Maintaining the risk-reward ratio

Following a year of record grain harvests, sky-high prices, and stretched trade-finance lines, Kathleen Williams speaks to several banks about the effects of falling prices, stock surplus and financing requirements in what has become an increasingly liquid and competitive market.

Last year’s grain markets were tumultuous, as they tend to be in this commodity group, and its traders optimistic with prices doubling, even tripling, within a few short months into 2004. However, with abundant harvests and growing demand from countries like China, speculators, producers and funds started to reverse their positions in the second quarter to protect their gains. By June 2004, most prices started to come down and have largely remained that way.

In 2005, this lower-price environment coincided with an extremely liquid bank market, particularly in Europe, North America and Brazil, due in part to the increasing interest and entry of new participants into the arena of grain financing during 2004. The increase in pricing last year meant that regular trade-finance lines had to be stretched (even doubled), which led to a higher utilisation of credit lines and a gravitation of banks and other financial institutions – not traditionally associated with this commodity class – to the grain trade.

Newcomers included several Japanese, Korean, and European banks such as ING, which set up a dedicated grain team within its SCF unit in 2004, led by vice president Pieternel Boogaard. Leveraging off the bank’s track record in metals, oil and gas, its strong presence in Central and Eastern Europe, and its long track record of structured transactions, ING is refocusing its strategy to include more dedicated pre-export finance to soft commodity producers, and now has dedicated people in Brazil, Amsterdam and London.

It’s not just the doubling up on trade-finance lines that made grain financing an attractive prospect for trade financiers; greater transparency in traditional ‘high risk’ markets has also played a role in increasing the competition. “As a number of countries and companies have become more transparent and are producing IAS financials, competition among the banks has increased in offering longer tenors at more competitive prices,” says Boogaard. This sentiment is echoed by Federico Papa, head of commodity finance for ABN in Latin America, who says, “Increasing interest from outsiders to the market, such as local banks and hedge funds, has brought down prices significantly and increased the aggressiveness in tenors and overall structuring conditions.”

While the entrance of new players has inevitably had a direct impact on pricing, Sebastien Ribatto, director of agricultural finance for SG Corporate and Investment Banking (SG CIB), points to the impact on credit spreads for BB borrowers and below, which plunged throughout 2004, but have turned around for the last three months reflecting a more realistic risk premium. “We feel that the trend of increasing spreads for middle-market companies will continue through 2005 and are urging our customers to lock in attractive spreads now in multi-year deals.”

Last year’s high price, tight liquidity environment looked ever so promising prompting talk of a renaissance within the grain industry. This year, the general outlook tends to be more cautious. Prices are lower than forecast, liquidity needs are minimal, and capital supply is plentiful. According to one commentator, “It really is another case of too much money chasing too few assets.”

In this environment, producers are reluctant to fix prices early in the season and tend to hold on to their inventories for as long as they can, hoping for higher prices. “This usually translates into a very low level of financing-need for the industry as grain elevators in the US, South America, or the Ukraine, store grain without buying it, collecting storage fees but with minimal financing requirements,” says Ribatto.

Cases where there might be a lacklustre demand for grain finance in 2005 could be attributed to the fact that many exporters took advantage of the high prices in early 2004 to secure long-term financing for capital expenditures or crops expansion, especially in South America’s most active grain markets – Argentina and Brazil. “Last year’s grain markets were mid-range and this year we are seeing more of the same,” says Canadian Wheat Board spokesperson, Louise Waldman. “In terms of financing requirements, they have certainly been within the normal range, with no demand in increase.”

While many financiers like Papa expect the high liquidity to result in less sophisticated, unstructured financing, ING reports seeing longer tenors and more direct financing at the moment, although not via traders. “Structured pre-export has become a more standardised product, but we do see a change in some techniques or risk mitigants as the insurance market and collateral managers play a bigger role in many transactions,” says Boogaard. In terms of the more traditional structured transactions, there is still demand from companies in countries such as Russia, where the local bank sector has remained underdeveloped.

Since Standard and Poor’s upgraded Kazakhstan’s country rating to investment grade, foreign banks have increasingly vied to penetrate this market with a number of interesting deals having emerged over the past year. ABN Amro has established a good track record in this arena with a number of precedent-setting pre-export finance facilities, most notably the 18-month $70m asset-backed revolving grain deal with Ivolga, the largest privately-owned grain producer in Kazakhstan.

Rabobank is no stranger to Kazakhstan either, having arranged a $20m credit facility with a club of banks in October 2004 for the state-owned Food Contract Corp of Kazakhstan, which is the largest producer and exporter of grain in the country. The 18-month transaction was structured as a pre-export financing facility secured by the proceeds of future deliveries of Kazakh grain to blue-chip international traders.

The privatisation of once state-owned companies and producers in former Soviet Union (FSU) countries like Kazakhstan and others has been one of the most significant developments in the grain trade over the past few years, and 2004 saw some large private traders come to market to export wheat and other grain products, largely taking the place of the old institutions. “In most countries where government monopolies exited, traders have had to adapt and start dealing with private entities, which has been a new challenge. We have seen this in Mexico where, since the collapse of Conasupo a decade ago, a number of private importers have emerged for corn and rice. Similar things have happened in Western Africa in the rice trade and the collapse of the Caisses de Perequations,” says Ribatto.

While world market prices have been pressured by the increase in supplies, importers have also faced a renewed steep rise in ocean freight rates, driven mainly by strong Chinese demand for bulk commodities. “The impact of higher freight combined with rising flat prices created a huge liquidity vacuum in the grain world. Between October 2003 and February 2004, grain and oilseed prices more than doubled and every grain shipper needed to double its credit lines,” says Ribatto looking back at 2004.

Freight rates continue to remain high this year, which has resulted in the development of other supplying countries close to China, with a higher cost of production set off by less transportation costs, most notably the FSU countries such as Kazakhstan, which is increasingly active in cotton, and the Ukraine, which has increased its soy harvest. “The region is now a structural exporter and will be the object of continued focus in 2005 and 2006,” says Ribatto.

Continued economic growth in Asia, specifically in China and India, the world’s two most populous countries, will continue to impact grain financing in the years to come. With over two billion people in those two countries alone and as the purchasing power of those populations increase, so too will demand for grain, as domestic consumption continues to outpace production growth. Grain production in China is said to have fallen 10% in the past decade.

Looking ahead, ING expects to see more competition in Central and Eastern Europe, the FSU, and Brazil.

As these countries become more transparent and their legal systems are upgraded, more risks can be sold to insurers and banks. “The focus will be on top-tier and medium producers/ exporters in the Ukraine, Kazakhstan and Russia,” says Boogaard. Aside from China and India, Iran is another importing country to watch closely over the next year. According to Waldman, aside from the FSU region, exporters to watch include Canada, the US, Australia, and Argentina.

Lest one forget what a volatile market this can be, spare a thought for those countries struggling to cope with an oversupply thanks to the record harvests of 2004, particularly those where national currencies have strengthened. While exports from the main southern hemisphere wheat suppliers – Argentina and Australia – surged this year, South Africa has seen the market drop dramatically due to an oversupply of grain. And, with the strengthening of the rand, the import parity on pricing has dropped as well as the export parity. “In terms of financing requirements, the year ahead is going to be difficult with excess global supply at the moment. This is the because the input costs of producing grain are higher than expected, so this will have a huge influence on how people finance next year,” says Peter Martin, director of structured trade, commodity and agricultural finance for Africa at Barclays Bank. “Certain organisations are trying very hard to stop farmers from planting, specifically in South Africa, to reduce the supply.”

The 2005 crop is forecast to be even larger than 2004, but there is too much low-protein wheat being planted to

satisfy demand says Ribatto. In addition to concerns about the quality of wheat, CWB says the biggest challenge for

the grain market over the coming year will be the weather. “We are already seeing concern over dryness in parts of Australia and the US, and continued dryness in parts of Europe and North Africa. However, with projections for world wheat production of over 600 million tonnes, it remains to be seen what kind of impact these dry production areas will have on the markets,” says Waldman.

Grain markets are possibly the most complex of commodity markets and the ones making use of the most sophisticated hedging and arbitrage strategies. Looking back, the successful grain traders of the past 40 years were the ones that understood trade as an ideal vehicle for financial arbitrages, whether between Argentine and American interest rates or between embedded US government subsidies and emerging market bank funding rates. As Ribatto points out, it is difficult for grain traders to be competitive globally without an adequate level of financial sophistication, and the same goes for banks involved in financing grain globally.

Looking ahead, banks will need to have a sharp understanding of these complexities to stay ‘ahead of the curve’ and to maintain the risk-reward ratio in what is becoming an increasingly competitive market.