Say 50-50.”

Backing that argument is the correlations observable between food commodities, even those grown in different parts of the world. The weather was not bad at once for all the crops that spiked in 2008. Yes, the oil price played a big part, but there was no shortage of oil either in 2008 – just a high price and lots of speculative interest.

And the fundamentals for wheat could yet improve, Miralles counsels, something which would prick the bubble. “With wheat prices as high as they are today, what are farmers going to do? Go out and plant as much as they can.” Nothing cures high prices like high prices, as the old adage goes.

“I would be much more bearish than the market is reacting right now,” he concludes. “The high of €236.00 we’ve reached is, I believe a short term top in the market. I think €180/tonne is not unreasonable as a target price as harvest pressure and selling prevail in the next four to five weeks. Based on short term factors, I’d call the market here. The longer term outlook for wheat is less certain and continues to retain a bullish outlook.”

Should consumers be worried that the weight of speculators could hide short term changes in fundamental demand until these become extreme, leading to wilder swings?

Some market attitudes are worryingly blasé. As one senior figure at a commodity exchange put it recently: “We like to think of ourselves as a golf course. We provide the facilities – people come along and play.”

Others take a more critical view. “When you get food speculation, that really impacts people’s lives,” argues Lavelle. “I’m sure the regulators will have a look. Do I think we’ll see increased interest from them? Absolutely. The commodity markets are finite. People moving into the market is obviously going to have an effect.”

Sugar rush

Of course, with speculation comes liquidity – essential to the running of any transparent market.

“What we want to see is liquidity,” says Miralles. “This can be a double-edged sword when one thinks of the current volatility in prices. However, over the longer term, it will only add to the benefit of such tools from a risk management perspective.”

And what goes up can come spectacularly down – as sugar investors discovered earlier this year (even Ward appeared to be down £33m on paper the week after his cocoa trade, as prices dropped 5% in two days).

Raw sugar prices leapt to a 30 year high of 30¢/lb in March, on poor harvest warnings for India and Thailand. Some were predicting an annual shortfall of as much as 14.8m tonnes.

But by the end of March, the rush had turned sour. Barely a month after peaking, prices had more than halved to 13¢. Production estimates were moderately scaled upwards – Brazil, the world’s largest producer, looks set for a record harvest.

By the middle of August, ICE Futures US’s benchmark Sugar No 11 Futures (see graph) were back trading around 19¢/lb.

So, a natural correction of a speculative bubble as the market came back into line with fundamentals? Toby Cohen, chief analyst at London sugar merchant Czarnikow (pictured below), thinks not.

“A lot of comments suggest that some people thought the rally was a bubble. Those arguments aren’t true,” he says. “Physical demand was there but its impact on the futures market was overwhelmed as prices fell and investor positions were liquidated. The size of the resulting order flow from the physical market is a lot smaller than the order flow from the investment side when positions are large.”

Mass dumping of positions at ever lower prices was to blame, Cohen argues, as traders became desperate to offload. “I traded physicals for 10 years. I know how much work goes into selling 5,000 tonnes of sugar, let alone 50,000 – especially given the tightening of credit lines. With hindsight, 13¢/lb was an amazing buying opportunity, but a lot of people in the market were forecasting single digit prices.”

So does he stand by his February statement that the era of cheap sugar is over? “That’s what we’re saying,” he maintains. “I’m very much behind that. I don’t see it as a bold statement. Europe used to subsidise the export of large amounts of sugar before the reform of the European Sugar Regime. If you take that subsidised sugar away, the general price level has to be more remunerative.”

Over the past four years, reforms to the EU Common Agricultural Policy have cut the guaranteed price of sugar by more than a third. The logical result, Cohen suggests, is a movement by European farmers into more lucrative crops. Those deciding what to plant next year will need little encouragement when looking at the returns on offer in wheat.

Changing lanes

So what else is ripe for a spike? “It’s difficult to pick,” says Lavelle. “The hard commodities take all the headlines, but if you look into non-traditional areas, you’re seeing much more price volatility. Options traders love that. The hedge fund market’s waking up again too. People realise it’s a sector that’s been under-invested in.”Toby Cohen, Czarnikow

“There’s a lot of interest in rice, in particular,” says Stein. “We get a lot of questions about commodities that we didn’t in the past. In the good old days, it was just wheat, corn and soybeans. Now it’s all about oilseeds.”

And judging from the plethora of dairy contracts launched this year on both sides of the Atlantic, the exchanges are keen to target other booming sectors too.

On the biofuels front, scare stories about farmers ploughing their resources into energy crops aren’t borne out by the facts just yet. Demand for ethanol from Brazilian sugar has been lower than expected, says Cohen. “It’s not such a factor in terms of exports this season. Domestic demand is rising sharply and growth in the physical market should help the futures contract on BM&F Bovespa.”

Stein agrees: “I don’t think there’s significant interest yet.”

He instead touts China as the only circus in town worth watching as a global leader of prices. “China, in the past five years, has changed the complexion of the market globally,” he argues. “Before, we had such high wheat reserves, they were an effective price cap. China was the catalyst for driving interest in commodities globally.”

Cycles upon cycles

Just as with energy and metal commodities, for agricultural products China is the emblem of the long term bull story. The world’s population is growing fast and sections of it are getting richer and consuming more. Production is unlikely to keep pace with this demand.

There you have it. But the rate of price growth is not nearly fast enough to wipe out the bumps along the way – pockets of oversupply that can mean prices dropping and pain for farmers. As Lavelle puts it, in commodities “there are massive opportunities for huge corrections. The whole market could double or halve in a short space of time.”

Overlaid on that is long term speculative demand from commodity ‘investors’, eager to ride a long bull trend. Does this keep prices higher than they should be – or make them more volatile? If it doesn’t already, might it do so when commodity investment funds under management double again?

Some think so, others disagree. What seems a certain bet is that from producers, consumers and investors, the agricultural derivative markets are going to keep on getting more and more attention.