“You can’t just turn cows on and off”

An article in the WSJ highlights how over optimistic expectations over Chinese demand growth helped contribute to the current lull in commodity prices we are seeing. In this article they show how strong Chinese demand growth for dairy products soared between 2008 and 2013 prompted farmers in New Zealand to ramp up production to to supply the growing demand.

“Chinese imports of whole dry milk powder soared to 619,000 metric tons in 2013 from just 46,000 in 2008, according to U.S. Department of Agriculture data. Farmers in New Zealand ramped up production to supply the growing demand, adding 450,000 metric tons of capacity during that stretch, an amount that is equal in weight to about one billion 16-ounce milk containers.”

Then when demand fell short, prices collapsed.

China’s imports of dry powder milk have since flattened. Its inventories of the product tripled between 2011 and 2014, and prices tumbled, according to the USDA.

Related article: Dairy price rebound looks unsustainable on weak Chinese interest

Since the start of 2014 whole milk powder prices have dropped from $5,000 per tonne to $2,300 per tonne (GlobalDairyTrade)

Expectations are vitally important to commodity markets. Indeed, their importance, particularly in agricultural markets has been recognised for almost 150 years.

“….A scarcity or abundance of crops affects the exchange of the world, and tends to forecast future prices, and to give some clue to future production…”

Samuel Benner, “Prophecies of Future Ups and Downs in Prices” (1876)

Cow face, Otago Peninsula, NZ

The observation was expanded on further through The Cobweb Theorem, developed in the 1930s. The theory shows how supply and demand responds in a market where the amount produced must be chosen before the price is observed. Agriculture is a great example of where the theory might apply, since there is a lag between planting and harvesting.

Suppose for example that as a result of unexpectedly bad weather, farmers go to market with an unusually small crop of wheat, resulting in higher prices. If farmers expect these high price conditions to continue, then in the following year, they will plant more wheat relative to other crops.

When they then go to market after the crop has been harvested, supply will be high, resulting in a drop in the price of wheat. And so it goes on. If they then expect low prices to continue, farmers will reduce planting of wheat for the subsequent year, resulting in a return to high wheat prices yet again.

Very short-sighted of those farmers, you might say.

Critics of the Cobweb Theory have argued that rational farmers should be able to work out what the equilibrium level of supply should be, given current information about supply and demand. The farmers, it is argued should base their price expectations on how they expect the market is likely to work, rather than just reacting blindly to price movements.

Back to those dairy farmers in New Zealand and their expectations of Chinese demand. Were they short-sighted too?

Well, may be a little.

When prices have been high and rising for some time (as it was for dairy prices as with many other commodity prices), it becomes an entrenched assumption that high prices will persist for the foreseeable future and vice versa. As much as you or I like to think of ourselves as forward-looking, the truth is that we are all backward-looking to some degree and update our perception of the world only gradually (something called adaptive expectations).

However, as with iron ore miners who reacted to strong Chinese demand growth in 2005 to bring on more iron ore supply, there is a time lag between the decision to increase supply and that supply actually materialising.

What will be interesting now is how dairy farmers in New Zealand respond. Will they now look to reduce the size of their herds, perhaps setting the stage for the next surge in dairy prices?

“You can’t just turn cows on and off”

See the FT 4th June 2015 “Dairy price plunge highlights hedging handicap”

Have global food prices now reached a trough?

Global food prices fell to their lowest level since September 2009 in May according to the UN Food and Agriculture Organisation’s (FAO) food price index. The index fell 1.4% from April and is now down 22.4% since May 2014.

Chart: UN Food Price Index


Source: UN FAO

High global production, cheaper crude oil and the strong US dollar (particularly against many food producing economies, e.g. Brazil) have pressured food prices over the past year.

Related article: Why are agricultural commodity prices so weak in 2015?

Investor appetite for agricultural futures is suffering with hedge funds bearish bets hitting record highs, perhaps indicating that prices are now oversold. Could global food prices have now reached a trough?

There are tentative signs that it could.

The FAO forecasts that global cereal production will hit 2.524 billion tonnes in 2015-16, compared with its previous forecast of 2.509 billion tonnes. The higher cereal forecast is mainly due to larger than expected harvests in Africa and North America, but with 2015-16 output still expected to be 1% lower than last year’s record harvest. Cereals stocks at the end of the 2015-16 season are forecast to reach 634.3 million tonnes, compared with 646.5 million tonnes in 2014-15. Still very high by historical standards.

Societe Generale sees prices for many agricultural commodities rising above what the futures curve alone might indicate. The bank forecasts that corn will rise back above $4 per bushel early next year, up from $3.62 per bushel now. SocGen highlight the trend for years with record yields, like 2014, to be followed by poorer results while forecasting higher feed use for 2015-16 than the US Department of Agriculture has penciled in.

Crude oil prices have rebounded since the late January lows which should give some support to agricultural commodity prices. But with oil remaining vulnerable to further weakness going into the second half of 2015 its impact is likely to be muted.

The Brazilian Real since March after suffering a sharp decline against the dollar and many other currencies over the past year. This increased the incentive for Brazilian farmers to increase output for export. SocGen see sugar prices (perhaps the commodity most closely correlated to movements in the Brazilian currency) rising back to 14 cents per lb by the first quarter of 2016 with the bank seeing a continued rise in Brazilian use of ethanol shaving “some of the excess sugar off the global balance”.

The likelihood that El Nino returns may also prompt higher agricultural prices. But with grain stock levels so high the impact is likely to be limited.

Related article: Bumper harvests to curb El Niño impact on food prices

Physical crude market a tenuous anchor for crude futures prices

“Like pushing a rock up a hill”

That’s how some trader’s view the current disconnect between the physical market for crude oil and the futures market with speculators pushing futures prices higher while the physical market remains moribund.

Before continuing it’s important to make the distinction between the physical market for crude and the crude futures market.

Physical (also known as cash) market prices are determined by the supply and demand for physical crude. Here traders buy oil from the producer and sell it to the refiner, for immediate delivery. Physical buyers and sellers have a direct pulse on the market and may feel immediately when it is well supplied, or not.

Futures prices on the other hand are determined by the supply and demand for crude futures positions. Futures markets provide a means for trading the probability of where crude prices will be at certain points in the future; this allows physical market participants a means by which they can hedge their position and so reduce risk.

The physical crude market tends to show weakness (i.e. too much crude swashing about) when the premium for the best crude grades weaken against the benchmark Brent. One of the most favoured grades in Europe is Azeri Light due to its high quality.

Over the past couple of months physical crude traders have noted the weak premiums for Azeri Light versus Brent as other cargoes, particularly from West Africa compete to supply crude into an already oversupplied Atlantic Basin market.

This apparent disconnect between the futures and the physical market appears eerily similar to mid-2014, just prior to crude prices collapsing. So is the current weakness in the physical crude market a precursor to an imminent weakening in crude futures prices?

Don’t bet on it – at least not based solely because of what the physical market is doing.

While the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years.

If commodity futures prices rise too much, perhaps as a result of speculative interest as there is now physical supplies will start to be delivered against short positions (a manufacturer looking to hedge its inventory of raw materials might have this kind of position).

In practice, there is never enough physical material readily available to deliver against all the short positions, so rising futures prices can only be offset by buying back crude futures contracts rather than making physical delivery. It takes time to divert and accumulate sufficient physical crude supplies to meet a rise in futures prices driven by speculative rather than fundamental factors.

To get an idea of the extent to which this process is occurring take a to look at the net contract short position for commercial hedgers from the US CFTC weekly Commitments of Traders report. Back in mid-2014 the net short position amongst commercial hedgers (actual producers and users of crude) rose to around 500,000, a record level. This position has since fallen to just over 300,000, but it is still high on an historical basis.

As we know from the months leading up to the oil market crash that began in the middle of 2014, oil futures prices can divorce themselves from the physical fundamentals for a long time.

The price of crude, as with any other commodity is only worth what someone is prepared to pay for it. The markets perception of scarcity in mid-2015 is such that participants in crude futures markets are now willing to pay less than half what they were paying just one year ago.

While theory suggests crude futures markets are anchored to the physical market as contracts expire, in reality the link is a lot more tenuous. As with the myth of Sistyphus the rock will eventually start to roll back. Timing when that will take place and the catalyst involved is a whole different matter.

First published at www.oilprice.com