Article Thriving in the New Global Agribusiness Environment

ARTICLE

Thriving in the New Global Agribusiness Environment

Julian Eyre
Julian Eyre
Openlink Contributor | September 8, 2015

Executive Summary

Today's global agribusiness organizations face unprecedented levels of complexity as their trading and risk environments have changed. Shifting and volatile markets, the use of multiple disparate and often outdated systems, and a lack of visibility into their operations have left organizations pondering how to simplify these complexities and better manage their risk. Wherever your firm is positioned in the value chain, regardless of its focus—grain, oilseed, coffee, cocoa, or any other commodity—the world has and will continue to change. Adapting to these changes has never been more crucial.

Recent price dynamics have amply demonstrated that even subtle forms of risk can compromise hedge effectiveness amidst some of the most benign market environments.

For example, recent bumper crops have eased input costs for certain firms, such as those involved in grains or oilseeds, but, if history is any guide, the relative stability of margins will not continue for long. Such flux in the markets forces organizations to rethink their approach to stay ahead of the curve and become proactive rather than reactive in their decision making process.

A commodity trading and risk management (CTRM) solution can provide the transparency and simplicity your business demands in this new environment. A CTRM system provides several key benefits that are explained herein and include:

  • Consolidating disconnected data from multiple, obsolete systems into one system for transparency across the organization and a complete view of financial and physical risks, including quantity and quality across the value chain
  • Increasing capital efficiency and implementing more effective hedging strategies across the supply chain to maximize revenues and profitability
  • Accessing global prices and transportation rates in real time to capitalize on optimal market positions and arbitrage opportunities
  • Improving reporting capabilities while integrating with third-party financial software to allow for automatic and accurate calculations, maximizing the existing corporate infrastructure

Transparency across the Organization

Agribusiness organizations face challenges from many different angles, but perhaps none more significant than the matter of sufficient quantity and quality of the original crops. Supply, or a lack thereof, presents as great a challenge as any—for without quality product, few other challenges even exist. The production of substantial, quality crops coupled with high demand clearly drive the market. Recent trends in the market environment for certain commodities have been fairly balanced. In many cases, prices have stabilized or even trended lower since 2012. U.S. bumper yields have helped achieve a greater balance in supply and demand within the grains and oilseeds market segments. Current conditions suggest that stocks will build, which should continue to put downward pressure on volatility.

Stability does not, however, imply a lack of uncertainty. Risks are still quite apparent among grains and oilseeds, as well as other key commodities as depicted in Figure 1 below.

Yet, questions abound as to the quality of the crops. Protein content appears under threat because of rains during harvest in the Northern Plains of the U.S. and in France. Consequently, some market participants expect a shortfall in milling quality wheat coming out of the U.S. and E.U.; the Black Sea crop may meet outstanding demand, but geopolitical risk around Ukraine could conceivably disrupt exports.

Meanwhile, the presence of vomitoxin, a toxic fungal residue, in certain key crops has re-emphasized the need for effective tracking of quality, origin and other key parameters. For example, one major North African importer indicated that it would not accept mixed batches of wheat from Europe.

Commodities firms pay careful attention to all of these supply and quality challenges as they look to understand how it will drive the market. However, with quality specifications and supply quantities coming in through various sources and continuously changing, how is any single organization expected to keep up, much less look ahead in an effort to predict future market trends? It is a tough question, especially for those using disparate or antiquated systems to manage their businesses.Investing in and implementing a CTRM solution automates and manages many of these fluctuating figures. With a CTRM system, organizations can easily track their volumes, quality specs, prices, tariffs, etc., through the sales contract in a single, integrated system. If materials are lost during a transportation transfer from rail to truck, those who need to know are informed immediately and can then decide whether to write it off or escalate the issues as needed. If a price originally entered changes, it can be quickly updated and all upstream and downstream factors adjust automatically, reducing manual labor costs and eliminating the potential for human error. Firms have no control over the volatility of the global landscape and its supply or quality thereof, but they can rest easy knowing that any and all data associated with their exposures can be tracked and managed in a single solution, providing complete transparency across the broader organization.

Effective Hedging Strategies

Risk management efforts in agribusiness have tended to focus on commodity price risk. Traditional approaches include:

  • Buying forward to lock in a future pricehEntering into option trades
  • Negotiating procurement contracts with embedded optionality that should limit the range of costs; or
  • Some combination of the three

Unfortunately, new derivatives regulations being implemented across the globe, such as Mifid 2, bring new challenges. For example, the regulatory frameworks in the U.S. and E.U. encourage the use of central clearinghouses to promote standardization and transparency across all trading activities.

Under these new regulations and standardizations, agribusiness companies face more stringent reporting requirements. Assessing the relative cost-benefit of different strategies, such as hedging versus not hedging or executing a trade through a clearinghouse versus a direct counterparty, requires enhanced analytics that account for margining and collateralization, both of which change the very economics of hedging. Firms that still rely heavily on spreadsheets to help define, manage, and analyze their hedges should consider updating to a fully integrated and automated CTRM system.

Staying ahead of the curve is the ultimate goal. Rather than reacting to changes as a result of uncertainty in the market, CTRM users can exercise what-if scenarios to analyze market possibilities and understand the potential impact on P&L. Organizations can create a level of security by proactively managing effective hedge strategies across the supply chain, ultimately maximizing revenues and profitability.

Capitalizing on Market Positions and Arbitrage Opportunities

CTRMs are particularly effective because they can incorporate or seamlessly interface with different functions across an organization. As hedging becomes more cash-intensive, it becomes increasingly important for the treasury and risk management functions to have a shared, firm-wide view of global cash balances and cash flows in real time. A CTRM solution pulls all of the required data from interfaced third parties and from within the system itself for visibility into an organization's financial positions.

Truly effective hedging in the agribusiness industry requires an integrated view of risks that coherently encompasses all physical and financial exposures. This includes the interaction of commodity, currency, rate, liquidity, and credit risks, as well as the implicit optionality arising from decisions around commodity type, processing, and logistics.

In some instances, a CTRM can put a familiar hedging choice on a more rigorous, analytical footing. With a CTRM, a producer can weigh the relative merits of shorting futures, entering a swap, or buying a put option. On the other hand, a vertically integrated business is able to look at its net exposure across production and processing and recognize natural hedges across the value chain.

A holistic view of market positions can help a firm identify new hedge strategies or even arbitrage opportunities. Historically, the volatile coffee market has been ripe for arbitrage due to the Arabica-Robusta spread, which has traded at close to USc100/lb for much of 2014—nearly double the average spread in 2013. However, coffee does not have a monopoly on innovative hedge opportunities.

Cocoa, for example, has tended to exhibit less volatile pricing with a time-lagged correlation to the GBP/USD exchange rate due to pound-denominated contracts trading in London and New York. This presents both a cross-hedging opportunity that uses commodity and FX hedges in tandem, as well as the possibility of arbitrage between New York and London cocoa contracts.

Integrated risk management enables real options and what-if scenarios to be valued. From a purely economic perspective, the decisions of if and when to commit to processing various input commodities on a future date should be contingent on forecast gross processing margins (GPM). A sophisticated CTRM can offer the analytical tools that enable a firm to understand the likely costs of different operational processes based on real world constraints such as capacity limits.

Real-Time Reporting: Visibility across the Entire Portfolio

Real-Time Reporting: Visibility across the Entire PortfolioWhen thinking about an uncertain future, agribusiness firms have traditionally put more emphasis on production planning. Even with a solid risk management program in place, transparency is often fragmented. Treasury, procurement, sales and trading divisions typically use distinct tools, processes, and technologies; however, they are often disparate and fail to provide a clear picture of the business.

An enterprise-grade CTRM can streamline workflows and allow timely data to be shared coherently across business functions—from procurement to accounting. Dashboard reporting functionality gives senior management greater visibility into the sources of risk and return, facilitating more informed decision making.

When an organization views its value chain through a risk management lens, it can make better strategic and tactical decisions within the wider context of total margin management. Understanding how paying a premium for sustainably sourced cocoa will impact a margin means solving a multifaceted problem. The firm must understand the forward cocoa curve, alongside locational and quality basis risk, as well as freight costs, currency volatility, and credit risk in order to fully anticipate hedge-related collateral and margin costs. The organization must also consider the price elasticity of demand among consumers.

Agribusiness risks are complex and interrelated. However, a CTRM built with an integrated risk management architecture brings value to every aspect of the business. Implementing a system such as that allows firms to hedge more effectively and be better prepared for the ever changing marketplace. It also allows organizations to gain more utility out of existing systems and infrastructure due to the ability to integrate with third-party financial software. Adopting a CTRM solution is a vital step toward total margin management and enhanced transparency around the financial, physical, and process-related drivers of P&L.

How Openlink Can Help

Agribusiness organizations are acutely aware of the major challenges and issues they face. Shifts in market conditions, financial regulations, and consumer trends have left the global agribusiness industry encountering new levels of risk management complexity. Mitigating these risks is important to not only maximize profitably but also to minimize exposures, increase efficiency, and optimize positions. CTRM solutions help firms navigate the ever changing agribusiness environment as well as provide key benefits to making them more competitive in the marketplace.

Openlink is a CTRM software provider with over 20 years of experience providing agribusiness organizations with complete management solutions. If you buy, sell, warehouse, merchandise or transform agricultural and soft commodities into finished products or by-products for distribution and sale, we can help you.

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