In recent years, global agricultural markets have seen a surge in both prices and volatility. According to the IMF Commodity Price Index prices have almost doubled since 2005, while radical commodity price fluctuations of up to 40 percent are being observed according to advisory group Spend Matters. The impact on the P&L is significant both for commodity traders and producers of consumer packaged goods who are heavily dependent on agricultural commodities.
A number of interconnected factors are responsible. In the past 12 months alone, La Niña weather patterns led to drought in Latin America, damaging corn and soybean harvests in Argentina, Brazil, and Paraguay. From June, hot and dry weather in the U.S. Midwest lowered corn and soybean yields. Adverse weather also caused the International Grains Council to predict a 20 percent drop in wheat output in Russia, the world’s fourth-largest exporter. The UN Food & Agriculture Organization also cut its global estimate for rice production by 1.1 percent because rainfall had dropped by 17 percent against the 50-year average during India’s monsoon.
At the same time, demand is up. Global population is expected to grow from seven to 10 billion over the next 35 years. This includes a rapidly expanding middle class in China, India, and other parts of Asia, which is set to grow by three billion people over the next 20 years, according to McKinsey. This has driven up direct demand for commodities such as oil, coal, and wheat; but has also increased indirect demand, as increased consumption of meat and animal products has diverted agricultural output towards animal feed.
Agricultural crops are also being diverted towards fuel production. This has driven up prices and increased volatility thanks to correlation with wholesale oil and gas markets. The rising oil prices has also driven up fuel and fertilizer prices and consequently the cost of production. Finally, stringent regulations regarding environmental practice and traceability, corporate governance and financial management add to the pressure.
These are long-term trends that will continue to drive acute commodity price swings, and increase agribusinesses’ exposure to the four key types of risk identified by the Committee of Chief Risk Officers (CCRO): price risk, operational risk, counterparty credit risk, and regulatory risk.
In this challenging environment, companies at all stages in the food supply chain have increasingly turned to commodity risk management systems to handle price volatility, optimize supply chains, improve decision-making and minimize risk. These sophisticated platforms enable energy firms to:
- Streamline the supply chain by scheduling transport of bulk goods and tracking inventory/storage, in-transit positions and P&L; handling straightforward physical trade matching as well as complex itineraries with multiple trades, commodities, transport methods and inventory movements; and managing all aspects of vessel operations and chartering including freight risk management.
- Provide product customization for farmers, by embedding derivatives in cash contracts for customization and improved farmer relationships, while aggregating risk within and across multiple commodities.
- Optimize complex trading operations by integrating physical and financial instruments; accessing real-time information to better manage current positions and leverage market movements; and utilizing variable price models including fixed, index and formula.
- Ensure compliance with corporate governance and financial management legislation including Hedge Accounting and Fair Value Disclosure through corporate accounting and controls, accelerated month-end reporting, and the flexibility to adapt as regulations evolve.
- Manage price risk and mitigate the impact of unforeseen events with analytical tools including what-if analytics, limits, VaR, credit, hedge accounting, simulation and Greeks/sensitivity modeling; and analyze real-time positions and exposure to market, volumetric, credit, delivery, and FX risk at granular and rolled-up level.