By Jacob Bunge, Financial Correspondent and Michael S. Fischer, Senior Financial Correspondent
Wednesday, December 19, 2007 6:09:08 PM ET
CHICAGO and LONDON (HedgeWorld.com)—Commodity trading advisers see big possibilities in the agricultural markets for 2008, if investors can navigate the rising volatility that's rocked the markets in the past year.
For professional traders, 2007 has been a year of transition in the agricultural markets, as they adjust to the new and heightened level of volatility that might be their new reality. Emerging markets' demand for raw materials and government-mandated biofuel programs are tightening supplies and lifting prices of agricultural commodities, while electronic trading drives ever-growing volume and new players are drawn to the markets by contracts' record highs.
Doug Carper, president and head trader of Lincoln, Neb.-based DEC Capital Inc., said he's reminded of the changes faced by energy traders as they watched prices in those markets double, and in some cases, triple. "A lot of people in that area had a difficult time transitioning to a much higher price plane," he said. "I think it's a case where professionals have to be more sensitive to managing volatility risk than ever before."
Mr. Carper speaks from experience. His vehicle, the DEC Futures Fund, got off to "a pretty good start" in 2007 and was up sharply in the first quarter, only to suffer through a deep decline in the second. Recovery began in the late summer, he said, but the fund's performance remained negative until the fourth quarter. He said he's currently projecting the fund would end the year with a 10% gain. Since inception, the vehicle has returned an annualized 17%.
Another firm that weathered 2007's significant volatility is Milwaukee-based Brock Capital Management LLC. Its Discretionary Agricultural Program lost 17% over August and September, only to rebound with a 14.7% gain in October. That month the program benefited most from a long position in orange juice and especially a short position in wheat, which paid off nicely, according to the firm's principal and manager Richard A. Brock.
"In 2007, for the first six months, there was no persistent trend at all and very choppy markets in the grains—if you happened to catch the bull market in wheat, that was pretty much the only good opportunity, but you still could've lost it all in the choppiness of corn and beans," Mr. Brock said. "The opportunities came in the second half."
The program is currently sitting on a 1.1% return for the year, though December's performance would probably add to that total, Mr. Brock said. He also predicted that his program would see big gains over the next two to three months as grain markets reached their peaks. "Ags, I think, were some of the best opportunities across all the commodities these past couple months, and that's going to continue for the next six months," he said.
But with the continuing high level of volatility in these markets, not much is certain. This year's bull market in wheat, for example, came as a surprise to Mr. Brock, and he now attributes it to heavy buying by index funds. At the peak, he said, index funds' position amounted to 250% of the crop, and as such their buying power far exceeded many traders' expectations. On the other hand, when the index funds stop buying, traders face downside risk. This was what provided Brock Capital's October windfall in the wheat market.
"I think that's where the soybean market is right now," Mr. Brock said. "[Index funds] have large long positions in soybeans and corn now, and unless they have more cash coming in the next few months … it will start to wane a little bit. Bull markets need cash to keep coming in. We saw it in wheat."
Index Funds and Other Influences
These phenomena, however, reflect a deeper change in the agricultural markets brought about by the arrival of index fund money. The real impact became obvious late in the first quarter of 2007, Mr. Brock said, and agricultural traders have had to adapt quickly to the new environment.
"As long as you recognize [index funds' presence], it can work in your favor, but it's important to recognize it changes the fundamental structure of a market," said Mr. Brock. "Markets don't react the way they used to, and that's why a lot of technical trading systems have had difficulties in the past couple of years, particularly in ags, because the market doesn't trend that well anymore."
At DEC Capital, Mr. Carper said he sees another factor—much of the volume going into trading floors and listed exchanges is being driven by hedge funds and other vehicles hedging over-the-counter transactions. Many of these transactions, Mr. Carper said, are very complex and the risk is difficult to manage, while the transparency is nowhere near the level required of CTAs. "It's wild, very wild," he said. "I would say that's a dynamite situation that could just get completely out of control."
Meanwhile, the growing momentum behind biofuel is exacerbating an already tight supply for agricultural commodities both domestically and globally, according to Mr. Carper. "[Biofuel] sounds wonderful, and it's like pulling a rabbit out of a hat for some politicians, but naturally it's disrupting the supply dramatically," he said.
Food prices are far more inelastic than fuel, Mr. Carper said, but they cannot compete against mandated demand. "So we have what could turn out to be a spectacular story unfolding here, but it could be spectacularly more so with any kind of hiccup or disruption in supply," he said. "We're trading on some uncharted territory, not only on prices, but on policy."
Not everyone foresees soaring prices. Mr. Brock, who described himself as something of a contrarian, said he believes the markets are on the brink of a long-term downtrend in energies, as those markets have already discounted all the bullish news that's come their way. "In 2008, overall, we'll see the opposite of 2007," he said. "It was a year of inflationary trends in agriculture and energy commodities, and I think 2008 will bring bear markets for both. . . . We're short the world."
Ags in 2007 and a Look Ahead
In their year-end commodities review, analysts at London-based ETF Securities wrote that in 2007, the attention of many agricultural commodities, propelled by high oil prices, turned from food to fuel. As the year progressed, this became a political issue that resulted in some countries reducing their exports or implementing export taxes. Resulting increases in food prices caused unrest among the public and a number of countries.
Besides new sources of demand such as ethanol, many agricultural commodities suffered from weather extremes while record-low inventories have supported prices and added to the effect of any supply disruptions caused by weather, according to the report. In addition, many commodities felt rising input costs, which are driven by rising energy prices and in particular rising fertilizer costs owing to rising demand.
Following is ETF Securities' roundup of the 2007 performance of agricultural commodities and the outlook for 2008:
The DJ-AIG Cotton Total Return Sub-Index was just about flat over the past 12 months. The positive effects of U.S. acreage rotation from cotton to corn and expectations of further rotations to wheat and other grains have been largely negated by increasing yields and higher-than-expected production in the United States. Long term, rising wealth levels in emerging markets may bode well for cotton demand.
The DJ-AIG Sugar Total Return Sub-Index fell by 20% over the past 12 months. High sugar prices in 2006 led to production increases in three large exporters, Brazil, India and Thailand, and to a sizeable global market surplus in 2007. Positive factors going forward include higher energy prices that will increase demand for sugar-based ethanol in Brazil, and higher corn prices, which should encourage substitution away from high-fructose corn syrup to sugar.
The DJ-AIG Coffee Total Return Sub-Index decreased by 4.5% over the past 12 months. Looking ahead, positive portents include tightening of land availability in Brazil as coffee, soybeans and sugar compete for acreage. In addition, coffee consumption has steadily increased in Japan and China, traditionally tea-drinking countries.
The DJ-AIG Corn Total Return Sub-Index fell by 4% over the past 12 months. After surging in 2005 and 2006, driven by burgeoning demand from ethanol-producing facilities, corn prices stabilized in 2007 because of record production in both the United States and worldwide. China, the world's fourth-largest corn exporter in 2006, could soon become a net importer of corn for the first time in more than a decade. China also suspended approvals for corn-based ethanol projects in an attempt to keep food price inflation under control. World inventories for 2008 are forecast at 14% of global demand, the lowest level seen in more than three decades. Despite massive crop rotation toward corn acreage this year, the United States is expected to achieve only a modest surplus, and the world market is expected to remain in deficit.
The DJ-AIG Wheat Total Return Sub-Index increased by 56% over the past 12 months. Wheat prices hit a record high in October because of all-time low inventories and weather-related supply disruptions in various place around the world. Since October, prices have receded on expectations that high prices could reduce feed demand and increase incentives to plant more winter wheat acres.
The DJ-AIG Soybean Total Return Sub-Index and the DJ-AIG Soybean Oil Total Return Sub-Index increased by 53% and 48%, respectively, over the past 12 months. Soybean oil prices are highly correlated with soybean prices. The surge was driven on the supply side by a sharp decline in soybean acreage in 2007, a direct consequence of crop rotation from soybeans to corn, which will likely lead to a sharp drawdown in U.S. and world inventories. Prices also were supported by supply disruptions in wheat that motivated feed substitution toward corn and soybeans. The trend also was reinforced by market concerns over dry weather in Brazil. On the demand side, growth from Asia was strong, led by China's demand for feed. The strength of both soybean and soybean oil prices has also been associated with rapidly increasing demand from bio-diesel production facilities, which in turn has been supported by high energy prices.
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