Speculate or Integrate:
Rethinking Agricultural
Commodity Markets
Are traders and financial hedging tools really necessary
in today’s turbulent economy?
Authors
Bart van Dijk, partner, Amsterdam
[email protected]
Gotfred Berntsen, principal, Oslo
[email protected]
Ivar Berget, consultant, Oslo
[email protected]
G
lobal consumer packaged goods companies are struggling to
meet the challenges of supply security and price volatility as
they source agricultural commodities such as cocoa, coffee,
wheat and sugar. As prices peaked dramatically after the 2008 food
crisis, companies deployed more risk management strategies — using
traders and financial hedging instruments. Yet significant questions
remain about the true costs and benefits of these tools. We believe
the time is right to consider a fresh approach to commodity sourcing —
one that goes beyond superficial financial hedging to focus on the
underlying causes of volatility.
When the once largely predictable world of
commodities turned upside down, companies in
the consumer packaged goods (CPG) industry
scrambled to regain equilibrium and, on the face
of it, seemed to have found about as good a footing as was possible at the time. A closer look,
however, reveals a somewhat different picture—
both in terms of the problems facing the industry
and the potential solutions. The business of sourcing commodities—and the need to ensure they
arrive in the right place at the right time and at
the right price—has never been more pressing.
And an overhaul of the industry’s sourcing and
pricing practices could be overdue. Consider the
most important factors:
Sourcing commodities. In purchasing agricultural commodities, the principal concern is
how to secure supply and manage logistics such
that availability at production sites, at the right
time, is guaranteed. In tight markets, with global
giants sourcing huge shares of production, this
can be a challenge, particularly for companies
with a large base of commodity suppliers (farmers) that must be handled simultaneously.
The current solution is to use middlemen,
such as physical traders, to manage the large base
of farmer suppliers. Traders perform three functions: Match millions of farmers, often in Africa,
with customers that are mostly in North America
and Europe. Move large volumes of goods from
origin to customers and in the process manage
operational costs such as transportation, quality
control and storage. Manage financing and risks
by paying farmers before the harvest and even
before negotiating a price with customers, and
transferring risk to a financial player via the futures
markets. While it pays to contract with outside
traders for these services, there is a downside:
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companies are removed from their supply sources
and from understanding the operational realities
at the farmer level.
Pricing commodities. A second but equally
important factor in sourcing commodities is purchasing them at a competitive price. As commodity buyers and sellers consolidate into global
giants, deals are becoming larger, and the risk of
buying at the wrong price becomes even more significant. While commodity prices fluctuate, there
is a new expectation that purchasers will use financial derivatives to reduce volatility and deliver
stable prices for consumers and stable earnings for
shareholders. Today, many companies have commodity departments with dedicated financial
hedging professionals whose primary goal is to
deliver predictable input costs with smart positioning in the financial markets. In fact, financial
hedging has become an established best practice
for many leading firms.
The move into commodity derivatives is not
surprising as they provide a flexible mechanism
for managing price volatility—from securing
physical supply and increasing market liquidity
and cost transparency, to creating a way to develop
a more complex price structure. However, the
practices of traders and financial hedging in this
environment do not always make sense.
Nestlé follows close behind with 10 percent; the
top five cocoa-sourcing companies account for
almost half of the world’s production (see figure 1).
So why bother with traders at all? Certainly,
traders do not add scale on this now larger playing
field. And does buying from traders really improve
security of supply? In the event of a major commodity shortage, even the big players such as
Kraft Foods and Nestlé will have difficulty obtaining supply regardless of their large network of
traders. Furthermore, leading companies purchase
directly from manufacturers for most other products and other commodities; why not for cocoa,
coffee, wheat and sugar?
Traders are manipulating markets. There are
clear indications that traders are now in a position
to manipulate the markets and, indeed, have
done so. Most notably, this happened to a large
degree in cocoa bean trading during the summer of
2010 on the London Exchange (see sidebar: Trader
Manipulates the London Cocoa Futures Market).
Figure 1
The top five cocoa-sourcing companies account
for almost half of the world’s production
12%
The Trouble with Traders
Both CPGs and physical traders have become big,
but traders are perceived to be getting by far the
best deals. Are traders really necessary in a turbulent economic climate? Let’s look at four reasons
why they are not.
Industry consolidation removes the need for
traders. Industry consolidation in key global
commodities such as cocoa and coffee has been
dramatic. Kraft Foods, for example, sources more
than 12 percent of global cocoa production while
2
10%
10%
5%
4%
Kraft
Nestlé
Mars
Hershey’s
Source: A.T. Kearney analysis
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Ferrero
Traders perform a key role in transmitting information from
the farm gate to the market — a pivotal position that can be
used to manipulate the market and profit from uncertainty.
Many traders use their knowledge of a particular market to take speculative positions in
commodity markets. The large traders such as
Cargill, Armajaro, Louis Dreyfus and Olam employ
sophisticated intelligence-gathering operations,
including on-the-ground staff, in an effort to
obtain the latest market information. Cargill’s
employees, for example, count competitors’ trucks
at the gates of almost every cocoa warehouse in
the port of Abidjan in Ivory Coast to get a better
picture of the size of the country’s output.
Armajaro deploys its own weather stations to
assess growing conditions. In general, trading
companies perform a key role in transmitting
information from the farm gate to the market, but
this pivotal position can be abused to manipulate
the market and profit from uncertainty — the
incentives of the physical traders may not always
be aligned with their customers, the CPGs.
Traders survive on volatility. Traders have
little interest in increased productivity or more
professional farming. In fact, they might benefit
from the opposite. Imagine a situation in which
there is no variability in crop yield. Large companies might soon adopt sourcing strategies that
eliminate the middleman. Volatility is life support
for traders so why reduce it?
Some commodities, with a significant element
of trader financing, have not seen a significant
increase in crop yield over the past 10 years. The
leading supplier, Ivory Coast, lost crop yields per
hectare of 13 percent from 2000 to 2009 and has
Trader Manipulates the London Cocoa Futures Market
During a shortage of certified cocoa
stocks on the London terminal market, the trader Armajaro capitalized
on an opportunity. Was it manipulative? Unethical? You decide.
Armajaro bought a large volume
of cocoa futures contracts with expiration dates of July 2010. As the
expiration date approached, traders
(having previously sold this contract)
had to fulfill their contractual obliga-
tions with the London terminal
market, either by delivering certified
cocoa to the market or by purchasing
cocoa futures contracts with delivery
in July 2010. Armajaro took delivery
of 240,100 tons of certified cocoa,
but there was not enough cocoa in
the spot market available for delivery.
As a result, many “shorts” were forced
to settle their contracts in cash with
the “longs.” But, as Armajaro con-
trolled a large share of the July
2010 long positions, it conducted
a “squeeze”, extracting profits from
the shorts by bidding up the settlement price.
Sixteen participants operating
on the London market wrote an
official letter of complaint to the
Liffe exchange and the U.K. Financial
Services Authority about Armajaro’s
behavior.
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3
had virtually no increase since 1995 (see figure 2).
Clearly, the trader is not solely responsible for the
low yield, for it is a multidimensional issue. But
the fact that traders have no incentives to improve
yield or modernize farming is certainly a factor.
Hedging does not solve the problem. As discussed, most CPG companies hedge their price
risk and consider financial losses and gains as an
inevitable part of their business—a random zerosum game of transferring risk between hedger and
speculator. But is it really a random zero-sum
game? Or is there an element of competence in it?
The anecdotal evidence is certainly intriguing, for
even as some speculators lose money on trading,
there remains a plethora of consistently successful
commodity traders.
Upstream Integration:
“Hands On” Makes a Comeback
Securing long-term supply and price stability
requires some level of direct control over the
underlying causes of instability. With this in
mind, we suggest a new view on commodity purchasing — one focused on improving crop yields
and the physical security of supply. Rather than
attempting to manage uncertainty through shortterm financial “hands-off ” hedging and traders,
perhaps it is time to revisit upstream integration.
Upstream integration has two main objectives: To improve and maintain security of supply,
and to drive productivity of the entire value chain.
There are several ways to achieve upstream integration — (1) contract farming with cost-plus
pricing, (2) acquire or lease-operate farm land, (3)
acquire or lease farm land whose operation is outsourced to trusted farmers, and (4) integrate virtually through third parties.
Whichever model is used, it has to be customized according to a company’s unique factors such
as competence, financial situation, organization,
support systems and access to partners. However,
the underlying principle should always be to gain
Figure 2
Cocoa bean crop yield in Ivory Coast
Yield (kg/hectar)
800
700
600
500
400
300
200
100
0
1995
1996
1997
1998
1999
Sources: ICCO Annual Report 2008-2009; A.T. Kearney analysis
4
2000
2001
2002
2003
2004
2005
2006
2007
Year
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2008
2009
Rather than managing uncertainty with short-term financial
“hands-off” hedging and traders, perhaps it is time to revisit
upstream integration.
some level of operational control over the crops.
The benefits of direct involvement in the farming
process have long-term significance:
• Increased yields and improved efficiencies
• Improved quality control and brand image
• More transparency, which is vital for addressing
future supply
The farmers also gain advantage, including
more predictable incomes, access to markets, and
support in areas such as credit, technology and
education. Furthermore, with upstream integration, the CPG takes on the role of middleman.
Excess supply, which to some extent can be
planned, can be traded to less integrated competitors or on commodity exchanges. Financial instruments can still be used to obtain a target price—
but priced from the company’s perspective.
Yes, there are obvious risks related to upstream
integration. While shedding various threats associated with middlemen, some new operational risks
are introduced. Supply must be handled through
crop management, not by a network of traders.
Risk of commodity price fluctuations are replaced
by risks related to operational farming costs.
Moreover, many commodities are grown in parts
of the world with widespread poverty and corruption, which presents an increased risk of adverse
publicity. However, these new risks are relatively
small compared to those they replace. Clearly, running out of supply and steep and sudden core
commodity price increases are far bigger threats.
1
It is important to gauge the best time to
embark on upstream integration, considering
factors such as business importance — the commodity’s share of cost of goods sold and its volatility — and perhaps even your level of power in
the sourcing market.
For the risk adverse, an alternative to upstream
integration is to sign long-term and transparent
contracts with middlemen or suppliers. This will,
to some extent, improve security of supply and
reduce volatility, though not to the same level
as upstream integration. Moreover, any opportunity to exert a mitigating influence in these allimportant areas will be gone, which means many
of these challenges may quickly reappear.
Case Study: Yara and Upstream Integration
Before concluding our discussion, we want to
touch on one company’s success with vertical integration. Yara, a leading global fertilizer manufacturer, is competing in a consolidating industry
with long-term demand and short-term volatility
for finished products (food), and extreme volatility both in price and availability of commodities.
Demand is mostly inelastic, as the need for fertilizer stems from the need for food. However, prices
can fluctuate in the short-term given the relationship between the price of fertilizer and the price of
major agricultural products. For example, between
January 2010 and October 2010 the price of urea
increased by more than 20 percent.1
Urea is a key agriculture product used in manufacturing fertilizer.
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In fertilizer production, the main inputs are
energy derived from various sources: natural gas
and oil, and the raw materials of nitrogen from
natural gas, which are subsequently processed into
highly volatile intermediate products of ammonia
(63 percent), phosphorus (22 percent) and potash
salt (15 percent). Natural gas and oil are traded to
a large degree, while only 12 percent of global
ammonia production was traded in 2009.
Phosphorus and potash salt are not traded to any
significant extent.
The fertilizer industry has seen several internal acquisitions in recent years, particularly as
state governments became less involved and a
focus on business replaced a focus on food security. The nitrogen segment of the business is less
consolidated than the phosphorus and potash
segments, as the latter two commodities are avail-
The Cocoa Industry
Soft commodities are mostly grown
in tropical regions where crop yields
can suffer from a range of adverse
effects, including poor weather conditions, diseases, pests, insufficient
farm management, political instability and corruption. Nowhere are
these challenges larger than in cocoa
production. Because of concerns surrounding future supply, many of the
leading consumer packaged goods
companies are beginning to take
a more active role in the cocoa
value chain.
The cocoa value chain stretches
from mostly small farms in Africa
to the chocolate products sold in
retail outlets worldwide (see figure).
As global demand increases, any
uncertainty in supply can cause
significant price fluctuations.
Cocoa is mostly grown in developing countries where corruption
and political instability can affect
agricultural production. The world’s
largest cocoa-producing nation, Ivory
Coast, is divided along regional and
ethnic lines hardened by the 2002
civil war and is currently recovering
6
from the recent crisis resulting from
the refusal of its incumbent president
to accept defeat in the country’s
elections.
While other major agricultural
commodities are mainly produced
on large-scale plantations, cocoa is
unusual in that it is still grown overwhelmingly by smallholders. Low
prices in recent years have led to
underinvestment, which in turn has
resulted in aging plantations and
rising losses due to disease and pests.
In general, cocoa farmers have
limited access to modern agricultural
technologies, materials and market
information. Few have received
education to help them effectively
market their product and manage
their operations. And farmers have
almost no contact with the big trading houses and processors. The cocoa
beans are instead sold to middlemen
who deliver them to the ports of
Abidjan and San Pedro.
Chocolatiers and traders have been
encouraging farmers to set up cooperatives from which they can buy
directly. But they have had limited
success as most cooperatives last only
a few years before collapsing from
poor management or corruption.
A small number of multinationals
dominate the export market: Archer
Daniels Midland (ADM), Barry
Callebaut, Blommer, Cargill and
Petra Foods. These large companies
have a significant degree of vertical
integration in the market and are
active in both the producing and
consumer countries. In addition to
trading in cocoa beans, they manufacture semi-finished cocoa products
and industrial chocolate.
Figure: The cocoa value chain
Producer
Local
agents
International
purchaser
Processor
Food
company
Retailer
Source: A.T. Kearney analysis
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Consumer
able only in some regions. The overall industry
now has six to seven major global players; Yara is
number four with an estimated 7 percent global
market share.
Yara adapted to industry consolidation. It
acquired—and intends to continue acquiring—
other industry players to benefit from economies
of scale, and developed individual sourcing strategies for the various volatile commodities the company sources.
Developing a vertical integration strategy
in 2005, the company now sources commodities
of which it has no global sourcing share, such as
natural gas and other energy sources, on commodity exchanges and via financial hedging.2
It uses an upstream integration strategy for its
key commodities such as ammonia, phosphate,
and potash:
• Ammonia is an intermediate commodity, to
a large extent produced by Yara or in factories
owned partly by the company. Yara takes the
trader’s role in this part of the business, trading ammonia not used for fertilizer produc-
2
tion. For the past five years the company has
held between 25 percent and 30 percent of the
global ammonia trade.
• Phosphate is an even more integrated commodity and, to a large degree, Yara extracts the raw
material from mines it owns or operates.
• Potash is less vertically integrated, which Yara
executives regard as a major operational risk.
The company has publicly stated its intention
to increase its integration of potash producers
in order to mitigate the risk.
Managing Volatility
Managing price volatility through financial hedging of agricultural commodities is a short-term
solution to a long-term challenge. Large consumer
packaged goods companies have a unique opportunity to fundamentally restructure the industry
value chain. With their size and market power,
CPGs can increase transparency, improve efficiency, and stabilize commodities — both in terms
of supply and pricing. Investment today will bring
long-term benefits.
Yara International was formed in 2004 and its first acquisition was in 2005 when it purchased 30 percent of Russian fertilizer producer OAO
Minudobreniya (Rossosh).
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