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.