Speculate or Integrate: Rethinking Agricultural Commodity Markets

Are traders and financial hedging tools really necessary in today’s turbulent economy?

Global consumer packaged goods companies are struggling to meet the challenges of supply security and price volatility as they source agricultural commodities such as cocoa, coffee, wheat and sugar. As prices peaked dramatically after the 2008 food crisis, companies deployed more risk management strategies—using traders and financial hedging instruments. Yet significant questions remain about the true costs and benefits of these tools. We believe the time is right to consider a fresh approach to commodity sourcing—one that goes beyond superficial financial hedging to focus on the underlying causes of volatility.

When the once largely predictable world of commodities turned upside down, companies in the consumer packaged goods (CPG) industry scrambled to regain equilibrium and, on the face of it, seemed to have found about as good a footing as was possible at the time. A closer look, however, reveals a somewhat different picture—both in terms of the problems facing the industry and the potential solutions. The business of sourcing commodities—and the need to ensure they arrive in the right place at the right time and at the right price—has never been more pressing. And an overhaul of the industry's sourcing and pricing practices could be overdue. Consider the most important factors:

Sourcing commodities. In purchasing agricultural commodities, the principal concern is how to secure supply and manage logistics such that availability at production sites, at the right time, is guaranteed. In tight markets, with global giants sourcing huge shares of production, this can be a challenge, particularly for companies with a large base of commodity suppliers (farmers) that must be handled simultaneously.

The current solution is to use middlemen, such as physical traders, to manage the large base of farmer suppliers. Traders perform three functions: Match millions of farmers, often in Africa, with customers that are mostly in North America and Europe. Move large volumes of goods from origin to customers and in the process manage operational costs such as transportation, quality control and storage. Manage financing and risks by paying farmers before the harvest and even before negotiating a price with customers, and transferring risk to a financial player via the futures markets. While it pays to contract with outside traders for these services, there is a downside: companies are removed from their supply sources and from understanding the operational realities at the farmer level.

Pricing commodities. A second but equally important factor in sourcing commodities is purchasing them at a competitive price. As commodity buyers and sellers consolidate into global giants, deals are becoming larger, and the risk of buying at the wrong price becomes even more significant. While commodity prices fluctuate, there is a new expectation that purchasers will use financial derivatives to reduce volatility and deliver stable prices for consumers and stable earnings for shareholders. Today, many companies have commodity departments with dedicated financial hedging professionals whose primary goal is to deliver predictable input costs with smart positioning in the financial markets. In fact, financial hedging has become an established best practice for many leading firms.

The move into commodity derivatives is not surprising as they provide a flexible mechanism for managing price volatility—from securing physical supply and increasing market liquidity and cost transparency, to creating a way to develop a more complex price structure. However, the practices of traders and financial hedging in this environment do not always make sense.

The Trouble with Traders

Figure 1: The top five cocoa-sourcing companies account for almost half of the world's production

Both CPGs and physical traders have become big, but traders are perceived to be getting by far the best deals. Are traders really necessary in a turbulent economic climate? Let's look at four reasons why they are not.

Industry consolidation removes the need for traders. Industry consolidation in key global commodities such as cocoa and coffee has been dramatic. Kraft Foods, for example, sources more than 12 percent of global cocoa production while Nestle follows close behind with 10 percent; the top five cocoa-sourcing companies account for almost half of the world's production (see figure 1).

So why bother with traders at all? Certainly, traders do not add scale on this now larger playing field. And does buying from traders really improve security of supply? In the event of a major commodity shortage, even the big players such as Kraft Foods and Nestle will have difficulty obtaining supply regardless of their large network of traders. Furthermore, leading companies purchase directly from manufacturers for most other products and other commodities; why not for cocoa, coffee, wheat and sugar?

Traders are manipulating markets. There are clear indications that traders are now in a position to manipulate the markets and, indeed, have done so. Most notably, this happened to a large degree in cocoa bean trading during the summer of 2010 on the London Exchange (see sidebar: Trader Manipulates the London Cocoa Futures Market).

Many traders use their knowledge of a particular market to take speculative positions in commodity markets. The large traders such as Cargill, Armajaro, Louis Dreyfus and Olam employ sophisticated intelligence-gathering operations, including on-the-ground staff, in an effort to obtain the latest market information. Cargill's employees, for example, count competitors' trucks at the gates of almost every cocoa warehouse in the port of Abidjan in Ivory Coast to get a better picture of the size of the country's output. Armajaro deploys its own weather stations to assess growing conditions. In general, trading companies perform a key role in transmitting information from the farm gate to the market, but this pivotal position can be abused to manipulate the market and profit from uncertainty—the incentives of the physical traders may not always be aligned with their customers, the CPGs.

Traders survive on volatility. Traders have little interest in increased productivity or more professional farming. In fact, they might benefit from the opposite. Imagine a situation in which there is no variability in crop yield. Large companies might soon adopt sourcing strategies that eliminate the middleman. Volatility is life support for traders so why reduce it?

Figure 2: Cocoa bean crop yield in Ivory Coast

Some commodities, with a significant element of trader financing, have not seen a significant increase in crop yield over the past 10 years. The leading supplier, Ivory Coast, lost crop yields per hectare of 13 percent from 2000 to 2009 and has had virtually no increase since 1995 (see figure 2). Clearly, the trader is not solely responsible for the low yield, for it is a multidimensional issue. But the fact that traders have no incentives to improve yield or modernize farming is certainly a factor.

Hedging does not solve the problem. As discussed, most CPG companies hedge their price risk and consider financial losses and gains as an inevitable part of their business—a random zero-sum game of transferring risk between hedger and speculator. But is it really a random zero-sum game? Or is there an element of competence in it? The anecdotal evidence is certainly intriguing, for even as some speculators lose money on trading, there remains a plethora of consistently successful commodity traders.

Upstream Integration: "Hands On" Makes a Comeback

Securing long-term supply and price stability requires some level of direct control over the underlying causes of instability. With this in mind, we suggest a new view on commodity purchasing—one focused on improving crop yields and the physical security of supply. Rather than attempting to manage uncertainty through short-term financial "hands-off" hedging and traders, perhaps it is time to revisit upstream integration.

Upstream integration has two main objectives: To improve and maintain security of supply, and to drive productivity of the entire value chain. There are several ways to achieve upstream integration—(1) contract farming with cost-plus pricing, (2) acquire or lease-operate farm land, (3) acquire or lease farm land whose operation is outsourced to trusted farmers, and (4) integrate virtually through third parties.

Whichever model is used, it has to be customized according to a company's unique factors such as competence, financial situation, organization, support systems and access to partners. However, the underlying principle should always be to gain some level of operational control over the crops. The benefits of direct involvement in the farming process have long-term significance:

• Increased yields and improved efficiencies
• Improved quality control and brand image
• More transparency, which is vital for addressing future supply

The farmers also gain advantage, including more predictable incomes, access to markets, and support in areas such as credit, technology and education. Furthermore, with upstream integration, the CPG takes on the role of middleman. Excess supply, which to some extent can be planned, can be traded to less integrated competitors or on commodity exchanges. Financial instruments can still be used to obtain a target price—but priced from the company's perspective.

Yes, there are obvious risks related to upstream integration. While shedding various threats associated with middlemen, some new operational risks are introduced. Supply must be handled through crop management, not by a network of traders. Risk of commodity price fluctuations are replaced by risks related to operational farming costs. Moreover, many commodities are grown in parts of the world with widespread poverty and corruption, which presents an increased risk of adverse publicity. However, these new risks are relatively small compared to those they replace. Clearly, running out of supply and steep and sudden core commodity price increases are far bigger threats.

It is important to gauge the best time to embark on upstream integration, considering factors such as business importance—the commodity's share of cost of goods sold and its volatility—and perhaps even your level of power in the sourcing market.

For the risk adverse, an alternative to upstream integration is to sign long-term and transparent contracts with middlemen or suppliers. This will, to some extent, improve security of supply and reduce volatility, though not to the same level as upstream integration. Moreover, any opportunity to exert a mitigating influence in these all-important areas will be gone, which means many of these challenges may quickly reappear.

Case Study: Yara and Upstream Integration

Before concluding our discussion, we want to touch on one company's success with vertical integration. Yara, a leading global fertilizer manufacturer, is competing in a consolidating industry with long-term demand and short-term volatility for finished products (food), and extreme volatility both in price and availability of commodities. Demand is mostly inelastic, as the need for fertilizer stems from the need for food. However, prices can fluctuate in the short-term given the relationship between the price of fertilizer and the price of major agricultural products. For example, between January 2010 and October 2010 the price of urea increased by more than 20 percent.¹

In fertilizer production, the main inputs are energy derived from various sources: natural gas and oil, and the raw materials of nitrogen from natural gas, which are subsequently processed into highly volatile intermediate products of ammonia (63 percent), phosphorus (22 percent) and potash salt (15 percent). Natural gas and oil are traded to a large degree, while only 12 percent of global ammonia production was traded in 2009. Phosphorus and potash salt are not traded to any significant extent.

The fertilizer industry has seen several internal acquisitions in recent years, particularly as state governments became less involved and a focus on business replaced a focus on food security. The nitrogen segment of the business is less consolidated than the phosphorus and potash segments, as the latter two commodities are available only in some regions. The overall industry now has six to seven major global players; Yara is number four with an estimated 7 percent global market share.

Yara adapted to industry consolidation. It acquired—and intends to continue acquiring—other industry players to benefit from economies of scale, and developed individual sourcing strategies for the various volatile commodities the company sources.

Developing a vertical integration strategy in 2005, the company now sources commodities of which it has no global sourcing share, such as natural gas and other energy sources, on commodity exchanges and via financial hedging.² It uses an upstream integration strategy for its key commodities such as ammonia, phosphate, and potash:

• Ammonia is an intermediate commodity, to a large extent produced by Yara or in factories owned partly by the company. Yara takes the trader's role in this part of the business, trading ammonia not used for fertilizer production. For the past five years the company has held between 25 percent and 30 percent of the global ammonia trade.
• Phosphate is an even more integrated commodity and, to a large degree, Yara extracts the raw material from mines it owns or operates.
• Potash is less vertically integrated, which Yara executives regard as a major operational risk. The company has publicly stated its intention to increase its integration of potash producers in order to mitigate the risk.

Managing Volatility

Managing price volatility through financial hedging of agricultural commodities is a short-term solution to a long-term challenge. Large consumer packaged goods companies have a unique opportunity to fundamentally restructure the industry value chain. With their size and market power, CPGs can increase transparency, improve efficiency, and stabilize commodities—both in terms of supply and pricing. Investment today will bring long-term benefits.

Authors

Bart van Dijk is a partner in the Amsterdam office.

Gotfred Berntsen is a principal in the Oslo office.

Ivar Berget is a consultant in the Oslo office.

¹ Urea is a key agriculture product used in manufacturing fertilizer.
² Yara International was formed in 2004 and its first acquisition was in 2005 when it purchased 30 percent of Russian fertilizer producer OAO Minudobreniya (Rossosh).

The Cocoa Industry

Soft commodities are mostly grown in tropical regions where crop yields can suffer from a range of adverse effects, including poor weather conditions, diseases, pests, insufficient farm management, political instability and corruption. Nowhere are these challenges larger than in cocoa production. Because of concerns surrounding future supply, many of the leading consumer packaged goods companies are beginning to take a more active role in the cocoa value chain.

The cocoa value chain stretches from mostly small farms in Africa to the chocolate products sold in retail outlets worldwide (see figure). As global demand increases, any uncertainty in supply can cause significant price fluctuations.

Figure: The cocoa value chain

Cocoa is mostly grown in developing countries where corruption and political instability can affect agricultural production. The world's largest cocoa-producing nation, Ivory Coast, is divided along regional and ethnic lines hardened by the 2002 civil war and is currently recovering from the recent crisis resulting from the refusal of its incumbent president to accept defeat in the country's elections.

While other major agricultural commodities are mainly produced on large-scale plantations, cocoa is unusual in that it is still grown overwhelmingly by smallholders. Low prices in recent years have led to underinvestment, which in turn has resulted in aging plantations and rising losses due to disease and pests.

In general, cocoa farmers have limited access to modern agricultural technologies, materials and market information. Few have received education to help them effectively market their product and manage their operations. And farmers have almost no contact with the big trading houses and processors. The cocoa beans are instead sold to middlemen who deliver them to the ports of Abidjan and San Pedro.

Chocolatiers and traders have been encouraging farmers to set up cooperatives from which they can buy directly. But they have had limited success as most cooperatives last only a few years before collapsing from poor management or corruption.

A small number of multinationals dominate the export market: Archer Daniels Midland (ADM), Barry Callebaut, Blommer, Cargill and Petra Foods. These large companies have a significant degree of vertical integration in the market and are active in both the producing and consumer countries. In addition to trading in cocoa beans, they manufacture semi-finished cocoa products and industrial chocolate.