Since the first round of the trade war between the U.S. and China in 2018, agricultural markets worldwide have been operating in an environment of extraordinary uncertainty. U.S. farmers have long counted on China as their top export market, but the see-saw nature of the trade negotiations — and China's decision to shift its purchases to other parts of the world — have radically disrupted traditional trade flows.
This uncertainty has reverberated in the agricultural futures markets, which provide a critical risk management service for the supply chain that flows between producers and consumers worldwide. Long-established pricing patterns have been thrown out of balance and trading volumes on major exchanges have declined as market participants have struggled to make sense of the headlines.
This has created new challenges for the futures brokers and clearing firms that support the agricultural industry. These firms provide access to the agricultural futures markets and clear trades for their customers, but they also serve as risk management advisors, helping clients adjust their hedging strategies to changing market conditions.
Recent history has not been easy for these firms. In the wake of the financial crisis, the clearing firm community has been burdened with an array of new regulations as well as increased capital requirements. On top of that, technological changes have added costs that have forced many players to reduce their footprint or even exit the market. Throw in a persistent low-interest rate environment for almost a decade, resulting in anemic returns on customer balances, and it's easy to understand why this corner of the derivatives industry has faced structural challenges.
One indicator is the number of clearing firms registered in the U.S. as futures commission merchants. According to FIA's FCM Tracker database, the number of FCMs that are holding customer funds for futures trading has fallen from 84 at the beginning of 2008 to 55 in June 2019.
The clearing firms that have weathered this storm, however, are lean and innovative companies that know what it takes to succeed. After years of heavy investment in regulatory compliance and an intense focus on operational efficiency, they are seeking new growth opportunities and working with exchanges and customers to help new products take root.
The challenges facing modern commodity markets are complex and there is much variance across the industry. But several firms spoke with MarketVoice about what they are seeing in their corner of the market right now, and what the future may hold for commodity markets going forward.
Changing Dynamics of Trade
Action in the soybean market illustrates how dynamic commodity markets have become lately. Consider that increasing trade tensions between China and the U.S. caused a massive 20% drop in soybean prices in early 2018, sending prices below $8 a bushel, the lowest level since 2008. Later that year, in November 2018, total U.S. exports of soybeans to China dropped all the way to zero as China retaliated against U.S. tariffs and instead imported more than 5 million metric tonnes from Brazil— nearly twice the volume of the prior year.
With persistent uncertainty around what Beijing or Washington will do next, clearing firms and the customers they serve have their hands full managing unpredictable moves in agricultural commodity prices. It's not just that markets are volatile, it's that the type of volatility is particularly difficult to manage.
Marc Ostwald, chief economist at ADM Investors Services International in London, explained that the trade war has caused short-term price volatility that is different than when fundamental factors come into play.
"Commodity prices, above all ags and metals and to some extent oil, have been very sensitive to trade war news, but the volatility is 'spikey'," said Ostwald. "In other words, Tweets and headlines spark very sharp movements in prices, in both directions, depending on whether the moment is one of irrational exuberance or deep visceral fear. But then in the absence of actual commercial activity, fundamentals reassert themselves, and price movements on that front are generally more modest."
One result is that some market participants, including both speculative traders and commercial hedgers, are pulling back from trading, he added. That effect has been compounded by the decision by several banks to reduce their market-making in commodities in order to conserve capital, which has reduced the amount of liquidity in these markets.
"This sort of spikey volatility leads to specs [speculative traders] and commercials being whipsawed and typical seasonal strip curve pricing patterns being blown out of the water, in turn making both sides wary of overly exposing themselves," Ostwald said. "To add to the complexity is the fact that a number of major banks have closed down or sharply reduced their market-making activities over the past nine to 12 months."
Serving Clients Through New Products and Education
While this environment of uncertainty has created many challenges for clearing firms and their customers, it has also created opportunities for clearing firms to develop new solutions for their customers. And in some cases, it has brought new customers to the markets.
INTL FCStone, one of the top nonbank players in the commodity futures business, has many years of experience working with agricultural market participants such as grain elevators and ethanol plants that use futures to manage their price risks. Recently, however, the company has been seeing new customers emerge in the food and manufacturing industries, according to Dave Smoldt, the firm's head of commodities North America.
Higher volatility in commodity prices, caused in no small part by increased uncertainty relating to international trade, has sparked an interest in more sophisticated risk management. Many of these customers have not been large users of derivatives in the past, so INTL FCStone is putting a lot of time and energy into education, Smoldt said, including numerous face-to-face seminars for prospective customers all across the midwestern states of the U.S.
INTL FCStone is also seeing growing interest in a handful of new products. Smoldt said one area of particular note is fertilizer, where manufacturer consolidations, transportation difficulties, historically high raw materials costs and an increasingly volatile international trade environment have aligned to create an uncertain marketplace with unique risk-management needs.
CME Group has listed fertilizer futures for many years, but volume and open interest only recently have begun to take off. Total volume jumped 50% in 2018, and Smoldt commented that there is now enough liquidity for the firm's clients to hedge their risks.
"Fertilizer is an example of a close partnership between FCMs and the CME, where the FCMs collaborate with the exchange on contract specs [specifications]and advise customers on how to use the contract," Smoldt said.
Demand for Structured Products
Another area of growth is in structured products that offer agricultural producers more flexibility than the standard exchange-traded futures and options. Several nonbank clearing firms have ramped up this business in recent years and say that it gives them more ways to serve customer needs.
For example, R.J. O'Brien has had success in marketing products called "accumulators," according to Thomas Meierotto, a commodity risk manager at RJO's office in Des Moines. He said these structured products allow farmers to sell their soybeans at a premium over the current price, in exchange for an offer to sell additional bushels if the price increases. The producer gives up the potential gain if there is a major rally, but he is rewarded if prices rise modestly, stay flat or even move lower.
"It's something customers have been interested in, because they are now less convinced that the [trade] situation will be resolved quickly." Meierotto said.
For farmers struggling to understand the whipsaw movements in commodity prices, that certainty can be very attractive. Meierotto pointed to calendar spreads in the soybean market as an example of the dramatic changes in pricing patterns. The price differential in calendar spreads used to "punish you for holding beans one crop year to the next" with the entire industry incentivized to "push the beans out the door as soon as possible" and avoid rising storage costs. Now that Chinese demand has disappeared, those spreads have hit the widest level in the last 10 years, and RJO has been working with its customers to adjust to this new normal.
Some may think volume would be booming in commodity markets. However, the data tells a different story. Top agricultural products including soybeans and wheat have seen volume decline so far in 2019 compared with 2018. Meierotto suggested that trend is happening because directional traders are reluctant to take positions.
"It's a very different environment now, where trade announcements come with very little warning, often just a tweet," he said. "As a result, there seems to be lack of participation among hedge funds and speculators." That naturally impacts volume in markets that his core agricultural customers are looking to access, he said.
Will Acworth and Kirsten Hyde contributed to this report.
