A recent article on Bloomberg highlighted the pressure that many commodity-trading companies (and commodity trading desks within banks) are under to make adequate returns. This has sparked a debate as to whether this situation is cyclical, a result of low prices and surpluses, or structural, part of a longer term trend. As usual, it is probably a mixture of the two.
Over the last few decades it has become increasingly difficult for traders to make a margin doing what they do best, moving commodities from surplus areas to deficit area. The reasons behind this trend are well documented. Price information travels so quickly now that geographical price differentials erode almost instantly. Meanwhile weather and crop information – and analysis – is so widely available that it is difficult to find an edge in predicting future supply.
In addition, trading partners are better educated now than in the past, and governments have largely exited the commodity-supply business, taking numerous inefficiencies with them.
At the same time there has been a shift in power from producer to consumer. Consumers who were once viewed as both too passive and too diverse to offer an opinion have now found a collective voice on social media. Once stampeded, they can be hard to stop. This has resulted in the strengthening of consumer trends such as the collapse of demand for orange juice or the war against sugar. On a more positive note, it has also resulted in a move towards a more sustainable and traceable supply chain.
Some of the bigger trading companies have reacted to reduced margins by increasing their activities on the futures markets, leveraging their knowledge of the physical commodity flows. In particular they have concentrated on the convergence of physical and futures prices at the moment of delivery. After all, this was the one area where they still had an edge.
Although they still have that edge it has become a crowded trade. It has become increasingly expensive to put on the physical positions against which to leverage the futures. Competition to do so is brutal, and the negative physical trading margins that result can quickly more than offset any expected gains from the futures. At the same time, as politicians and regulators continue to crack down on speculation it is becoming harder to justify the big leveraged futures positions that this business model requires.
As well as leveraging spot positions trading companies have traditionally tried to use their knowledge of physical trade flows to predict future flat price movements. In his book Homo Deus: A Brief History of Tomorrow, Yuval Noah Harari argued that electronic algorithms are now superior to humans’ biological algorithms. Unfortunately that probably also applies to commodity trading: computers now outsmart human traders. Algorithmic trading systems appear now to dominate market movements (at least in the short-term). When they pass through a market they often drown humans in their wake.
None of this is breaking news. The big trading houses have been aware of these structural changes for years, and have been slowly but consistently constructing alternative business models.
When I started with Cargill over forty years ago my first manager told me that the company often made a loss on the last leg of a grain trade, the bit from FOB to C&F. However, even then, that loss was already more than made up by the margins that they made at every stage up to FOB: (at that time) selling the seeds to the farmers; storing the grain in their silos; barging it to the export ports; and elevating it through their port terminals. Being involved at every stage of the process gave Cargill a considerable edge over any competitor that was just trying to buy FOB and sell C&F.
As well as earning a margin on transport and distribution, Cargill was also turning itself into a processing company, supplying food (or ingredients) in bulk to the big processed food manufacturers. Cocoa is a good example of that change. The chocolate manufacturers no longer buy or process cocoa beans themselves; they buy the cocoa butter and the powder from processors like Cargill. The food companies have stepped backed from managing processing facilities to doing what they do best, managing their brands.
Glencore Agriculture, starting from a cleaner slate, is quickly becoming a transport, distribution and logistics giant, building up a solid asset base of silos, terminals and transport logistics. They recently announced that eighty-five per cent of their profits now come from distribution, and only fifteen per cent from old-fashioned trading.
ADM is also taking a step back from trading to become more of an ingredients company, looking to supply, for example, flavourings and non-calorific sweeteners to the processed food companies.
Dreyfus and Bunge appear less sure of the direction they should be taking. The former made the headlines this week when key traders left the company. One source is reported as saying that “the departures were due partly to disagreements over trading strategy… Dreyfus wants to focus on trading of its physical grain assets, rather than proprietary buying and selling of paper contracts”.
Dreyfus appears to be trying a bit of everything, emphasizing their processing and distribution activities while arguing that the downturn in margins is cyclical and not structural. Bunge meanwhile appears to be wondering whether their future might not be rosier with a bigger partner.
Bunge and Dreyfus have been hampered by their past investments into the Brazilian sugarcane industry. Both companies took oversized bets that energy prices would rise, and that sugarcane ethanol offered a cheaper and more environmentally sustainable solution to mineral oils. Neither company foresaw the big increase in oil supply that was to come from fracking, nor the global mood swing against sugar itself.
The smaller trading companies are also looking at how to adapt. Some are turning themselves into consultancies, advising their clients on pricing and hedging. Some are trying to find small, higher margin niches. Others are making small, targeted bets into packing and distribution at destination, buying into the view that you can no longer make a return on market intelligence alone; you need physical assets.
There is an argument that agricultural commodity trading is unsuitable for a publicly quoted company, where investors traditionally look for both growth and steady income. Weather events and crop cycles have often resulted in trading companies providing the occasional stellar profit year, followed by long grinding periods of losses or low returns.
We are in such a period now, but is it enough to sit it out, like Wilkins Micawber, from Dickens’ David Copperfield, in the hope that “Something will turn up?”
Markets will eventually turn up; they always do. However the structural changes with the sector mean that the trading companies, big and small, have no choice but to adapt. The ones that can’t adapt will either disappear or be absorbed by the ones that can. Consolidation in the sector will result in larger companies that can take advantage of economies of scale, both industrial and financial. This in turn will lead to a more efficient and lower cost supply chain.
And that’s exactly what we need if the world is to feed the nine billion people that will be living on this planet by 2050.