Special report

C O M M O D I T Y R I S K M A N A G E M E N T & T R A D I N G

risk.net February 2015

Managing risk in agricultural commodities

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Biofuels go globalSCB & AssociatesWith global output at an all-time high, and increasing demand for clean and secure energy, biofuels have become integral to international energy markets. SCB & Associates offers customers the market insight and product knowledge to trade biofuels effectively

Centralising forceMurexAs more agricultural organisations explore ways to develop and enhance their trading and risk management activities, a flexible, robust, centralised technology platform should be a top priority

Global expansionCME GroupAn increasingly diverse set of market participants require agricultural price risk management tools that can not only match current needs but also adapt to future market developments

Trading talentCommodity AppointmentsAfter an active year for mergers and acquisitions, competition is fierce among agricultural trading companies looking to attract the best staff

External pressuresExport Trading GroupHow agricultural commodity risk management strategies have evolved in response to recent market shifts spurred by the latest global financial crisis

Adapting to changeCargill Risk ManagementThe continued evolution of commodity markets has necessitated the development of new risk management strategies and created demand for a more diverse pool of trading partners

Agricultural commodities are rarely written about in the mainstream financial media, and often only hit the headlines when an extreme weather event or natural disaster affects supply and prices. But, despite this relentless focus on bad news, many public and private sector organisations exposed to agricultural commodities fail to make full use of modern risk management techniques. Instead, they blame suppliers, traders and liquidity providers for shortages and price spikes that hit their balance sheets, subsidies or social programmes.

In fact, agricultural commodity risk is just like any other type of commodity risk, and needs to be managed properly. Naturally volatile, agricultural commodities can be easily spoiled and are also affected by the usual problems, such as shipping capacity and transport costs. Although such risks can be absorbed by firms and governments with large balance sheets, they might prove lethal for others if they are not managed appropriately with exchange-traded or over-the-counter derivatives.

This report highlights price risk management strategies by looking at how leading companies manage their exposures to agricultural commodities. It also examines the commodity trading and risk management and IT systems used in the market – both of which are vital tools for helping firms get a handle on their risk – as well as the impact of regulatory change.

GLOBAL EXPANSIONCONTENTS

INTRODUCTION

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Peter Petkov, publisher, Energy Risk

managing risk in agricultural commodities

Sponsored by

managing risk in agricultural commodities

With global output at an all-time high, and increasing demand for clean and secure energy, biofuels have become integral to international energy markets. SCB & Associates explains

how it offers customers the market insight and product knowledge to trade biofuels effectively

BIOFUELS GO GLOBAL

from government support schemes. With agricultural yields and acreage trending higher each year, so-called ‘discretionary biofuel blending’ looks likely to become more prevalent in future as global oil products consumption continues to climb.

Crossing continentsUnderstanding the regional policies and dynamics underpinning trade in physical and listed biofuels products is key to providing customers with the market overview they need to trade effectively. As well as providing a dedicated regional focus, SCB’s brokerage offices in Europe, the US and Singapore give its eclectic customer base broader global visibility of the risk management needs and trading opportunities available to counterparties operating across regions. SCB’s research arm packages the firm’s wide-ranging trade-generated market data into accessible bespoke analysis and tools to better inform customers’ trading needs.

In 2014, SCB’s teams of physical brokers in Singapore, Europe and the US helped deliver Malaysian and Indonesian palm-based biodiesel and Argentinian soy-based biodiesel to destinations in Asia, Europe, the Mideast Gulf, west Africa and the US. Brokers have co-ordinated deals for Brazilian ethanol into the huge US domestic market, as well as from the US to South-east Asian export destinations. EU biofuels policy, meanwhile, is starting to fold biofuels trade into existing emissions trading schemes. SCB brokers have been at the forefront of navigating customers through Europe’s patchwork of markets as they adjust to new mandatory standards aimed at achieving international carbon reduction targets.

SCB’s US and European swaps desks facilitate execution and price

Biofuels have come of age as a sizeable and integrated part of the world’s energy mix. Mature biofuels support programmes in the US and Europe that are aimed at cutting carbon emissions and increasing energy independence led global biofuels output to reach more than 1.3 million barrels per day in 2013. This makes biofuels as large a contributor to global energy supply as mid-ranking OPEC members Libya or Algeria. Ethanol now delivers around 10% of the entire US gasoline supply, while the European Union (EU) is targeting a 10% share for renewables in road transport fuel by 2020. Governments in parts of Asia and Latin America are stoking double-digit demand growth to achieve the same emissions reduction and security of supply goals as US and European governments.

Manufactured largely from agricultural commodities but consumed in the traditional fuel supply chain, biofuels prices are driven by the complicated interplay between crude oil and agricultural fundamentals. Policy changes regarding specific regional biofuel support structures represent another ever-shifting fundamental.

This mix creates a complicated trading and hedging proposition for the agricultural and biofuel producers, oil companies, trading houses and banks involved in the well-to-wheel biofuels supply chain. With both producers and consumers spanning the globe from Latin America to Asia, arbitrage opportunities for achieving supply/demand efficiencies are plentiful.

Sizeable discounts relative to conventional fossil fuel prices in 2014 for the corn, palm fruit and oilseeds needed to manufacture most ethanol and biodiesel lifted oil company demand for cheap biofuels to use as a blendstock, without any help

With global output at an all-time high, and increasing demand for clean and secure energy, biofuels have become integral to international energy markets. SCB & Associates explains

how it offers customers the market insight and product knowledge to trade biofuels effectively

SCB & Associates Limitedwww.starcb.com

T: +44 (0)20 7571 0508E: research@starcb.com

discovery in the world’s largest markets for listed biofuel derivatives and blending obligation tickets. Desks covering listed agricultural and energy products allow customers to access the futures instruments needed to hedge market risk alongside their physical and over-the-counter swaps portfolios. And SCB remains at the forefront of the development of new hedging instruments, with SCB’s Singapore office instrumental in establishing CME’s new dollar-denominated swaps in palm oil and olein, aimed at international firms exposed to the growing South-east Asian palm oil market.

Although a relative newcomer to the world energy stage, the biofuels industry is evolving rapidly. Commercial technologies to convert waste biomass into high-quality, environmentally friendly liquid fuels will drive the next step change in market structure. SCB will continue to provide its customers with the market insight and understanding needed to succeed in this fast-changing but fascinating environment.

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Ethanol versus gasoline

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with producers. Kraft Foods, for instance, signed a long-term supplier agreement with cocoa and chocolate manufacturer Barry Callebaut in 2010, making the Swiss firm a major global cocoa and industrial chocolate supplier for Kraft.

Although one of the most common strategies for managing fluctuations in the price of commodities is the use of financial hedging tools, this method of price risk management is not without its challenges. Most recently, post-financial crisis regulations have impacted supply and demand for these products. On the supply side, several major banks, including Deutsche Bank, Barclays and JP Morgan, have scaled back their commodity market activities, reducing liquidity in some segments of the market. The banks that remain as dealers have seen increased competition from hedge funds and commodity houses, which have expanded their commodity trading teams to fill this vacuum.

On the demand side, many corporates and agribusiness companies are subject to more regulation related to trade reporting, counterparty risk and changing accounting standards, which has increased hedging costs. In addition to the new rules, agribusiness companies currently face several other challenges when using financial tools to hedge against today’s volatile commodity prices.

Lack of visibility The agricultural commodities business is a diverse and complex ecosystem that requires major expertise to create meaningful financial positions to hedge. And it is not always easy for organisations to gain the necessary visibility when it comes to their

Managing fluctuations in commodity prices has become central to many agricultural organisations’ business activities in recent years. Volatility can affect a company’s bottom line, creating uncertainty that can impact funding, investment programmes and shareholder income. As a result, agribusiness organisations have increasingly seen the need to adopt a more active approach to managing commodity price risk in recent years. But what strategies are common to this part of the market? How has the financial crisis and subsequent regulatory squeeze affected the market? And what internal changes have – and should – agribusiness companies put in place to enhance exposure visibility and build a robust price risk management programme?

Changing marketsAgribusiness price risk management programmes can include a range of strategies. Vertical integration, for instance, allows an agricultural company to expand further up or down the production chain and diversify the markets and regions in which it operates. Singapore-based commodity house Olam International, for example, purchased Archer Daniels Midland’s cocoa processing business for $1.3 billion in December 2014. Olam will now operate throughout the entire cocoa value chain – from production, to processing, to marketing, allowing for more effective total margin management.

Other options available to a processor may be to substitute more expensive commodities for cheaper alternatives, enter into long-term fixed-price contracts or develop exclusive long-term partnerships

As more agricultural organisations explore ways to develop and enhance their trading and risk management activities, a flexible, robust, centralised technology platform should be a top

priority, says Amine Chbani, head of commodities business development at Murex

CENTRALISING FORCE

exposure to various types of risk within the commodity markets.

A starch producer, for example, might sell to diverse industries such as human and animal nutrition, pharmacy/cosmetology and biochemistry. Each open-sell contract creates a potential exposure to corn, power, sugar and freight prices, as well as to different currencies and even interest rates, if financing is involved. The same producer has also typically purchased raw materials on the market or through long-term supply contracts that might vary in terms of volume/quality delivered and type of price paid.

As such, the producer needs to be able to map the demand forecast and actuals on the supply side and determine the net volume exposure to price risk for each risk factor and contract time period. The complexity of this challenge only increases when taking into account the fact starch can be produced using a variety of inputs including corn, wheat, potatoes, rice and tapioca. Additionally, some of those commodities may not even trade in a liquid market and so risk managers must use proxies, creating additional basis risk.

Legacy IT complexitiesAs a result, there is a very pressing need to extract, transform and aggregate a lot of data to properly monitor an organisation’s real commodities exposure. This is further complicated by the fact that, after years of mergers and acquisitions activity, some agribusiness companies have layered many legacy IT platforms on top of one another. Many organisations still operate in silos, allowing business units to develop their own solutions, rather than forming a central technology hub.

managing risk in agricultural commodities

Amine Chbani

These layers can affect visibility when trying to manage exposure to key commodity markets. In an attempt to address this problem, some organisations have invested in a reporting layer connected to a risk warehouse to achieve better company-wide technological integration. The integration layer gathers data from myriad internal systems, stores it in a massive risk warehouse and then uses built-in business intelligence tools to make sense of the information. However, such a strategy can be a productivity trap. It often involves a lot of manual effort and hidden costs, and it may not even provide the necessary reporting frequency to guarantee optimal reactivity to market events.

Creating a central hubAn additional complicating factor for many agribusiness organisations trying to manage commodity price risk is the fact they often have business units all over the world, all of which create exposure to commodities. An international chocolate maker, for example, might have several production units in different regions, each forecasting a certain level of demand for cocoa, dairy products, sugar and energy. As such, establishing a central trading desk that serves different business units across an organisation can be a useful strategy when hedging against commodity price fluctuations.

These desks can be stand-alone profit-and-loss centres reporting to procurement or treasury and servicing

local operating centres through transparent price transfer policies. A centralised trading desk receives input from each location into a master trading and risk management system that provides a global view of the organisation’s overall commodities exposure. This allows risk managers to work out a cost-effective company-wide hedging strategy.

The benefit of having this global view is that the organisation’s entire position can be taken by a central desk that interacts with the market and executes the transaction. This should save time, money and resources. In certain situations, it also allows the organisation to profit from natural hedges when netting different positions in terms of currencies or in certain commodity markets.

Robust technology platformOrganisations implementing this type of centralised trading strategy typically look for technology platforms with a range of tools including multi-entity access, multi-currency functionality and multi-Gaap software solutions. Today’s trading and risk management platforms provide a variety of tools to easily build, manage and mitigate enterprise-wide commodity positions. This can include: native unit conversions, with formulas linking end-products to raw commodities; family curves projecting illiquid products to liquid market equivalents; spread correlation management; real-time prices; valuations against curves

differentiated by physical and logistics characteristics, such as quality, location and international commercial terms; and the ability to manage several commodities and other asset classes, including foreign exchange and interest rates, on the same platform.

But organisations should only invest in a new platform if it is part of a real transformation programme. While some organisations have the necessary in-house expertise to build their own systems, or to extend their enterprise resource planning or treasury systems, many turn to off-the-shelf trading and risk management solutions. Hedging strategies typically involve the use of standard products and, as standard technology solutions exist to support these activities, why reinvent the wheel and develop something that already exists in the market?

Although linear derivatives and vanilla options are typically the most popular products in this sector, agribusiness players are also increasingly making use of more complex products such as accumulators. These more tailored products provide a way to build a position over time at enhanced price levels – sometimes at zero initial cost but with more risk. Over a period of six or nine months, for example, the product accumulates cash or positions in futures, depending on changing market prices. This type of product provides a lot of flexibility in terms of building a position and creating a cost-effective hedge, but it should be carefully monitored using a robust trading and risk management platform.

Making price risk management a more integral business activity is crucial for those companies facing changing markets and a more volatile price environment. When establishing a strong strategy for monitoring and managing commodity price fluctuations, agribusiness organisations must have access to the necessary tools and be able to implement robust systems and processes to support risk management activities. With the support of a centralised trading technology solution, enterprise-wide risk management can become more efficient, effective and successful.

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Customer feedback has also enabled the continued development of CME Group’s agricultural options complex. In the past, we found that while many of our customers were interested in using options to manage price risk, they were often deterred by high premiums in times of market volatility. With this in mind, CME Group developed a range of options that carry lower premiums but still provide solid protection against price fluctuations. A corn producer, for example, might want to hedge against a drop in prices when planting corn for the upcoming season in January or February.

Traditionally, the producer would buy an option that expires in November on the following December’s futures price. However, CME Group’s short-dated new crop options contracts allow producers to buy a contract covering a shorter period of time at a reduced premium. A contract covering the planting season, for instance, would expire in May, rather than in November, and would therefore cost less. Such products have been created as a direct result of interaction with customers who have expressed interest in using options in a more targeted way.

As a result of this focus on customer feedback, CME Group’s non-standard options products – such as options on calendar spreads or short-dated contracts – have been gaining traction in the agricultural market. CME Group’s weekly agriculture options traded more than 110,000 contracts in October 2014 – the second-highest volume since inception and a 245% increase in average daily volume (ADV) year-on-year. By November 2014, open interest in 2015 short-dated new crop options had already reached more than 45,000 contracts. More than 26,000 contracts traded during November 2014, a 158% increase compared to November 2013.

Hedging has always been a popular way to manage commodity price risk, particularly in more developed agricultural markets and among the processors and manufacturers that form the middle of the agricultural value chain. However, the popularity of this form of risk management has also spread to other parts of the market in recent years. Producers are becoming increasingly sophisticated in their use of hedging tools to manage risk, for instance, as are end-users of all types. We are also seeing an uptick in interest in agricultural risk management in new countries and regions around the world. In line with this increased activity, agricultural organisations continue to become more astute at managing risk through the use of futures and options products such as those offered by CME Group. And access to a diverse set of risk management tools is crucial for businesses that wish to hedge against fluctuations in agricultural commodity prices efficiently and effectively.

As interest in this area of risk management continues to grow, exchanges must maintain a constant dialogue with their users, keeping abreast of market trends to ensure contracts provide the necessary coverage. CME Group, for example, worked with the market to tweak the specifications of its live cattle contract, which celebrates its 50th anniversary this year, to ensure it remains consistent with current commercial terms. Improvements in feeding productivity in the livestock market in recent years have resulted in larger cattle. Since the contract is physically delivered, we want to ensure delivery of cattle is consistent with the physical marketplace. As such, it is very important for us to stay close to our customers and ensure our products are appropriately designed to reflect their needs.

An increasingly diverse set of market participants require agricultural price risk management tools that can not only match current needs but can also adapt to future market

developments, says Tim Andriesen, managing director of commodity products at CME Group

GLOBAL EXPANSION

Historically, the over-the-counter (OTC) market fulfilled a lot of the demand for non-standard options. However, regulations put in place after the onset of the financial crisis in 2008 have squeezed OTC market activity, driving demand for non-standard options products offered by exchanges instead. As these new options products have gathered pace in the market in recent years, CME Group’s customers tell us they have begun to replace the traditional tailored OTC offerings in this area. Indeed, it is difficult for OTC products to compete with exchange-traded futures and options in markets with slim margins, such as the agricultural sector. Our bid-ask spreads are extremely tight and the market is very deep and has a lot of liquidity. As such, CME Group has been very successful in designing products to help customers manage commodity price risk.

In line with increased interest in hedging commodity price fluctuations throughout the world’s agricultural markets, CME Group will also continue to expand the global distribution of its risk management products on Globex, CME Group’s global electronic trading platform. For example, since 2010, traders have had access to Bursa Malaysia’s benchmark palm oil futures contract on Globex. This means Globex offers hedgers and traders access to the two most popular vegetable oil contracts in the market – soybean and palm oil. Such partnerships provide CME Group’s customers with a great deal of flexibility when it comes to managing commodity price risk, and we look to continue building partnerships throughout the global agricultural markets to ensure that continues to be the case for our customers.

Tim Andriesen

managing risk in agricultural commoditiessponsored by

After an active year for mergers and acquisitions, competition is fierce among agricultural trading companies looking to attract the best staff, says Commodity Appointments’ Matt Havill

TRADING TALENT

Commodity Appointmentswww.commodity.jobs

T: +44 (0)20 3008 7653E: mh@commodity.jobs

Matt Havill, Client Partner – Ags & Softs Commodity Appointments

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The agricultural trading job market is likely to continue to be very active in 2015, according to analysis conducted by executive search firm Commodity Appointments. Although trading conditions in key markets such as grains and sugar have been poor of late, recruitment activity tends to spike in the periods immediately following the execution of mergers and acquisitions – and 2014 has been an active year for deal-makers.

Recruitment levels have been boosted by deals such as Chinese agricultural trader Cofco’s $1.5 billion purchase of a controlling stake in Noble Group’s agricultural trading unit last April following its earlier acquisition of a 51% stake in grain trader Nidera NV in February, as well as the launch of Alvean; Cargill and Copersucar’s 50/50 sugar-trading joint venture in August 2014. While the entrance of new participants in this market has had an impact on hiring trends, several large merchants and banks, such as JP Morgan and Barclays, have also been in the process of winding down divisions or diversifying portfolios away from the commodities sector, freeing up traders and risk managers for positions at other agricultural trading companies.

In general, any restructuring or diversification of trading organisations is likely to lead to movement of the industry’s top talent. During

periods of intense activity, such as that seen in 2014, competition for the best staff can become fierce. It can be challenging for organisations to find and retain strong personnel at the best of times but, with so much change occurring throughout the agribusiness markets, the healthy rivalry seen for the top talent this year is likely to continue into 2015.

As a direct result of this competition, from a remuneration perspective, the industry is beginning to develop into a more mature trading environment. Many agricultural companies – from large physical players to asset-light trading houses – are starting to implement more desirable bonus structures in order to attract and keep traders and commercial teams. Such schemes are typically directly related to the profit and loss performance of the trading desk.

Companies that wish to attract the top talent must have access to quality information about the typical salaries, bonuses and benefits offered

by competing firms. Through the use of extensive in-house data

and information-gathering resources, Commodity Appointments can harness big data to analyse where the markets have been, where they are now and where they are likely to go in the future. We have an entire team dedicated to collating

key information on remuneration and providing analysis, intelligence and trend forecasting we can use

to help our clients. Commodity

Appointments

tracked more than 2,100 career moves across the commodity trading markets in 2014, which saw 347 job changes within the agriculture and soft commodities complex, specifically. The most active companies were Brazilian bank BTG Pactual and global commodity trading house Noble Group. In addition to the companies that are looking to hire new employees, we also work with a wide range of individuals to help them find new roles – from traders to country heads, and risk managers to chief executives.

This provides us with insight into the remuneration packages offered for many different positions and levels at organisations throughout the industry. Thanks to our ability to track each sector and collect detailed information on how employees are remunerated, our clients are fully equipped with the most up-to-date information necessary to attract and retain the desired talent. As an example, during a recent salary benchmarking exercise for a client that wished to ensure its traders were competitively remunerated, Commodity Appointments gathered data from more than 1,100 traders across the European gas and power sector. This allowed us to paint a detailed picture of compensation trends throughout this section of the market for our client.

Firms that wish to compete for, and attract, the top trading and risk management talent in the agricultural markets need to have access to the right information. By partnering with an executive search firm that can provide this data, trading companies can ensure they have access to the market intelligence and analytical tools that will help them to build a successful and satisfied workforce.

managing risk in agricultural commodities

processes are in place to assess the new market participants that have begun to enter the market in recent years? How have the tools used to trade and manage risk changed as a result of new regulations, and how has that affected your risk management strategy? What will these changes mean for the internal structure of your business? How should an organisation position a growing trading and risk management function? What about the information technology infrastructure that underpins your entire organisation?

There are many important factors to consider as the markets continue to adapt to the post-crisis world. At Export Trading Group (ETG), a global supplier of African agricultural products, we believe we are on course to develop a viable and competitive risk management infrastructure fit for today’s agricultural trading markets.

Regulatory impactOn the whole, the impact of new financial regulations has been material and I believe that, while first-movers such as ETG are absorbing the initial impact of the new regulations, we will ultimately be the first to benefit from these changes to the structure of the financial markets.

However, following the financial crisis, the push toward tighter global financial regulations has affected our trading space. At present, the playing field remains uneven, since these new rules have resulted in mispricing to some extent. Rallying to meet new regulatory requirements in various regional markets has also inevitably resulted in casualties, having an impact on where and how we trade, as well as

The financial crisis of 2008 set in motion a chain of events that has shaped the price risk management policies of agricultural organisations in recent years, and the landscape of trading across the financial markets has changed irrevocably as a result of tighter financial regulations. Various monetary policy initiatives, put in place by central banks in an attempt to repair the economy, have also had an impact on the market. New rules covering reporting and capital, as well as liquidity requirements, have changed the face of many markets, including commodities. In addition to affecting how financial markets operate, these interventions have also affected participants in those markets. Organisations of all shapes and sizes have exited the commodity trading space in recent years and have been replaced, to some extent, by new players with fresh ideas and capital.

How have agricultural companies developed risk management strategies in response to the market shifts brought about by the 2008 financial crisis, as well as the various policies put in place by regulators and central banks in its aftermath? Organisations that remain active in markets such as agricultural trading have been forced to rethink risk management and trading, reformulating strategies to tackle this brand new financial world.

Thinking aheadThere are several major factors that any participant in the agricultural trading markets should take time to consider before putting a new risk management strategy in place. Questions that should be asked include: who can – and should – you transact with? What

Hardi Wilkins, global head of risk and trade compliance at Export Trading Group (ETG), discusses how agricultural commodity risk management strategies have evolved in response to

recent market shifts spurred by the latest global financial crisis

EXTERNAL PRESSURES

with whom. At present, ETG’s trading partners are a good blend of established trading houses and small to medium-sized traders with strong ties to our market space. As they rely, to varying degrees, on our operational and financial capabilites, for ETG, existing relationships and a strong track record in the relevant market also count for a lot when it comes to choosing the partners with which we trade.

In addition to tighter oversight of the financial markets by global regulators, central banks brought interest rates to record lows following the financial crisis in a bid to bolster the markets. Now that sufficient time has passed, central banks around the world are beginning to change gears, implementing policies of monetary normalisation, which could result in volatility throughout the global financial markets.

Speaking at the International Symposium of the Banque de France in Paris on November 7, 2014, US Federal Reserve chair Janet Yellen said that while “the headwinds associated with the financial crisis will wane”, the normalisation of monetary policy “could lead to some heightened financial volatility”.

The Fed has pledged to provide clear guidance regarding future monetary policy in an effort to minimise any disruption to the financial markets. However, uncertainty about the global economic growth trajectory, the strength of the US dollar and the likely direction of interest rates could still play havoc with commodity prices. As a result, this has been a strong theme in the risk management strategy ETG has developed over the past two years, and it will continue to be a major factor

managing risk in agricultural commodities

Hardi Wilkins

when making decisions in this area of the business. Against this backdrop of monetary policy normalisation and an increasingly important African continent with growing import and export demand, constructing a successful risk management strategy has not been a simple task.

Finding the right toolsRisk optimisation should be the main aim of any agricultural price risk management effort. As such, hedging can be a very effective tool for an organisation that wants to de-risk its trading book while maintaining its physical market position. ETG has developed successful and cost-effective risk management strategies by hedging total risk attribution, as well as focusing on combinations of different types of risk – such as price, currency, operational and credit risk. It is important that such strategies are flexible enough to operate in a constantly shifting environment.

The level of sophistication of the tools used by ETG to hedge price risk is generally dictated by the trading environment. In our experience, a string of vanilla products can often produce a better result than a more tailored product, so we tend to favour such structures over complex, packaged off-market paper.

Over-the-counter (OTC) products are appealing in certain circumstances due to the benefit of deferred settlement but, as a rule, if a contract

feature

cannot be priced, it should not be traded. As a strong player in the credit market, ETG has access to a range of vanilla OTC and exchange-traded products on both the buy side and the sell side.

Risk infrastructureOf course, such tools and strategies must be underpinned by a strong internal infrastructure in order for an organisation to successfully manage its exposure to commodity price risk. The significance of an integrated view cannot be understated when it comes to structuring the risk management function within a company. Strong processes and procedures are crucial, and must be based on solid systems and a robust risk framework that are well-understood across the company. By putting such an infrastructure in place, a centralised specialist team can use available data to monitor exposure and risk to constantly develop metrics and effect real mandate shifts in line with changing market events and emerging trends. This type of structure has resulted in a transparent environment for ETG, with dynamic detection capabilities and risk share via a network of accountable stakeholders trading in 11 core commodity types across 40 countries.

A strong risk management function also requires a sound IT infrastructure. Twelve months ago, ETG set out to identify the best commodity trading risk

management (CTRM) solutions provider for our business. Given ETG’s focus on African agricultural markets, we were particularly keen to partner with a CTRM software solutions provider that has a proven track record in emerging markets. After researching our options, we chose to partner with Just Commodity, because we felt the company had the necessary products and experience to deliver on the particular requirements of our markets, traders and risk managers.

As we did not have legacy trading systems, when it came to implementing the new software, integration with our existing enterprise resource planning system has been relatively easy. Our goal is now to produce a world-class integrated treasury, supply and trading system with a forward-looking focus. We believe this partnership with Just Commodity will help ETG develop such a system.

Risk management strategies will always be under pressure to remain flexible in the face of external market forces – whether that relates to monetary policy, new regulations or even just the vagaries of supply and demand in the commodity markets. Agricultural organisations must plan ahead, ask the right questions and partner with excellent third-party vendors in areas such as technology in order to build a solid base for their price risk management activities.

generally looking for more dynamic strategies that are flexible enough to meet their needs in an ever-changing commodity market environment.

Cargill believes the long-term outlook for commodities is positive, as changing demographics, income growth and the expansion of the middle class continue to create greater demand. However, risk management tools and expertise will remain in demand as businesses look to protect profits and prevent losses. There is a range of strategies available to agricultural organisations interested in hedging against price fluctuations. Cargill Risk Management works with customers to manage and hedge commodity price risk using customised solutions – these can span vanilla options, to over-the-counter (OTC) swaps, to structured products. Cargill’s price risk management solutions are typically implemented through a direct financial relationship with a customer or within the supply chain to price – or re-price – the commodity as part of the physical contract.

Working together, our trading and risk management teams can gain in-depth insight into the risks that agricultural businesses face. Through Cargill’s global footprint and its physical trading operations in the major agricultural markets – we trade in 15 currencies and more than 55 commodities, including grains, meat, dairy, softs, edible oils and animal feed proteins – we are able to gain a unique perspective that becomes a part of the risk management process.

Customised solutionsCargill Risk Management has built up a solid customer base that

The commodities market is in the midst of the longest price slump in 25 years. In 2014 alone, commodity prices declined by about 10%. Lower grain prices are coinciding with significant weakness in energy and petroleum markets. In this type of environment, businesses seek optionality to protect margins and control costs.

Uncertainty about future commodity market developments also creates volatility. Geopolitical and macroeconomic conditions are a major influence. With 2014’s slowdown in emerging markets, we have seen dramatic price fluctuations due to concerns about burdensome surpluses. In this kind of environment, agricultural organisations around the globe typically look to risk management strategies, such as hedging, to protect their businesses by managing commodity price fluctuations.

Cargill founded its risk management business unit in 1994. As a provider of customised commodity price risk solutions for customers around the world, Cargill Risk Management’s customers include producers and consumers of agricultural, energy and base metal commodities, as well as institutional investors seeking exposure to these markets. In recent years, the general approach to risk management has changed among our customers due to external market developments such as financial regulation, as well as a number of events that continue to affect the demand and supply of commodities around the world. As such, many of these organisations have started to rethink their approach to risk management. They are now

The continued evolution of commodity markets has necessitated the development of new risk management strategies and created demand for a more diverse pool of

trading partners, says Mike LeSage, president of Cargill Risk Management

ADAPTING TO CHANGE

includes corporate and industrial clients in more than 60 countries – the producers and consumers of more than 55 commodities and consumers of 15 currencies. Cargill Risk Management’s customers are looking to navigate the commodity markets with varying objectives and priorities, but we can work with all of them to provide customised solutions. Farmers and ranchers, for instance, are a key market segment for Cargill Risk Management. We have seen significant growth in the use of risk management solutions among these groups to complement the physical delivery of crops to other parts of the supply chain.

Cargill Risk Management also works closely with some of the world’s largest and most respected pension plans, endowments, foundations and mutual funds. Institutional investors generally allocate 3%–5% of their portfolios to commodities, for inflation protection and portfolio diversification. These groups look to diversify their portfolios and gain beta and alpha exposure to commodities. We offer such organisations access to our global footprint and fundamental trading insights, as well as expertise in OTC structuring and hedging. For example, we can create customised indexes based on fundamental analysis of micro, regional and global supply and demand, leveraging Cargill’s physical insights.

New playersIn the aftermath of the 2008 financial crisis, many agricultural companies started transacting with a wider range of risk management providers as some participants pulled back from certain markets, including commodities. While, in the past,

managing risk in agricultural commodities

Mike LeSage

many organisations typically sought risk management solutions exclusively from large banks, the market has started to open up. Cargill Risk Management, for example, can offer customers a strong alternative based on 150 years of commodity markets experience, a stable balance sheet and a reputation as one of the world’s largest, privately held companies.

As a result of the post-financial crisis regulations introduced under the US Dodd-Frank Act, Cargill registered as provisional swap dealer with the US Commodity Futures Trading Commission in February 2013. Cargill Risk Management is the only authorized business unit within Cargill underwriting commodity swaps.

Although there have been additional costs to ensure compliance with these new regulations, we are committed to providing competitive products to our customers. When it comes to how we interact with customers, little has changed. Our discussions with customers and the solutions we provide continue to follow the same guiding principles that have led Cargill’s business for 150 years. Our strict adherence to integrity and transparency assures our customers that we have their best interests in mind.

A holistic approachTighter regulation of the financial markets has contributed to the continued evolution of the structure of the agricultural trading markets in recent years. However, we have also seen substantial changes in terms of how end-user organisations approach risk management internally. Many agribusiness players are now seeking to develop a more dynamic and comprehensive approach to risk management. Our customers have become more proactive and strategic in managing their portfolio of commodity exposures versus a single commodity or currency.

Price points are impacted by a variety of factors, so simply hedging risk through futures trading or a fixed instrument will not meet all of the needs of our customers. Instead, they

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typically seek customised solutions that can provide greater effectiveness and efficiency. Customers are also looking to work with trusted partners to develop their risk management capabilities. In line with this attitude, Cargill Risk Management encourages a holistic approach to risk management. We take into account the value of the underlying product, energy inputs and currency exposure, because each of these factors impacts the bottom line and should be addressed when mitigating risk.

A holistic approach should begin with an assessment of the customers’ needs to gain an understanding of their general level of risk and to assist in the process of creating customised solutions. We work with customers to build a hedging strategy based on the pricing period, time of shipment, exact volume, expiration and other factors that affect pricing. We then modify a structure that aligns with their risk profile.

Once a customised strategy has been established, it is vital to remain vigilant about updating it as and when market changes occur. In our view, an active hedging strategy should include diversification,

discipline and control. As such, it is important to create a structure that will help customers achieve their budgetary goals. We work with our customers to achieve discipline in setting targets to defend or strengthen margins.

Cargill Risk Management can also provide tailored solutions utilising our proprietary technology platforms. Several members of Cargill Risk Management’s trading technology team sit on the trading floor to better understand the needs of our trading and risk management divisions. As a result, the IT team gains insight into the technology requirements and has developed strong expertise in this area of the business.

A swap dealer’s products and services should offer the necessary flexibility and control to respond in real time to market volatility and changing business dynamics. Such attributes are crucial in constantly changing commodity markets. As agricultural businesses continue to take a more proactive approach to managing commodity price risk, demand for more dynamic strategies will only continue to increase, as will the demand to work with experienced partners.