What China's appetite means for futures

What China's appetite means for futures

By Nelson Low, executive director for commodity products, Asia, CME Group

China’s huge appetite means it is almost always a factor in setting the price on a range of commodities. Now we see a new trend, as China is not just buying pork and soybeans on international markets, but gobbling up a range of international food and agricultural companies as well.

This is significant because we can now expect Chinese buying to ripple not just across agricultural commodity markets, but also international derivative markets, as companies seek to manage the risks that come with these cross-border acquisitions.

As Chinese companies find themselves with newly-acquired foreign operations, including a plantation in far-flung Kalimantan and a wheat mill in Belgium, they have also acquired much of the know-how and expertise needed to use derivatives to manage risk in cyclical commodity businesses.

There is also a leapfrog in size: following these acquisitions, the new entity will have a bigger balance sheet, which confers more buying power on international commodity markets and thus its related futures. In effect, the Chinese book will get bigger.

This outward pivot happily coincides with efforts to internationalise the Renminbi and liberalise the capital account. These foreign acquisitions can only nudge this process forward as the RMB gains further acceptance and recognition as a currency of settlement.

Rather than just stockpiling commodities, the authorities see the need to improve wider industry efficiency through consolidation and acquisition.

There are a number of reasons to believe this trend will continue.

For one, it appears to be a state-supported policy.  Ding Xuedong, chairman and CEO of China Investment Corporation (CIC), China’s sovereign wealth fund, has publicly stated in a recent op-ed piece in the Financial Times that CIC “wants to invest more in agriculture around the world and across the entire value chain”.

This in part comes back to China’s changing appetite as Beijing seeks to rebalance the economy to prioritise consumption over investment. As household incomes rise, this also means people are eating better, with a greater demand for more protein-intensive diets and higher quality produce.

In the past, Chinese meat producers have rarely used derivative risk management tools as they have been primarily focused on domestic production. But this has changed with the purchase of Smithfield, as now WH Group will have to manage risks internationally.

These risks have been apparent this year as volatility in pork prices related to the porcine virus in the U.S. has been accompanied by steep price increases.  Equally volatile, beef prices have seen a similar price trend (thankfully not due to illnesses). The U.S. had one of the smallest cattle herds on record in 2013.

Another area where we have seen new buying activity is in agricultural commodities, where China National Cereals, Oil and Foodstuffs Corp (COFCO) has been on the acquisition trail. This year it bought a 51% stake in Noble Group’s sugar, soyabean, and wheat operations for $1.5bn, which came on the heels of it buying a similar stake in Dutch trader Nidera.

These acquisitions represent a departure from previous food security policies where China has focused primarily on supporting internal production, or building up stockpiles of agricultural commodities.

Here again, these new companies will provide COFCO with considerable expertise on using global risk management techniques and potential efficiencies through the consolidation of multi-continent supply chains.  This is likely to accelerate the process of Chinese companies becoming accustomed with using derivatives contracts to manage risks.

Dairy is another important food industry where China is taking steps to improve efficiency by accelerating consolidation efforts.  Here China is already the world’s largest importer of dairy products, a demand which in recent years has contributed to pushing up prices worldwide.

The government has publicly stated plans to consolidate the industry with the creation of about 10 large milk-powder groups, each with annual revenue of more than two billion yuan ($323m). Further out, it plans to shrink the number of companies to three to five large milk-powder groups with annual revenue of more than five billion yuan each.

By forming enlarged entities with larger operations dealing in greater quantities of milk, it also means a bigger price risk exposure.

These new Chinese dairy juggernauts will have little choice but to turn to domestic and international dairy futures exchanges, like CME Group and New Zealand Exchange, to hedge their price risks.

Of course, using derivatives successfully and effectively to manage risk takes time. What we have sometimes seen in the past in less developed markets is a tendency to first dabble in derivatives to put on speculative positions.  This can be costly and lead to a “once bitten twice shy” outcome.

Yet equally there are pitfalls if companies abstain from using risk management tools with the misguided notion this is being risk adverse – especially when operating in global markets.

One example of this is if you go back to the 2004-2005 China soybean crisis, where many domestic producers were unprepared for intense price volatility. The end result was that a large number of Chinese entities had to sell out to multinational firms.

Ultimately, the lesson here is that agricultural and food companies need to learn how to use derivatives effectively to manage risk in today’s volatile and inter-linked global commodity markets.  If they can, this will boost efficiency, profitability and ensure longevity.

Content belongs to CME Group and Open Markets. For the original please visit: http://openmarkets.cmegroup.com/8944/what-chinas-appetite-for-food-companies-means-for-futures-markets