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Understanding Commodities: Price Certainty Vs. Supply Certainty

Oct. 18, 2016
Farmers and food processors have relied on futures contracts as a pricing hedge for more than 100 years. A better hedge may be a supply hedge.

Business people in general and finance professionals in particular hate uncertainty, whether it’s the uncertainty of raw materials availability or their cost. For many, managing that uncertainty is essential for a good night’s sleep.

For organizations large enough to play in the futures markets, there’s a broad assortment of commodity contracts they can enter into as a hedge against price increases. The oldest commodities are standardized, homogenous foodstuffs priced according to the rules of supply and demand — the wheat, corn and pork bellies that traders began buying and selling on the Chicago Board of Trade (CBOT) in 1848. Originally the exchange only dealt with domestic futures and options contracts, but the global nature of food has catapulted CBOT and other exchanges onto the international stage.

Food companies often are the contract buyers (along with speculators), and brokers from INTL FCStone Financial Inc. spent three July days explaining the arcane workings of the futures market and drumming up interest from food company representatives at what was billed as the Food Industry Forum, subtitled, “Market Outlook and Risk Management Training.” If you were curious about the long-term weather forecast and its implications for corn prices in August, the Chicago forum was the place to be.

Bakeries are the most likely food processors to engage in futures trading, given the impact wheat prices will have on the flour they need. “The food industry is good at creating demand for wheat,” Mike O’Dea, a risk management consultant with INTL FCStone, commented. The numbers bear that out: Domestic wheat consumption increased every year since 2013-14, with three-year projected growth of 42 percent. Some of the surplus ends up as animal feed.

Rock-bottom wheat prices have engendered an “anything but wheat” attitude among farmers, who are shifting to other crops, noted O’Dea. Everything that goes down eventually goes up, so bakers can anticipate higher flour prices at some point.

U.S. processors face greater price uncertainty with commodities not produced here. Coffee beans are the most volatile, according to Oscar Schaps, president of INTL FCStone’s Latin American division. Cocoa and sugar also are subject to big price swings. Brazil is the source of more than 35 percent of coffee beans, and political and economic upheaval there is certain to inject even more volatility.

That’s bad news for Maxwell House, but specialty coffees are where the action is, and those are the processors that growers want to sell to. Beans priced at $1.40 by commodity traders would command a $4 farmgate price, Schaps noted, so naturally growers prefer to sell direct.
Schaps’ colleagues brushed off questions regarding the impact of organic foods, interest in non-GMO ingredients and a move away from meat consumption as part of the healthy eating trend. “This is America, we eat beef, and that’s going to continue,” pronounced Ryan Turner, another INTL FCStone speaker. And that’s true, to some extent. But there’s more than a little self-interest involved when commodity brokers maintain the mainstream is impervious to food-consumption trends and that the global trend is up, up, up in demand for food commodities. They are experts on swaps and options, but do they really understand what drives consumer demand?

Sure, it’s a big world with a lot of hungry middle-class Chinese eager to pick up the steak knives and forks that Americans drop, but supply and demand doesn’t tell the whole story. Availability is affected by factors beyond next month’s prices. A glimpse of that came at last year’s Food Leaders Summit, where a panel of major cocoa buyers described their sustainable farming efforts. It sounds altruistic, but continued availability was the real motivation. Because an oligarchy of buyers has evolved, those companies dictate prices, and pricing has made farming a losing game. Older cocoa growers are retiring and the younger generation is looking for alternative income sources. The biggest issue isn’t price hedging, it’s supporting a wholesale price that doesn’t cause supplies to shrivel up.

Demand for organic products is growing 14 percent a year, forcing processors who rely on organic supplies to be creative. Nature’s Path Food, a cereal processor in British Columbia, has accumulated 5,640 acres in Canada and northern Montana that are leased to organic farmers in an unusual crop-share program. Instead of paying rent up front, the farmers provide a fixed percentage of the yield to Nature’s Path.

Chia seeds are an in-demand specialty crop that increasingly is used in health and wellness products. To ensure a steady supply, HapiFoods Group Inc., another British Columbia cereal maker, formed a Mexican co-op and provided $600,000 to plant and harvest 180 tons. To the chagrin of HapiFoods’ Brian Mullins, a third of the crop was hijacked. “We got $400,000 back and have been pursuing legal action in Mexico” to recover the balance, he reports.

An even more elusive ingredient is hemp seeds and oil, another superfood ingredient in the HapiFoods mix. The firm secured a license from the Canadian government that allows farmers to grow non-psychoactive cannabidiol (CBD) for it.

“We are developing non-THC CBD food products,” Mullins tells us. “With the legalization of marijuana in Canada, our world is about to turn upside down.”

Futures contracts always will hold some appeal to makers of white bread and other commodity products. But those contracts only are a hedge against price changes and are not intended to result in an actual exchange of goods. As one forum broker noted, packinghouses have abandoned futures contracts in favor of orders for delivered goods. Both abate uncertainty, but only one provides the certainty of continued production.

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