In the complex world of global commodity markets, this article delves into the intricate realm of commodity risk management (CRM). From supply and demand dynamics to geopolitical events and customized risk management strategies, it explores the many facets of CRM and provides valuable insights into the challenges and opportunities in today’s volatile markets.

Matt Ammermann
Commodity Risk Manager
Vice President of Eastern Europe/Black Sea Region
StoneX Financial Inc.

What is risk management?  The formal definition remains the continuing process to identify, analyze, evaluate, and treat loss exposures and monitor risk control and financial resources to mitigate the adverse effects of a loss. The purpose of risk management, and for the subject of this article, commodity risk management (CRM) is to identify potential problems before they occur and implement financial strategies to manage the price risk associated with position taken in the cash markets.  You cannot increase expected return without increasing risk, nor can you decrease risk without decreasing the expected return. CRM is the process of balancing risk vs return, and this involves defining what is acceptable versus unaccepted price risk.  

The word risk used to pertain to local and global supply and demand factors, but today’s world is much more complex and now those active in the markets must consider the influence of money flow or speculator influence. Money flow or speculator influence has greatly increased over the past few years and exponentially when compared to just a few decades ago, but like anything it ebbs and flows with peak interests and historically speaking corn and soybean futures as a percentage of open interests remains near historical norms going back to 2008. Meanwhile, Chicago wheat has an increased percentage of open interest similar to peaks of 55-65% of open interest seen in 2012 and 2016/17 and as such its Chicago wheat that has the increased price volatility vs other futures contracts. As the more traditional ‘futures pits’ were closed the market lost a bit of that human touch, emotion and processing. Nothing will replace a human fully, and it’s still hard to have AI have the emotions of a human. Yes, today’s markets are more efficient, tighter bids/asks, but with this also comes increased price volatility amid ‘algos’ that can trade a bit more irrationally than that of a human. So, this brings us to today’s markets where we have many risk factors influencing the commodity markets, from Supply and Demand factors globally, but also geopolitical events, population and consumer dynamics, supply chain disruptions, weather volatility, as well as fiscal and monetary measures taken by the central banks. With increased risk events in combination with an increased speculative flow conducted electronically, this makes for a unique combination to manage in today’s commodity markets.

THE COMPLEX WORLD OF SUPPLY AND DEMAND ANALYSIS

The most common subject to analyze to help assess price risk is a look at regional and global supply and demand factors. At the core of the markets, it’s always the fundamental view that sustains a trend, but as noted above, traders still must navigate how money flow may alter this view. Regional fundamentals obviously drive local prices and price spreads, just like global exporters/importers supply and demand influences the global trade flows and trends. Typically, it’s the SnD’s that first impact cash prices and price spreads and lastly the futures markets, where as money flow impacts the futures market first and the cash market/spreads last. Just like a painting can speak 1,000 words, so too can a SnD table of any market and thus market opinions can vary greatly from the same set of numbers, and a function that is as valued as this is what creates a market! We all can argue against USDA’s numbers, but at the end of the day, it’s of value to have a constant monthly view of global SnD’s. Due to the function of increased money flow/spec involvement, it does seem like the market trades most events/fears ahead of realizing the fundamental result. 

A factor within supply and demand remains seasonal supply pressures. A crop is grown one time a year and harvested one time a year and thus this produces supply pressures. Historically speaking the seasonal pressures were much more present when the U.S. held the majority of the global market share, but since the start of the ethanol era in 2016 amongst other factors brought in more Black Sea production and exports. More importantly South American production and exports. The reason why South American production is such a major factor for seasonals, is that their exports for soybeans come approximately 6 months after the U.S. harvest and their safrinha corn exports come 5-6 months ahead of the U.S. corn harvest. This in turn has added another major supply pressure within the calendar year, and thus alter the typical seasonal flows that we have historically seen. Major is a bit of an understatement as Brazil is now the #1 soybean and corn exporter globally. The facts show that the U.S. supply percentage globally has continually declined over the past few decades as non-U.S. supplies increase, but regardless of this fact, you still have crops grown once a year, hit peak weather/maturity risk once a year, and is harvested once a year in both the Northern and Southern Hemisphere.

SOLVING THE SUPPLY CHAIN PUZZLE

Global trade flows are important to consider from a supply and demand perspective, but this still requires proper logistics as well as efficient supply chains. We all realized the importance of this since COVID due to personal shortages, but now it equates to war logistics and the difficulties this presents as well as, abnormally low river levels seen in the Rhine, Mississippi and Amazon rivers. The Black Sea grain deal that ended in July has pushed Ukraine to get creative with its logistics to push its exports out. Ukraine has pushed on all avenues, Danube, Eastern European borders and now more recently its own Corridor through Odesa ports, all of which is improving its logistical flows and increasing its global presence once again, albeit the ongoing war risks that are ever present. Logistical/supply chain risks are always present, but with the function of time and price, a solution is typically found around the corner. 

Geopolitical risks for the grain markets have traditionally been a result of some tensions seen in the energy space, but since the start of the China trade war in 2018 to the ongoing Ukraine-Russia war and now the more recent Israeli-Hamas war, this has brought the subject in full focus of all financial markets. The U.S.-China trade war was in early 2018 in combination with weather of course pushed soybeans -20%, the Ukraine-Russia war lifted Matif wheat +60% and Chicago wheat +70% over the course of a few weeks and now the more recent Israeli-Hamas war has lifted energy prices modestly but more importantly put the fund short positions on high alter. Like any new event, geopolitical risks tend to have an immediate panic/fear around the event, but then with time the market collects more information and finds solutions to navigate the new normal. Yes, a sudden decrease was realized with the U.S.-China trade war due to decreased demand, but with time prices recovered after new policies/new markets were found.

The same can be said about the Ukraine-Russia war, with time the market (farmers, traders, consumers) found solutions to deal with the new normal for now and farmers are still plantings, traders are still trading with new strategies applied. Here too the saying holds true, that with time and price, a solution will be found, but this all comes at the mercy the Ukraine farmer right now as they are taking the brunt of the price pain. Moving forward some geopolitical risks to keep an eye on remain Argentina Presidential elections (Blue Peso rate 1,100) and what this means for how they export in the future, U.S. elections as it seems this has become a highly important global factor, China-Taiwan relations and in the immediate term how the Israel-Hamas war impacts other MENA regions and the implications on the energy markets and the speculators attitudes. 

Population changes are a key factor for long-term demand changes. Over the past few decades, it’s been China’s population growth that has been the focal point, but reality says the focus remains now on India. From 2000 to 2010 China’s GDP averaged growth of 10%+ yearly with its population growth of nearly 95 mln people. Since 2010, China’s economy has slowed to a GDP growth objective now of +4% and since last year the population is now in decline. 2022 marked a big year for India as its population surpassed China and will continue to do so in the coming years/decades. As India grows, so will the SE Asia markets as well, and with population growth comes more demand shifts and the need to source cheap inputs. India remains the largest importer and consumer of vegetable oils globally, as well as the world’s second-largest consumer of wheat after China, so keep your eyes focused here per future demand profiles. The biggest factor to consider is when will India be a net importer of wheat.

Monetary and fiscal policies have been an ongoing risk factor for the markets to navigate, but post-COVID they have become all the more important, especially fiscal policies seen from global central banks. We have seen some drastic measures taken during COVID (low-interest rates, aid given) to help limp economies through an extremely low demand cycle, to now a cycle of increasing rates at a record pace to help tame inflationary pressures. We have seen similar extreme actions by central banks when economic/geopolitics pose unique risks as well. 

I think we can get back to a normal/quiet monetary and fiscal policy influence on the markets, but this really takes inflationary pressures in the U.S. and now recently developing stagflation in the EU to be solved. China has also been a bit of a wild card with a bit less transparency than others post-COVID, but it seems actions are taken to help stimulate their demand profile, but at a much slower/quiet rate than what has been seen from the U.S. and EU. 

The one risk that drives most of the above and that remains out of our full control is weather and what Mother Nature provides us. Weather risk always keeps traders on their toes as there is always a surprise to be seen somewhere in the world. Most often, weather risks present themselves with the greatest risks in producing/exporting regions of the world. Supply risks typically are quickly realized and then prices do the work of demand rationing that of what is required, meanwhile, a demand shock takes months to unfold. The most recent weather cycle that caused major stress globally was the three consecutive years of La-Nina as this pushed production risks in Argentina and Australia specifically. We now have exited that weather cycle and now remain in an El Nino pattern, something that should produce a bit less stress for global production versus what we have seen over the past few years. Weather fears typically equate to an increased amount price volatility, and as such, an increased amount of speculative positions are found by the funds. Weather influences supply, which impacts demand via time and price. Current weather-related risks remain focused on Brazil and Argentina as they are in the process of planting their crops. As mentioned above, South America has had an increasingly important role with global supplies, and as such monitoring the weather in South America as become extremely important. 

MAXIMIZING PROFIT, MINIMIZING RISK

The above-mentioned risks help to show how complex the markets can be in today’s world. The unique aspect of the above-mentioned risks is that they are fully out of the control of market participants, and as such shows a reason why market participants should be active in managing their price risk in some way or fashion. There are many CRM strategies that can be applied to manage price risk.  It can be one or a combination of futures, options, OTC or even a cash market strategy. The market will always find a way to inflict pain on a position, so will you be prepared to navigate the risks on your cash position, or will you let the market dictate if/when you make money? If you are not active in managing your risk, your risk will manage you! What is the most speculative strategy? It’s doing nothing, because when you do nothing you allow the market to dictate if you make or lose money.

The futures, options and Over-the-counter (OTC) markets remain a place that buyers and sellers come together for price discovery and transparency, whether it’s from a hedging/CRM perspective or from a speculative perspective.  Hedgers remain anyone that has a cash-related position and wants to enter into an equal and opposite financial trade to help manage this price risk.  Futures trading is typically the most liquid and transparent strategy to use with the best protection in a highly correlated market, but it also has some disadvantages as it can carry a high risk of margin calls.  Options can provide a bit more flexibility than what futures can offer. Futures convey obligations to both buyers and sellers, whereas options convey rights to both buyers and sellers and for that right, an option premium is negotiated. 

Options remain known for their flexibility amid the fact that they provide right to the buyers of options.  For that right you pay an option premium which gives the option sellers the obligation to perform if the buyer decides to act on their right.  The most basic example of this is car insurance.  You pay a premium for protection and the insurance company is obligated to perform if needed. The option premium is derived for the intrinsic and extrinsic values. Intrinsic value remains the immediate value of the option if it remains in the money, whereas extrinsic value remains a time, price, and vol function. Given most businesses are cost-sensitive, most option traders decide to structure option structures where they combine both buying and selling options at the same time, creating a floor and ceiling in their price protections.  Selling options is very common and carries obligator risks if the market moves against the short option, but this is always the normal practice for a hedger because they have a cash position offsetting that financial risk of a loss. Both consumers and producers along the value chain can use options for risk management strategies as it relates to a past or future cash position, but also can be used in combination with a futures-based strategy. With options there are nearly endless strategies to consider, but picking the right one is key to success.

Why OTC? The main reason is that it’s more flexible and can be tailored to match a client’s price risk more closely vs that of what the futures market may offer. Exchange-traded products may be limited to standardized risk management solutions, while OTC products offer tailored, flexible risk management solutions. OTC markets are a bilateral contract between two parties vs a futures-based strategy has the guarantee of the clearing house.  In the OTC space, you can manage risk with all the same products that are available in the futures/options market, with the addition of custom option strategies as well as swaps that can settle against approved 3rd party indices which can create additional CRM strategies. 

What is a margin call?  This is the result of the market moving against your financial position.  When the market moves against your position, you have to post 100% of the unrealized losses into your derivatives account to satisfy the margin call that was generated.  Margin calls do not equate to financial losses on a hedged position, the reason why is that you have an unrealized cash market gain to offset the margin call exposure, it’s just that the margin call need is immediate, vs that of your cash market likely has a forward date when the PnL will be captured. With that said, the margin call risk and cash market position have a bit of separation, and with that, it can bring in some financial stress if you are not prepared for this.

INNOVATIVE PRICING PROGRAM

You must remember the reason you are hedging is because you have cash price risk, and another CRM strategy remains implementing futures/options/OTC strategies with a cash contract.  There are numerous innovative pricing programs that can be considered, including the use of Exchange for Physicals (EFP’s) and Against Actuals (AA) to help price your cash contracts more efficiently.  An example of pricing programs for consumers and producers to be considered remains Minimum and Maximum price strategies which implement an options-based strategy to help enhance an already priced physical. 

There are also many other strategies that can be implemented through your cash contract supplier if they are able to offer this service, but it should be noted all this is driven by the use of futures, options, and OTC derivative markets and CRM strategies utilized. 

There are many ways to manage price risk, with futures, options, OTC or a combination of all.  In an ideal situation, if your outlook is 100% accurate, its best to be fully unhedged. However, if your outlook is wrong there may be a high level of unacceptable price risk, and this is the function of CRM in that it bridges that risk gap for market participants. So how to navigate all these growing price risks as well as CRM strategies? First off remember success favors the prepared. The subject of price risk management can take on different meanings and understanding, but it’s the job of StoneX Financial Inc. to help you understand your price risk and the best strategies to implement to help manage them. 

For some, this might be a great awareness of what could be driving the marketplace, while for others it might be sophisticated strategies to manage price risk.  

Is the current price volatility the norm or will it reduce in the coming months? I doubt it!  We have key S.A. weather to influence the market, as well as, the agri demand hopefuls that are expected to remain in the U.S. markets, but also growing geopolitical risks that I mentioned above and global economies that still have to deal with the after-effects of the current inflationary cycle.  Whether you are new to the industry or a seasoned trader, the goal remains the same; to manage price risk rather than allowing the market to manage you. So as I typically say, let the charts guide you, stay nimble, stay hedged up and trade accordingly!

*This material should be construed as market commentary, merely observing economic, political and/or market conditions, and not intended to refer to any particular trading strategy, promotional element or quality of service provided by the FCM Division of StoneX Financial Inc. (“SFI”) or StoneX Markets LLC (“SXM”).  SFI and SXM are not responsible for any redistribution of this material by third parties, or any trading decisions taken by persons not intended to view this material. Information contained herein was obtained from sources believed to be reliable, but is not guaranteed as to its accuracy. Contact designated personnel from SFI or SXM for specific trading advice to meet your trading preferences. These materials represent the opinions and viewpoints of the author, and do not necessarily reflect the viewpoints and trading strategies employed by SFI or SXM. 

Related topic: Risk management solutions in grain trading