Barron’s had an interesting article on agricultural commodity trading last week: "Prepare for a Bountiful Harvest."
In the article, Barron’s recommends going long Archer Daniels Midland (NYSE:ADM) due to certain anticipated demographic and population trends. The article states: “The U.N.’s Food and Agriculture Organization estimates that agricultural production will need to increase by at least 70% worldwide between now and 2050 to meet the needs of more protein-hungry populations, particularly in the developing world.”
While there is no doubt that the world is growing, and the demand for food is growing along with it, it’s misleading to argue that ADM and other commodity traders will automatically benefit. This argument assumes a cartoonlike simplicity and doesn’t take into account all the complexities of the industry. It’s both misleading and irresponsible to claim that food prices going up means commodity traders will make money. Why? Because that’s not how the business works.
How Commodity Traders Make Money
Commodity traders are just that — traders that buy and sell commodities and match sellers with buyers; the heart of the business is managing trade flow and being a good middleman. ADM doesn’t produce corn; it buys it on the open market. For example, the majority of assets ADM owns are not production assets — they’re processing and distribution assets: ports, mills, grain elevators, etc.
Therefore, when the price of corn goes up, ADM doesn’t benefit, because it’s not in the corn production business, it’s in the corn trading business: It buys corn from farmers, processes it and sells the finished product. In fact, when corn prices go up, that’s a negative for ADM because its input costs just went up. And this is a critical distinction that Barron’s fails to address in the article. The real winner of higher corn prices is not the trader; it’s the farmer.
In fact, higher and fluctuating prices make life for commodities traders even more difficult. In a high-price environment, many farmers are ready to sell, so commodity traders are stretched thin trying to get product to market. This puts stress on the logistical supply chain, from processing and packaging all the way to distributing.
On the flip side, when prices are low, farmers are reluctant to sell. Many wheat farmers in North Dakota right now are unwilling to sell the wheat they finished from the spring harvest until they see higher prices. The commodity trader then has to exert extra effort to source the wheat from other parts of the world — this is time-intensive and capital-intensive and eats into the already razor-thin profit margins traders operate on.
Commodity Trading Isn’t Easy
In addition to the high capital and infrastructure costs, global traders have a host of other factors to deal with, such as credit risk, currency risk and sovereign risk. Let’s take large agricultural trader Bunge (NYSE:BG) as an example; this is a well-managed company with a nice mix of products ranging from sugar and fertilizer production to corn and wheat milling.
Bunge has substantial operations in Brazil: 60 percent of its assets are in the country. This exposes it to a large currency risk, since its Brazilian industrial costs are denominated in Brazilian real but its sales are in U.S. dollars. When the real increases against the dollar, Bunge is at a major disadvantage, since its costs increase on a dollar basis and its Brazilian exports become much less competitive.
This is the perfect example of the right company being in the right commodity at the right time, and yet its bottom line is getting destroyed by global currency movements that it has no control over. Even though Bunge is at the heart of the emerging market food growth story, its business plan can be dramatically derailed because of currency movements.
Emerging-Market Commodity Traders
The Barron’s article acknowledges that food demand will be driven by emerging markets, yet fails to mention some important emerging market trading houses. One is Olam International, based in Singapore. Olam is one of the top three traders of rice, coffee and cocoa globally, and is at the heart of the Asian-African trade axis, which is fast becoming one of the most important trade corridors in the world.
Even more important is that Olam doesn’t simply manage trade flow (e.g., buy cheap cocoa from Africa and sell it to Asia); it’s also involved in real value-added trade. For example, Olam will buy wheat from Argentina, ship it to its Nigerian mill and sell the finished product (flour) to the local Nigerian market. This means it records sales in the heart of emerging markets, an overlooked but absolutely critical factor that will generate high value in the long term.
Also, Olam is aggressively moving into acquiring production assets, such as coffee plantations and rice farms. The companies that are able to acquire the most production assets will be long-term winners since they have a natural cost hedge and can benefit fully from price upside; this is in stark difference to a broker who’s matching buyers and sellers. Although Olam trades on the Singapore exchange, any U.S.-based broker will be able to purchase and hold the shares for you.
The commodity supply chain is extremely complex, especially in agricultural sector, and arguments such as “food demand is growing, so buy Archer Daniels” overlooks this critical factor. The business is much more complex.
That said, agribusiness is a long-term buy, and if you’d like to get broad exposure to the industry, then take a look at products such as the Market Vectors Agribusiness ETF, MOO. MOO gives you broad exposure to the industry and has a healthy balance between producers, traders and fertilizer companies and also among commodities: corn, sugar, coffee and cocoa, among others. For investors looking for broad-based agribusiness exposure, MOO is a good option.
Disclosure: I do not own any of the stocks mentioned.