El Niño And La Niña: Rattling Commodities

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Includes: CORN, DBB, JJC, JJN, JJT, JO, KOL, NIB, RIO, SGG, SLX, SOYB, VALE, WEAT
by: Arya Nakhjavani

Summary

A strong El Niño, followed by a strong La Niña, will result in severe weather anomalies around the global that can be predicted to affect the production of various commodities.

Current El Niño conditions are nearly identical conditions to the 1997 record setting El Niño.

The El Niño will continue through the Spring and then transition into a ENSO-neutral phase that will most likely be followed by a La Niña event.

A strong El Niño after a five-year neutral stage on the El Niño Southern Oscillation Index (ENSO), similar warm temperature anomalies to the strongest El Niño ever recorded, and high chance of La Niña following the El Niño provides unique opportunity for investors.

"El Niño" refers to the warm phase of the El Niño Southern Oscillation (ENSO) during which unusually warm temperature anomalies are recorded in the South Pacific and typically occurs, on average, for nine to twelve months. During "normal" or neutral conditions of the ENSO, trade winds push the warm water westward, which allows currents to pull cold waters up along the South American Coastline. However, during an El Niño, these trade winds cease pulling warm water and the warm water is instead pulled up the South Pacific Coastline. These ocean temperature anomalies cause massive shifts and irregularities in global weather patterns which have historically affected the price of certain commodities. Multiple independent studies have already concluded a correlation between the observance of SST Anomalies (ENSO cycle) and the variation of commodity prices. An International Monetary Fund study conducted by Allan D. Brunner found that "over 20 percent of the variation in these [commodity] prices are accounted for by ENSO shocks." While a study by the International Research Institute for Climate and Society at Columbia University found that fifty percent of the variation in local weather conditions globally can be explained by variation in the ENSO cycle.

The El Niño also affects the upwelling process that brings the colder nutrient-rich water to the surface. This process of upwelling increases the biological productivity of surface waters. The decreased upwelling that occurs during an El Niño can have significant negative economic impact as international fishing markets are threatened with lower outputs.

In addition to the many changes, El Niño has also been linked with an increase in certain epidemic diseases due to the shift in global weather patterns. The observed diseases are primarily those transmitted by mosquitoes which thrive in the warmer temperatures.

Historically, most El Niños occur coupled with a period referred to as La Niña. "La Niña" refers to the cold phase of the ENSO during which unusually cold temperature anomalies are recording in the South Pacific. The event has been recorded to occur with its coupled El Niño dating back to 1876. During this La Niña oscillation of the ENSO, sea surface temperatures across the Eastern Pacific Ocean drop roughly 3-5 °C. This results in significant changes in global weather patterns which can affect the price and production of certain commodities. Together, the El Niño and La Niña form the extremes of the phenomenon known as the El Niño Southern Oscillation.

Though similar, La Niña is not the identical opposite of an El Niño. While El Niños can last up to one year, La Niñas typically last anywhere from one to three years of varying severity. Unlike the El Niño, La Niña's effects on fishing are negligible compared to the destructive force of the El Niño. In addition, La Niñas can occur in a mutated form called "La Niña Modoki," which differs from the regular La Niña. A normal La Niña occurs when the surface sea temperatures over the eastern pacific drop. However over the last two decades, a shift westward has been observed. The word "Modoki" is a Japanese word meaning "similar, but different" and have been increasing in frequency of occurrences. Currently, there is much debate on whether the occurrence of La Niña Modoki is a result of global warming.

Source: National Oceanic and Atmospheric Administration and NASA Jet Propulsion Laboratory

With its severity, the current El Niño will be followed by a short neutral period and then a predicted La Niña. As predicted, the El Niño phase of the El Niño Southern Oscillation has lasted through the 2015 winter and is predicted to continue strongly into the 2016 spring. This El Niño period is forecasted to end roughly around April or May. Following the El Niño, the coming La Niña has been forecasted. The ENSO and its patterned oscillations can be analyzed and its effects observed and forecasted. The effects of the El Niño Southern Oscillation has been extensively analyzed by organizations which focus on forecasting such as NASA's Earth Observatory and the NOAA's Climate Prediction Center. From the data they collect, information can be extracted that reflects shifts in related financial securities.

El Niño

During the warm episode of the ENSO, known as "El Niño," due to the forecasted and historical data available on its effects globally, the following recommendations for investment are advisable. Historical data as well as future forecasted data on the impact of the El Niño on global surface temperatures and precipitation patterns have been converted to actionable investment data. The majority of the world's cocoa beans come from the Ivory Coast and as a result of the expected dryness, cocoa output will likely be adversely impacted and the same extreme dryness will affect the coffee yield in Columbia. Southeast Asia will be hit hard with extreme dryness that will greatly impact production of coffee, rice, palm oil, rubber and sugar.

During El Niños, Brazil, the top sugar exporter, historically experiences heavy rains which will cause delays in harvest of sugarcane and lower levels of sugar yield per crop. The weak monsoon season will harshly hurt the Indian agricultural market, as the dry conditions hurt output of cotton as well as sugar. The dryness of Indonesia with adversely impact the mining of copper and nickel. With this decease in production in Indonesia, Peru historically experiences flooding which coupled with the shutdown of two major mines, will cause increases in the price of Zinc. This decrease in the number of hurricanes and severe weather events which occur in the Atlantic ocean can effect the production of resources which are active along the coast line as well as in the Gulf of Mexico: primarily, the domestic production of oil and natural gas. With this trend of decreased hurricanes, oil rigs and natural gas rigs are allowed more weeks of operation where typically they would be unable to operate due to severe weather or hurricanes.

La Niña

During the cold episode of the ENSO, known as "La Niña," due to the forecasted and historical data available on its effects globally, the following recommendations for investment are advisable. Historical data and accurate forecasts can estimate the occurrence and impacts of a La Niña following the El Niño. The increased wetness which results from excess rains threatens to cause massive flooding which greatly threatens the production of coal, cattle, iron, bauxite (which is processed into Aluminum) and petroleum products. Western Australia exports 20% of the worlds Bauxite and as one of the world's top producers, will negatively impact the output for the year.

As a result of the colder surface sea temperatures, the subtropical ridge position and formation of tropical cyclones shifts westward. This causes a greater threat of landfall for tropical cyclones to China as well as the formation of tropical storms and heavy rains over Southeast Asia. These threaten the production of rubber, palm oil, coal, and tin as flooding and heavy rains create poor conditions. Droughts and lack of rains in Central America and southern South America will negatively impact the production of soy beans as well as corn while the heavy rains and flooding in north South America threaten the production of Columbian Coffee. With the decreased rainfall coupled with the expected extreme dryness of the central region of North America comes the risk of lower than expected wheat, corn and soy bean yields. Additionally, the eastern half of North America will be experiencing warmer than expected weather, and as four of the top five largest consumers of natural gas are within this region, natural gas prices are expected to be heavily impacted.

Furthermore, a study conducted by the Department of Agricultural Economics at Mississippi State University found that both the El Niño and La Niña events could be correlated to a statistically significant reduction in corn yields in the Western and Eastern Corn belts. This correlation was found to be stronger during La Niña events than El Niño oscillations.

Source: National Oceanic and Atmospheric Administration

Analysis

The El Niño in 1997 was one of the strongest El Niño phases ever recorded. Using sea surface temperature data from the National Oceanic and Atmospheric Administration (NOAA), the similarity between the 1997 El Niño and the 2015 El Niño can be observed. NASA as well as the NOAA have used this comparison to hypothesize that the 2015-2016 El Niño will be of similar severity to the one recorded in 1977. According to data from NASA, the current El Niño phase has shown no signs of weakening. The 1977 El Niño peaked in November with the majority of its global impact hitting in December. As surface sea temperatures continue to rise, NASA's Jet Propulsion Laboratory is confident we have not seen the peak nor the full impact of the current El Niño. Predicting the peak of an El Niño is an important metric in determining when the majority and most severe weather anomalies will occur. Using models constructed by various agencies, shown in figure below, we are able to use the NOAA predicted average of these models to give us the most likely timeline. These models aggregately show, through the dynamic average, that the El Niño will persist through the spring and will may linger into the summer before reaching the full neutral phase. The International Research Institute, along with the NOAA, predict using their models as well as an aggregate average of all accurate existing models that the El Niño will continue strongly through March and into April. This forecast can be coupled with the historical observations of the largest variation on global local weather patterns to show that the majority of the variation of weather patterns as a result of the ENSO cycle will occur in the spring.

Though a La Niña occurring following an El Niño is not guaranteed, data suggests that the probability of one occurring is significantly increased with stronger El Niño periods. Every strong El Niño since the 1957 has occurred coupled with a La Niña of relative strength. The data suggests that strong El Niños occur coupled with strong or moderately strong La Niñas. Of the last 10 La Niñas since 1970, eight have been classified as "La Niña Modoki" and of those eight, five have followed strong El Niños. La Niña Modoki events tend to cause increased precipitation over northern and northwestern Australia rather than the typical eastern Australia. Currently, the Climate Prediction Center of the NOAA predicts that the El Niño will last through the spring of 2016. The El Niño will then transition into a ENSO-neutral phase that will most likely be followed by a La Niña event. Most models support this forecast but differ in the exact month that the El Niño will end. As you can see, the probability of the El Niño continuing decreases slowly until the May-July range where it is 40% and continues to decrease while the probability of a La Niña jumps from 30% to 50% over the same period.

Risk Factors

Analysis of macro weather patterns as well as predicting the phases of the ENSO can be difficult at times with so many factors and variables involved. One of the primary risk factors involved with the exact timing of occurrence of the El Niño Southern Oscillation, is the vast and many times unknown variables that can play a significant and unforeseen role. Though the models and projections used in this report are the most accurate models that can be formed given the information constraints, the models themselves are subject to change at any time as the relative agencies update their forecasts.

Currently, the commodities markets seem to be unstable as the recent general market volatility has made the investors unsure of future outlooks. As a result, many have fled away from more speculative markets such as futures and commodities and have flocked to more insulated investments. Though the global weather impacts of the cycles of the ENSO effect are generally patterned and predictable, there exists a risk that some or several of the predicted variations does not occur. However, it is important to note that large deviations from the expected observable weather changes during a ENSO cycle is highly unlikely.

Recommendations

Given the predicted impact on the production of certain commodities that I have discussed above, I will also list the commodities that I think will be most predictably impacted. Though various studies have been conducted on the degree by which different commodities are affected by either the El Niño or La Niña, I believe that my list is viable given the above mentioned changes in weather patterns. Of course, half of the commodities depend on a La Niña event occurring in 2017 or perhaps in the immediate years to follow and therefore my timeline is subject to change.

Here is an easy list of ETFs and ETNs that represent the commodities I mentioned above.

El Niño 2016

  • Cocoa - Dow Jones-UBS Cocoa Total Return Sub-Index ETN (NYSEARCA:NIB)
  • Coffee - iPath Dow Jones-UBS Coffee ETN (NYSEARCA:JO)
  • Copper - Dow Jones-UBS Copper Total Return Sub-Index ETN (NYSEARCA:JJC)
  • Nickel - Dow Jones-UBS Nickel Total Return Sub-Index ETN (NYSEARCA:JJN)
  • Soy Bean - Teucrium Soybean Fund ETF (NYSEARCA:SOYB)
  • Sugar - Dow Jones-UBS Sugar Sub-Index Total Return ETN (NYSEARCA:SGG)
  • Zinc - PowerShares DB Base Metals Fund (NYSEARCA:DBB)

There are no pure Zinc ETFs available in the US Markets but zinc makes up roughly one third of the exposure that investors get from DBB.

La Niña ~2017

  • Aluminum - Dow Jones-UBS Aluminum Total Return Sub-Index ETN (NYSEARCA:JJU)
  • Coal - Market Vectors Coal ETF (NYSEARCA:KOL)
  • Coffee - iPath Dow Jones-UBS Coffee ETN
  • Corn - Teucrium Corn Fund ETF (NYSEARCA:CORN)
  • Iron - Rio Tinto PLC ADR (NYSE:RIO), Vale SA ADR (NYSE:VALE), Market Vectors Steel ETF (NYSEARCA:SLX)

There are no pure Iron or Iron Ore ETFs for investors but you can gain exposure using some mining companies or the Steel ETF which has 30% exposure to iron mining.

  • Rice - Unfortunately, there are no common ETFs or ETNs which give exposure to rice. The largest grants a 2.85% exposure.
  • Sugar - Dow Jones-UBS Sugar Sub-Index Total Return ETN
  • Tin - Dow Jones-UBS Tin Total Return Sub-Index ETN (NYSEARCA:JJT)
  • Wheat - Teucrium Wheat ETF (NYSEARCA:WEAT)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a registered investment advisor or broker/dealer. Readers should conduct their own research and due diligence and obtain professional advice before making investment decision. I will not be liable for any loss or damage caused by information obtained herein. Readers are solely responsible for their own investment decisions.