I Spy with My Little Eye
Weather, demand, and speculation. How does commodity trading work?
Today, hedging transactions on exchanges play an essential role in keeping agricultural trading going. For farmers, the day’s commodity prices have become just as important and informative as the weather report.
Text: Dirk Böttcher
Illustrations: Xenia Fink
+++ Pigs: mostly stable. Potatoes: new seasonal high at 32.50 euros. Wheat: favorable start to the weekend. Oilseed: rapeseed down slightly. +++
That is how the daily market updates from Kaack Terminhandel GmbH in Cloppenburg, Germany, read. The brokerage specializing in commodities futures trading acts as an intermediary between market participants. On this hot July morning, analyst Stephanie Stöver-Cordes is puzzling over the information flashing across the three screens on her desk. “The price of potatoes is falling for no pressing reason,” she says. But Stöver-Cordes already thinks she knows why.
Around 10 a.m., the European Energy Exchange AG (EEX) in Leipzig, Germany, releases initial quotations for potatoes futures contracts. Stöver-Cordes gets to work placing her clients’ orders. Although the EEX is better known for electricity price quotations, it also acts as a futures exchange for potatoes and dairy products. Marketplaces like these bring together the entire agricultural sector: producers, traders, mills, dairies, the food industry, importers, exporters – and speculators.
735 million t
The chart below shows the global consumption of wheat between 2014 and 2018. According to the most recent statistics, the world consumed 735 million metric tons of wheat.
The first futures contract was signed on March 13, 1851, on the Chicago Board of Trade (CBOT), which had been established three years earlier. This new financial product was designed to protect producers and traders from the price fluctuations on the market that posed a serious threat to their existences. Volatility could be caused by too much or too little rain decimating crops, or by winter frosts freezing over cities’ waterways and preventing traders from being able to ship their grain, pushing prices up to lofty heights just to send them crashing down again in spring when the ice melted. Standardized futures contracts allowed farmers to sell their wheat at a set price, even though it would not be delivered for another three months. Traders, meanwhile, had the peace of mind that they would receive their goods at the agreed price.
This mechanism continues to drive futures trading to this day. Beside the CBOT, the world’s largest wheat futures exchange, there are also markets in Kansas City, Minneapolis, and Paris. The marketplace in France traded 10,000 contracts a day in 2005. By 2015, that number had already risen to 317,000 – compared to 478,000 in Chicago. Today, Paris’ Euronext is considered to be the leading exchange for European grain. Traders appreciate the hedge effectiveness (the ratio of the actual price to an envisioned target), the trading hours, and the pricing in euros.
For Michael Lutzke, the morning’s prices in Paris are a little disconcerting. A report out of Ukraine stating that the country, an exporter of wheat, was planning to reduce its exports due to drought has triggered a wave of volatility. “That stirs up memories of 2010,” Lutzke says. Back then, Russia capped its exports, causing prices to rise. But this time, the panic soon subsides: The report is traced back to a Facebook post by the government, which distances itself from the statement as the day moves on. Prices begin to settle down, but they remain high.
Lutzke has his desk in an open-plan office with eight traders, some of whom are bankers and agricultural economists by trade. “It is important that we understand our clients’ business in great depth,” he says. Nord LB in Bremen is among the leading providers of commodities futures trading in Germany. The bank does not engage in proprietary trading, instead focusing solely on executing transactions on behalf of clients. Nord LB’s trading system, which its clients can also use, gives it access to the largest exchanges around the world. It also works for brokers such as Kaack Terminhandel, whose orders it executes on the markets in its role as a clearing house.
In the past, numerous banks were involved in this market. But today, their number has dwindled. Major banks such as Goldman Sachs and J.P. Morgan are still active, while international agricultural conglomerates such as Cargill use their own trading systems.
“The financial market plays an essential role in agricultural trade,” Lutzke says. Prices are influenced by the weather and political decisions. The trade dispute between the U.S. and China is currently turning the oilseed market on its head. Farmers in the United States, along with their counterparts in Brazil, supply the lion’s share of the world’s soy. The Chinese market, their largest buyer, could now be off-limits. Meanwhile, the drought is the driving factor behind European wheat prices. Back when farmers were preparing to sow their crops in fall, prices stood at less than 150 euros per metric ton. At the time, futures contracts for August guaranteeing them a price of 180 euros seemed like a good deal. But with prices now standing at over 200 euros, those same contracts could be seen as a source of frustration.
And what will the future bring for the price of wheat? This question is also on the minds of Stephanie Stöver-Cordes’ clients. “I don’t have an answer either, of course,” the analyst says. The strict banking supervision rules also prevent her from making recommendations of this nature. “But we can provide information,” she adds.
Her explanation for today’s falling potato prices is a simple one: “Every Friday, speculators face a dilemma: If it rains on Sunday, prices will fall on Monday because the harvest may just turn out better than expected. If it doesn’t rain, prices will rise.” This past Friday, most traders expected rain. But come Monday, they realized they had missed the mark.
Value of speculative investments in agricultural products worldwide, in billions of U.S. dollars
Share of the overall U.S. futures market accounted for by wheat futures
In 2011, the CBOT saw trade at 73 times the actual volume of harvested wheat. Back in 2002, that number stood at just 11 times the actual harvest volume. Dr. Sören Prehn sees that as a good sign.
“The term ‘speculation’ has garnered an undeserved negative connotation,” says the agricultural economist at the Leibniz Institute of Agricultural Development in Transition Economies (IAMO) in Halle, Germany. “Speculators ensure liquidity on the futures exchange market, giving farmers a constantly available trading partner to hedge their price risks.” That happens on a minute-by-minute basis for day traders. For farmers, who engage only in hedging transactions, several months may go by between purchase and sale.
In Prehn’s opinion, these futures exchange markets are important for the continued survival of farms, since they help guarantee profitable prices. But there is plenty of room for improvement, “especially when it comes to making decisions as to when someone acts on the market and as to the quantities involved.” To achieve that goal, farmers need better basic knowledge and a marketing plan that also takes their own cost structures into account, he says. Until now, most have used the traditional approach of selling one-third before the harvest, one-third during the harvest, and the rest later on.
In North America, farmers and investors make more creative use of the possibilities offered by futures exchange markets. There are also more hedging options, such as insurance policies that cover harvest failure and loss of income. But they come at a price: Farmers foot a part of the bill, with the rest being picked up by government agencies. Droughts, such as the one currently plaguing farmers in Germany, are therefore at least partially hedged. The only one-off incident for which insurance is available here is hail. As a consequence, the general public (the taxpayer) has to pay for harvest failures – or farmers get stuck with the losses.
CLAAS provides useful tools for creating an optimum marketing strategy. Together with Saatbau, an agricultural trading company, the subsidiary 365FarmNet offers an application called Profit Manager that makes it possible to visualize the effects of the various options available on the financial market. The data that 365FarmNet analyzes on its platform also enables real-time statements regarding the quantity of biomass currently on fields, the cost of production per hectare, and the resulting yield expectations. By combining these insights into the farm’s operations and developments on global markets, the system is capable of recommending dozens of earnings and cost strategies while also listing risks and opportunities. It is up to farmers to make a final decision.
Michael Lutzke recalls that prices were subject to little volatility just ten years ago. “Since then, however, we’ve been seeing a phase of extreme volatility, as well as an abundance of information that has the potential to change markets at tremendous speed,” he says. As a result, proper risk management is essential for farmers. Ultimately, as the banker points out, there are no real winners or losers on the futures exchange market. “Any gains a buyer achieves result in a loss for the seller – and vice versa,” he adds. Or as Stephanie Stöver-Cordes puts it: “In the end, it all balances itself out.”
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