GTR Asia Event Prep notes: Performance, pricing and managing the supply chain: Coping with challenges in the soft commodity space

GTR Asia Finance week – 9 September 2015: Performance, pricing and managing the supply chain: Coping with challenges in the soft commodity space

Moderator: Chris Pardey, Chief Executive Officer, RCMA Commodities

Gopul Shah, Director, Corporate Treasury & Trade Finance, Golden Agri-Resources

Jacqueline Chang, Regional Head of Commodities, Asia, ABN Amro

John Reeve, Director, AgRee Commodities

Jean-Francois Lambert, Global Head of Commodity & Structured Trade Finance, HSBC

* Sugar, coffee, cocoa, grains, cotton, and palm oil: How have these various sectors performed over the past year when it comes to pricing? Where is the most volatility predicted?

* Are we seeing fewer participants in the commodity space as we near the end of the ‘super-cycle’? Is this expected to be a long-term trend or something more cyclical?

* With banks keen to minimise risk and limit exposure to price volatility, how has this impacted on the use of hedging as a financing tool?

* Is greater linkage and innovation needed across the modern Asian supply chain? Are new models required for companies to engage directly with smallholders?

* Sustainable commodities: Are banks and traders doing enough to support the growth of sustainable production? Are greater incentives needed to make a business case for such initiatives?

Audience poll (respondent answers and priorities in the sequence)

Q1. What do you see as the main market challenges at present?

1.            Down trend in commodity market

5.            Credit and performance risk

3.            Inability to hedge or non-availability of hedging mechanism

2.            Stronger and volatile USD impacting client ability to buy

4.            Cost of production considerations

Q2. What are your priorities for the rest of 2015/16?

1.            Risk management and contingency

2.            Cash flow and funding

3.            M&A and divestures

4.            Talent and people management

Q3. Has your awareness of sustainable trade initiatives increased over the last year?

3.            Yes, through changes in market / customer practice

2.            Yes, my company takes these issue seriously

4.            Yes, heightened awareness of environmental issues and CSR activities

1.            Yes, through industry fora like this

5.            No, this is too much cost versus benefit

6.            No, my customers do not care

1) Commodity pricing and volatility: As of 8 September 2015, the 1-year return basis Bloomberg Composite index is -29.12% while agriculture is -19.53%, energy -47.80% and metals -22.16%. If you notice, agriculture commodity prices have not performed badly compared to other commodities though the low oil price has positively impacted the cost of production and price of agriculture and other commodities. 

As domestic consumption increases with the rise of middle class in the developing world, trading of strategic agricultural commodities around the world will continue to be fuelled by emerging demand and as trading pattern emerges. 

Transacting highly strategic commodities, such as soybean, corn, palm oil for food and bio-fuel, have shown resilience and robustness despite economic downturns.

* Low commodity prices has created winners and losers.

o  Low prices are playing well for many consumption and import driven countries whose currency is not depreciated relatively speaking like CNY, INR. This has resulted in lower inflation, budget deficit and increase in disposable income particularly in China and India.

o  Companies and producers whose commodity sales are linked to USD prices and have an USD functional currency while costs are in local currency are relatively remain less impacted due to falling price. The depreciation in commoditiy countries currency (Brazil, Malaysia, Indonesia, Australia) verus USD has had made exports from these countries more competitive as the export realisation inrespective  local currencies have increased.

The most volatility is predicted in agriculture due to weather and oil markets due to geo-       politics when impacts the supply chain.

      

* In the medium and short term; companies will

o De-leverage and reduce its debts,

o Use its debt and cash flows wisely,

o M&A and divestures will be in vogue as the industry consolidates to purge capacity or debt levels. Banks will lend to companies that have a long term core business model and good governance practices.
[** Medium term growth and opportunities will emerge from China, India, Indo-China region]

* Long-term, commodity prices will recover but how long is ‘long term’

o   Inventories will deplete, demand cycle re-emerge

o   Economic growth in emerging markets will support demand. The majority of the world’s population lives in countries which have not industrialised, and it won’t be long until they do. Hundreds of megacities around the world are taking shape, and all of these will be hungry for steel, copper and oil. Emerging and developed markets are making structural changes.   

o  World population growth will support global growth and demand for commodities.

* The world will see a 'new normal' of a reduced global growth of about 3%, China growth of about 5.5-6.5% pa and low commodity prices; asset valuations will have to adjust to new normal cash flows and EBITDA's.

2)     Why are commodity prices falling?

* China market is changing: China has less need for more infrastructure, and thus for iron ore, steel, copper an other base metal commodities.

* Global economic growth concerns or the new normal which the commodity price decline seems to reinforce. Composite purchasing managers' indices for the manufacturing sector in the emerging market countries have dipped slightly below 50, indicating a decline in output. The IMF cut its global growth forecast for this year to 3.3% from 3.5%, largely on American first half weakness. 

* Most emerging markets have made little structural change so domestic consumption is not catching up: The lack of structural changes to the economy has resulted in no real domestic growth and local consumption.

* Supply and capacity glut: excess capacity and supply as a result of huge investments in prior years due to cheap money and demand from China.

* Margin calls and clearing houses requirement has resulted in de-leveraging and exits of market makers:  Banks and hedge funds are exiting commodities as regulation and large commodities houses are facing working capital requirements as regulations are imposed like the higher capital requirements and a push to using clearing houses to settle trades. Many European banks have exited the sector. Financial markets structured the equivalent of $22 trillion worth of commodities through OTC commodity derivatives and now they're unwinding.

* Higher interest rate is anticipated:  speculators are thinking ahead and shifting out of commodities today in anticipation of future higher interest rates in 2015; the result has been to bring next year’s price increase forward to today.

* Dollar strength: Appreciation in USD against other currencies also explains that commodity process are down in terms of dollars and up in terms of other currencies. The prospect of US monetary tightening coincides with moves by the European Central Bank and the Bank of Japan toward enhanced monetary stimulus. The result has been an appreciation of the dollar against the euro and the yen. The euro is down eight percent against the dollar since the first half of the year and the yen is down 14 percent. That also explains how so many commodity prices can be down in terms of dollars and up in terms of other currencies.

* Downward pressure is coming from oil prices:  producers have flooded the world with oil; the cartel has vowed to keep pumping. Shale gas is keeping oil price in check. Oil is used for agriculture and supply chain hence the cost of production is reduced as oil prices is lower.

3) Hedging, price volatility:

*Producers, plantation companies, farmers, miners and resource extractors face a dilemma in a volatile market

o Hedge or not to hedge, it’s an option and has a cost? How to read the market and predict supply and demand, weather, financial market and regulatory driven volatility? Say if you sell today when market is perceived to be higher then what happens when market rises suddenly.

o Is long term hedging opportunity available? Can companies hedge beyond 18-20 months? Are customers willing to buy long term at fixed prices? Can the cost of production be hedged – note most investments of these companies are in fixed assets, the valuation of which is fixed upfront.

o So in volatile market conditions many companies don’t hedge long term but they (i) manage their supply chain well, (ii) pricing in the short and medium term range, (iii) ensure that their cost of production, SGA and interest costs remain low, (iv)stay liquid and cash flow positive.

* Hedging isn't that difficult for a back to back trader or a brokerage business model as long as it manages its counter party performance risk, compliance, and cash flows well.

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* Hedging can be controversial topic ?

4) Smallholders financing, expertise and risk sharing with government and local financial institutions is the key: 

Difficult for international banks to engage and fund smallholders directly; the best experts are corporates, local banks and government policies and financial or risk support. In current business environment, banks are focused on real economy and to companies that have a long term core business model and good governance practices. Key focus for banks today is compliance, risk management, credit and market risk mitigation.

5) Sustainability matters! 

No business can survive nor sustain without the environment and the support of the community, stakeholders, and customers.

a. Sustainability, corporate social responsibility, community development, and environment protection is become a key mandate within most corporations.

b. Multi-stakeholder collaboration is a good strategy to achieve workable solution. The emphasis for companies is to find a workable balance between growth and profitability, environmental protection, socio-economic needs of the community, conservation and compliance with regulations, industry standards and laws. 

c. Sustainability standards and policies will keep evolving and corporates will have to constantly invest in compliance even when costs do not justify returns.

d. Over past 20 years, the sustainability business practices have evolved and gone through the change management process of denial, resistance, exploration, and change commitment.

e. Initiatives around sustainable energy from solar, wind, bio-diesel, etc. will keep oil prices in check for a long time.

f.  Investors, banks, stakeholders, and customers are eagerly supporting companies that have strong sustainability governance mandates across production and supply chain.