Abundant stocks and lower prices continue to be features of the global food market. Barring any weather events this is unlikely to change in the foreseeable future. We take a look at the outlook for the soft commodity sector and how traders can protect themselves.

The agricultural commodity sector has not escaped the volatility which has plagued the commodities market over the last 18 months. While the beginning of 2015 saw a steep increase in prices this was mainly due to the uncertainty of adverse weather conditions on crops. As a result, this quickly turned to a downward price trend as expectations of another record crop started to weigh on prices across the board.

The outlook for the year ahead

While external factors continue to make it difficult to predict what will happen in the commodity market this year, abundant supplies are keeping international prices under pressure.

Market analysts predict the downward price trend is unlikely to be reversed, at least for the time being. Energy price prospects remain subdued and with economic uncertainty in major importing countries such as China, there is little sign of an upturn in global demand prospects. However, weather events can easily turn abundance into scarcity. As such, prices will always be susceptible to major swings.

Until a major weather event occurs, however, it is unlikely that prices will rise significantly. This will continue to put pressure on the income of major producers and indeed on those traders who rely on market volatility to make money.

Change in commodity prices in 2015 FOD Food price index 2002-2004=100

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FOD Food Commodity price indices 2002-2004=100

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Source: Food and Agricultural Organisation of the United Nations

What does this mean for traders?

Where a continued and sustained low commodity price results in producers being unable to cover their own production costs, there will be an increase in, and higher risk, of defaults. Similarly, a highly volatile price can result in an increased risk of default as contracts may cease to be profitable for the buyer or seller depending on the direction of price movement. For commodity traders there are a number of ways that you can protect yourself.

1. Complete due diligence on your counterparty

It is likely that there will be an increase in speculative traders. Smaller, new entrants should be treated with caution as these market entrants may have no assets, or what assets they do have may be in jurisdictions where enforcement may be problematic. Enforcement is often challenging where speculative traders default.

2. Get your fundamentals right

It is imperative that your contract terms are strong. Often contracts are ignored as a result of the need to sell, however this of course increases your risk. Ensure you agree to an enforcement friendly jurisdiction and governing law (such as English law). In the spot market this is often standardised in Trade Association contracts such as GAFTA and FOSFA. This will provide you with greater protection should something go wrong and help increase your chances of enforcement.

3. Ensure your contracts are back to back

Traders take on all counterparty risk but your risk can be minimised by having your contracts back to back.

Wheat

  • World wheat inventories are forecast to increase to their highest level in 13 years
  • Higher outputs reported from Australia, China, Morocco, Turkey, Ukraine and the United States
  • Feed use is forecast to grow by 4.2%, largely driven by stronger demand in Asia and North America
  • Wheat prices fell to a five year low in August and September 2015

Coarse grains

  • Large supplies in several exporting countries are likely to intensify competition for market share
  • Projected contraction in world import demand, particularly in Asia
  • Maize accounts for nearly 80% of the world’s coarse grains output

Rice

  • International rice prices have continued to fall amidst weakening world import demand
  • Has been deeply affected by the unfavourable climatic conditions associated with El Nino
  • With trade rebounding in 2016, inventories carried over by major rice exporting countries are anticipated to shrink substantially

Source: Food and Agricultural Organisation of the United Nations

Traders need to proceed with caution. Getting the basics right will help protect them once the market turns around.