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Preparing for the Black Swanqrcode

−− US-China trade war shows why commodity price risk management in the Agricultural sector is critical

Dec. 11, 2018

Forward Favorites Print Dec. 11, 2018
 Brett Cooper

Brett CooperFollow

The first “shot” of the U.S.-China Trade War was fired Friday July 6 with the USTR announcing an additional 25% tariff on over $50 billion worth of Chinese goods. China returned fire by levying tariffs on $34 billion worth of U.S. goods, focused mainly on commodities. If there’s one thing that’s guaranteed by this trade war, it’s volatility in the market, especially in the agricultural sector which is heavily influenced by China’s trade flows. 
 
One of the commodities that has been greatly impacted by this first round of tariffs are U.S. soybeans, of which, China consumes just under 60% of U.S. exports.  In June alone U.S. soybean futures on the Chicago Board of Trade dropped 14%, the largest decline in four years. Soybeans are just one of the major agricultural commodities affected, and with new Chinese tariffs on corn, cotton, and tobacco, we are only seeing the early effects of the conflict at this point. 
 
Chinese tariffs on U.S. imported cotton will undoubtably effect U.S. cotton competitiveness in what has historically been an important market for U.S. producers. The point being these “black swan” events that arise quickly, and have unpredictable consequences, are hard to hedge against and can have  significant adverse impacts on bottom lines.  
 
Both the commercial hedger and the institutional investor carry exposure into this seemingly random market, driven by forces that are near impossible to predict. This emphasizes the benefits of having a structured, disciplined approach to risk management and highlights the exposure the market has to these “black swan” events.  
 
From my perspective, many asset managers view operational management as their core competency and the key criteria for day-to-day operations. As a result, they tend to focus their time and efforts on facilitating generic physical sales programs and steer away from other, what they deem to be, “non-core” competencies (e.g. price risk management). Though asset managers are experts in controlling costs or increasing profit margins, very few of them have specialized price risk management expertise and capabilities in-house. In fact, from what appears to be a limited understanding of today’s sophisticated trading strategies, instead of viewing price risk management as a “pillar” of portfolio management, many asset managers in Asia view it as “risky” or “adding risk.” In their view, new and indirect, sophisticated trading strategies could negatively impact their portfolio as they will initially have to commit more capital and therefore increase risk. As a result, adding price risk management as a new function is perceived as adding risk, not mitigating it, which is of course what these strategies are designed to achieve.
 
Agricultural commodity price risk needs to be managed properly, just like any other type of commodity risk. Naturally volatile, agricultural commodities are exposed to risks at every stage of the supply chain, both from mother nature and, as has been clearly shown more recently, jurisdictional positioning. Many institutional investors in Asia fail to recognize the benefits that a true risk management strategy can provide to their bottom line. I believe there is a bridge that needs to be crossed in terms of education and what is practical and consistent with investors’ objectives. To cross that bridge, we must rethink risk management and hedging strategies to tackle today’s volatile agricultural trading markets.  
 
To start, here are the top processes every agricultural asset manager and investor should consider:

1.

 

 

 

Do the work. See how correlated your commodity is with an aligned listed contract. However, don’t dismiss low correlation as the contract may still facilitate “disaster insurance,” even with low daily correlations.  A basket approach may also work.

2.

 

 

Consider all pricing alternatives your counterparties will offer – if you don’t ask, you don’t get. You may be surprised that your competition is utilizing different pricing methods to price the same commodities you are.

3.

 

 

 

Monitor your basis. In its simplest form, you should adopt the discipline of breaking price down to its individual components. This will not only give you a better understanding of what is driving price, but will also provide invaluable insight into how the futures market interacts with your profit/loss ratio.

4.

 

 

 

Run “what if’s.” If this is your entry into the world of risk management run dummy strategies. “Today, I would put this trade on to protect this risk.” Then monitor the outcome. This allows you to hit the ground running when you eventually pull the trigger.

5.

 

 

Seek advice. There is an endless list of specialists. However, there are few firms that provide the guidance and knowledge to take companies from initially identifying key risks, all the way through managing exposures. The full scope is what’s important.

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