Ripe and ready?

Dominic Tonner examines soft commodities and asks whether prices are finally firming up after a rollercoaster year for producers.

For farmers, green shoots are nothing new, but ‘boom and bust’ certainly hits them harder than almost anyone else. So they will no doubt be cheered by the signs of green shoots of recovery in the soft commodity market after a turbulent period marked by defaults and bankruptcies, tighter credit for producers and consolidation among lenders. Challenges remain – as always – but the corner may have been turned.

One sign of the changed reality was the annual pre-export financing (PXF) of the cocoa crop in Ghana, the world’s second biggest producer with a reputation for quality. Even as the harvest drew to a close in early June 2009, there were reports that Ghana Cocoa Board (Cocobod) was offering a significant increase in pricing to reflect the higher margins expected by banks in the current climate.

“There are indications in the market suggesting that the pricing at Cocobod could increase substantially and should generate additional interest, even considering the difficult environment,”says Dr Ruediger Braun, Director in WestLB’s Commodity Finance department, “but Ghana Cocobod is a quality market.”

Even so, James Cunningham, Practice Leader UK, Political Risk & Structured Credit at insurance broker Marsh, cautions that commodity pre-export finance activity remains low – Cocobod will no doubt scoop up what it needs as a reasonable price due to the reputation it has acquired as a top-notch client over 20 years, but many less exalted organisations will be snubbed.

During the first half of 2008, almost every other commodity market spiralled higher in price and softs was no exception. The International Monetary Fund (IMF) index of internationally traded food commodities prices increased by 130% between January 2002 and June 2008. The increase from January 2007 to June 2008 alone was 56%.

These prices were acutely felt in shops and markets around the world. US food price inflation jumped 5.5% in 2008, the highest increase since 1990. From January 2005 to June 2008, the price of corn almost tripled, wheat more than doubled and rice rose 170%, while arabica coffee, the highest quality bean, hit 10-year price highs.

Chinese demand drove much of this growth (as in so many commodity sectors). As wealth has increased, diets have changed accordingly, with newly affluent people enjoying more and better food – consuming more meat and luxury food products. Indeed, Investor’s Chronicle claims that China and other emerging economies accounted for a 26m metric tonne average annual increase in consumption of major food stocks between 2001 and 2007.

There were other important factors to take into account as well, such as the spike in the price of oil, which jumped from $70 a barrel to $147 a barrel in a year. This raised production and distribution costs, but also increased interest in the use of ethanol and other biofuels, which are derived from sugar, corn, soybeans and other agricultural produce.

Biofuel boost
With many of the world’s leading economies offering subsidies and other incentives to biofuel producers, the proportion of arable land used for biofuel as opposed to food crops continued to grow, further helping the ramp-up in food prices. Higher ethanol use accounted for between 10% and 15% of the rise in food prices between April 2007 and April 2008, according to the US Congressional Budget Office. In 2004, only 11% of corn produced in the US was used to make ethanol, but by 2007 that had jumped to 25%.

The ever-growing world population was another factor. From 1974 to 2005, it grew by more than 1.1 billion, expanding by about 78 million every year. By 2050, there will be another 40% more. This has put, and will continue to put, enormous pressure on a dwindling resource – arable land – and has highlighted various countries’ struggle to produce crops cheaply and efficiently.

Indeed, the ratio of arable land available per person has been more than cut in half in the past 50 years, declining from 0.42 hectares per person in 1961 to about 0.20 currently, according to the United Nations’ Food and Agriculture Organization (FAO).

The difficulty in ramping up production in some parts of the world also pushed up prices. While there was a 12%-13% increase in production in wealthy countries in 2008, developing countries – excluding such giants as China, Brazil and India – only managed a 0.4% increase, according to the FAO, a modest rise more than offset by the increase in population. The FAO blamed ‘systemic problems’, such as weak infrastructure and dependence on seasonal rain. It did not mention political instability – or incompetence – in certain developing nations, although this may also have played a part.

No less important in driving demand and higher prices was the changing dietary habits of consumers in increasingly affluent markets, such as China, India, Brazil and Russia. Overall consumption in these and other developing economies has increased, while the expanding middle classes continue to switch to a more meat-based diet. The average Chinese now eats about 50 kilograms (kg) of meat a year, compared with only about 20kg in the mid-1980s.

This has forced up prices for two reasons: first, a greater proportion of land is being used to rear cattle rather than for crop production; and second, certain soft commodities such as grain are used as animal feeds – and it takes seven grammes of grain to produce a single gramme of beef, for instance.

There is also no denying that speculation played its part in driving up prices. “Soft commodities became an attractive asset class, drawing in investors not normally associated with them,” says Braun. What was once an alternative and difficult to access asset class, with scarce information, became more readily tradable and open to speculation.

On the London Stock Exchange, several listed exchange-traded commodities were created to track a range of goods, including grain and cotton. Investment funds with at least a large segment of their portfolio invested in soft commodities included Schroders’ Alternative Solutions Agricultural Commodities fund and Global Climate Change fund, the Ceres Agriculture Fund, managed by FourWinds Capital Management, the CF Eclectica Agriculture fund and the JPMorgan Natural Resources fund.

Return to structure
Trade and commodity finance deals, meanwhile, became more tightly structured, with PXF increasingly common in emerging markets, while freer lending to established producers was the norm in developed nations. Banks sought to re-price their more tightly structured transactions to reflect the increased risks involved.

Then, as with all markets, softs values fell sharply in the third and fourth quarters of 2008, but rallied in the first half of 2009.

Even so, by May 2009, most agricultural commodities were still about half their June 2008 values (see Figure one). Credit had tightened, slowing the flow of capital to producers amid reports that many farmers were struggling to raise the finance they needed for seeds and fertiliser, while low commodity prices made it less economical to grow certain crops. And as the credit crunch took hold, many institutional investors were forced to sell to cover their losses, forcing prices lower.

“Commodity trade finance is by and large a counter-cyclical business, which continues during a downturn with increased activity and a return to the use of traditional trade instruments,” says Willem Klaassens, Global Head, Commodity Traders & Agribusiness, Standard Chartered Bank. “With the exception of companies trading in a few specific commodities, most notoriously steel and cotton, most commodity traders had a good 2008 with several recording 2008 as their best year ever. However, on the producers’ side there was, and still is, much more hardship, where numerous projects became unviable or shelved due to lower commodity prices and the deterioration of the capital and liquidity situation at most financial institutions.”

The level of risk in almost all transactions has increased, resulting in a renewed focus on risk versus reward. “Because of the increased risk, on every level doing business has become more expensive, both for customers as well as for financial institutions,” says Klaassens. “This is reflected in the terms that are being offered to customers and has resulted in more structuring, more control from the side of the banks and higher margins.”

Dr Thomas Oehl, Global Head Commodity Finance and Managing Director at WestLB, agrees. He says that deals are being completed are on a more tightly structured and secured basis. “There is a slide into quality,” he says, quickly adding that WestLB “is still doing softs financings”.

The same cannot be said for all of its competitors. The credit crunch has led to a reshuffle of the banks engaged in commodity finance. In October 2008, German bank HSH Nordbank disposed of its commodity finance portfolio, totalling €3.2bn. (HSH has since been supported by the German state.) The following January, it emerged that Belgian bank KBC had cut its London-based structured commodity team from 15 to six as part of a refocus, it said, on core activities in its domestic market. A KBC spokesman said the bank was scaling back activities in the soft commodity market, “allowing existing commitments to roll off as they mature”.

Even French banking major BNP Paribas has been cutting back. It reportedly cut at least eight of its soft commodities bankers and traders in its New York office as part of a 5% reduction in its total corporate and investment banking headcount. But BNP Paribas will remain a key player in softs and its London office is said to be handling Latin America and other areas of responsibility previously held by the laid-off group in New York.

These and other moves created opportunities for others. Citigroup’s Asia business drew up plans to expand further into trading of agricultural commodities. Ananth Doraswamy, Managing Director, Asia/Pacific Head for Commodities at Citigroup, believes that softs will become more popular among its clients as the economies of China and India recover, barely touched by recession.

“We are ambitious and want to grow further. Asia/Pacific is still churning out growth rates that are the envy of the world and we will continue to invest further in the business. I want to keep growing at double digits for the next few years,” she told Reuters in June. “The number of competitors has reduced in the past year, so there’s some space out there to serve more clients.”

In spring 2009, the Agricultural Bank of China (Agbank) announced plans to establish bases in New York and London, building a round-the-clock commodity trading team to further Beijing’s ambition to become a major influence on commodity markets. Agbank said it would focus on trading in agricultural commodities and derivative products based on such crops as grain and corn, global markets in which Chinese banks are not (yet) major players. China is the world’s biggest importer of soybeans, and several other key commodities, but it trades very little wheat or corn at present.

It has been a similar story at Standard Chartered, which has been aggressive in hiring to boost its commodities business. Klaassens says the bank has been able to secure more business amid the climate of consolidation. “In 2008, Standard Chartered saw exceptional business growth and experienced an increase in business flow from customers who had seen the availability of credit lines at other financial institutions reduced, due to the latest bank mergers and institutions closing their traditional commodity finance businesses,” he says.

As liquidity grew and the credit crunch eased (somewhat) during the second quarter of 2009, prices began rising again and appeared to be on the cusp of another possible spike. Sugar and cocoa rose by between 10% and 20%, while orange juice jumped in price by 8%.

As well as the higher price of oil, which had risen to more than $70 per barrel by June, the weakening dollar appeared to be helping drive softs prices back up. The dollar is expected to fall further in value in the second half of 2009 because of the immense borrowing being undertaken by the Obama administration to pay for the President’s various social and economic stimulus programmes.

Low stockpiles
The relatively low level of stockpiles of certain commodities was also factored into the higher prices. In the US, corn stockpiles had fallen to a record low of 33 days’ supply by the end of May, thanks to a 35% increase in the use of corn for the production of ethanol in the previous two years. Heavy rains hit plantings in the corn belt states of Illinois and Indiana, with only 33% of corn planted by the end of the first week of May 2009 compared to the same time last year, making the chances of bolstering the reserves looking slim.

Meanwhile, a drought has affected agricultural production in Argentina, where farmers have been at loggerheads with the government for some time over steep export taxes, which farmers say stifle their incentive to produce for export. The USDA said that Argentina’s annual production of wheat and sunflower would be down by almost half for 2008/9. It also estimated that Argentina would experience a drop of one-third in corn production and a fall of one-quarter in soy production. On the back of this and a similarly bleak picture for Brazil’s harvest, grain prices, led by soybeans, enjoyed strong second-quarter growth.

And it is not just metals, such as copper, that have been bought heavily by Chinese sources in the first half of the year. Soybean prices have been similarly supported by Chinese buying, according to the FAO, which reported that US soybean sales to China had increased by 42% to 18.3m tonnes in 2009, compared to a year ago. Chinese sources appear to be increasing their own dwindling stockpiles, the FAO noted. Globally, stocks were estimated at 128 million tonnes in May 2009 by the US Department of Agriculture, down 8.6% on last year.

Allendale, a US-based commodities research company, said it believed this suggests that the global supply of corn is at 53 days, one day lower than the old record low set in 1999. Even cotton prices are heading back up after a fall in global output – most notably in China – combined with relatively low production in the US. Barclays Capital predicted a further strengthening of the price of sugar, already up 30% since January 2009, citing the ‘drastic under-performance’ of the Indian harvest this year (which began in October 2008 and ends in September 2009). It also said it thought that corn prices would grow, thanks to rising demand.

Wheat prices also appear to be on the cusp of a rise, with the International Grains Council predicting global wheat output of 650 million tonnes in 2009/10, down by 5% from the previous year. The largest declines were expected in the US, the European Union, China, Russia and Ukraine.

But as always with softs, the picture is mixed. Barclays expects the price of soybeans to fall by about 10% during the second half of 2009, as poor weather forces US farmers to consider a shift away from corn and into soybeans. And the price of cocoa seems set to slip in the second half of 2009 too. The International Cocoa Organization (ICCO) said in May 2009 that there had been the biggest annual drop in demand from wholesalers and chocolate manufacturers for half-a-century – a reflection of the global economic downturn. Far from indulging in chocolate as a cheap luxury in hard times, people are even cutting back here.

Yet underpinning the level of pricing in the latest Ghana PXF, the ICCO is anticipating a turnaround in 2010, with cocoa prices forecast to rise 13% to $2,875 a tonne. Possible structural problems in the Ivory Coast, the world’s biggest cocoa producer, which suffered a disappointing harvest in 2009, also promised to uphold prices.

Speculators return

Against such a backdrop, speculation has returned, helped by more electronic trading and exchange-traded funds. Liffe, the futures unit of NYSE Euronext, launched a central clearing mechanism for over the counter (OTC) soft commodities in the first quarter of 2009, addressing counter-party risk as well as boosting liquidity. Meanwhile, US internet marketplace operator Intercontinental Exchange, which trades futures and OTC energy and commodity contracts, said it planned to clear OTC cotton, sugar and coffee, subject to regulatory approval. And Pictet Funds added an agriculture fund to its Luxembourg-domiciled Sicav range, which will invest mainly in mid-sized farming companies.

These moves came amid reports that hedge funds and other large speculators were making a massive bet that prices of key soft commodities, such as sugar and corn, would rise substantially over the remainder of 2009. The evidence came in a May 2009 Bloomberg analysis of the net long-positions held by the funds in a basket of US commodities.

The report led to inevitable comparisons with the speculative commodities bubble of early 2008. However, there is also an expectation that greater regulation – in particular, in the shape of the previously underfunded Commodity Futures Trading Commission – may rein in runaway speculation.

As well as greater regulation, there are other risks. It has become clear during 2009 that continued state support for biofuels could not be taken for granted, as reflected by the raft of bankruptcies among US ethanol plants. One of the hardest hit areas has been the US Pacific Northwest, where local experts, citing more than 20 plant failures in the state of Oregon alone since January 2009, are already calling it a ‘biofuels boom to bust’.

Indeed, it remains an exaggeration to say that soft commodities are ‘recession-proof ’, despite the strong fundamentals. Yet growth in softs consumption has historically tended to hold up better than for oil, aluminium or other industrial commodities. And as the credit crunch eases further against a backdrop of low inventories, inefficient production, biofuel demand, food shortages and even, perhaps, more reasoned speculation, it is not unreasonable to predict that soft commodities will become a strong long-term bet for lending institutions and other investors.

Price forecasts for agricultural commodities

Commodity	Units	Q108	Q208	Q308	Q408	Q109	Q209e	Q309e	Q409e
Cocoa	US$ per tonne	2409	2769	2784	2259	2553	2400	2500	2700
Coffee	US cents per pound	143	136	138	112	113	120	122	125
Sugar	US cents per pound	12.5	11.2	13.1	11.6	12.7	14.5	15.5	14
Cotton	US cents per pound	73	70	66	46	46	55	60	68
Wheat	US cents per bushel	1025	836	784	547	548	560	550	600
Corn	US cents per bushel	517	629	578	384	377	405	415	475
Soybeans	US cents per bushel	1328	1382	1330	896	942	1105	1100	1000

Source: Barclays Capital