When it comes to the weather, the only certainty today seems to be that it is getting more extreme. Much of Asia, from Indonesia to Malaysia, is currently in the midst of its worst drought in 17 years, which has sent the prices of various crops surging.
Now the prospect of the first El Nino weather pattern in five years arriving this fall suggests that a range of agricultural commodities will be buffeted by yet more extreme weather conditions.
Earlier in March the National Ocean and Atmospheric Administration (NOAA) predicted only a 50 percent chance of an El Nino developing. However, the International Research Institute for Climate and Society at Columbia University reported a 70 percent chance of El Nino developing in August, rising to a 75-80 percent probability by October.
El Nino (warm episode) is a phenomenon when warm ocean-surface waters are carried to the Western Pacific by a reversal in trade winds. Previous El Ninos in Asia have brought a mixture of droughts and flooding with the situation in 1997 particularly severe. So, while Indonesia and Malaysia can expect the dry heat to continue, Southern China and the Yangtze Basin can expect deluges of rain.
But the difference this time around is that there are more and better tools for market participants to prepare for extreme weather spilling over into commodity markets. Not only are weather forecasts more sophisticated, there is a much wider variety of futures and other derivative contracts available to hedge the risk.
To get a sense of how to navigate the agricultural commodity market with an El Nino potentially looming, we sat down with Nelson Low, Executive Director of Commodity Products at CME Group in Singapore; and Heidi Centola, Manager, Weather and Alternative Investment Products at CME Group in Chicago. Centola is also a board member of the Weather Risk Management Association (WRMA) , an international trade organization dedicated to promoting the industry.
Can we expect El Nino to have a big impact on crops like palm oil, where 85 percent of production is in Asia?
Heidi Centola (HC): El Nino years typically bring a reduction in crop yields due to below-normal rainfall in the region. But we have to keep in mind there are other factors at play in determining these, besides El Nino. For instance with palm oil, the current weather will likely not impact the production and harvest cycle until 2015. You have to be aware of where there are longer growing cycles when predicting the impact on the harvest. That being said, the market has already moved up in anticipation of lower supply. For commodities that are impacted by the weather, you are definitely trading the future, rather than the now.
Have you seen an impact on palm oil futures this year?
Nelson Low (NL): On a macro level, there has been a lot of demand for managing palm oil price exposure from hedgers; and for speculators, taking on palm oil price exposure. Our partner, Bursa Malaysia Derivatives (BMD), owns the global benchmark to palm oil prices through their flagship crude palm oil futures contract.. Since launching on CME Group’s Globex platform in 2010, the contract has seen ADV growth of approximately 20 percent year-on-year. This shows that market participants are becoming more savvy in using this futures contract on palm oil. In 2013, together with BMD, we launched a U.S. dollar-denominated crude palm oil swap on Clearport. This contract has also seen impressive growth, and Q2 2014 was the best performing quarter since launch, with cleared volumes growing 28 percent quarter on quarter.
The impact of increasingly volatile weather conditions so far this year has pushed up trading volumes, as traders seek to manage weather-related risks.
What other commodities are likely to be impacted by El Nino in Asia?
HC: Apart from palm oil, wheat production in India and Australia are also likely to be impacted by lower rainfall, which would be bullish for prices.
China also is a significant corn and rice producing nation. Any reduction in global supply impacts the global market and CME Group’s flagship grain and oilseed products. For instance, if we get a significant shortfall in corn production from China, this will send a strong signal that there will be demand from the world’s largest customer and will result in corn prices rallying higher.
Aside from the primary grain markets, there are also secondary impacts all the way down the food chain arising from extreme weather conditions. For instance, livestock can be affected both through rising feed prices or the result of damaged pasture. For example, in 2013, New Zealand suffered its worst drought in almost 70 years, which also negatively affected production of cows, milk, as well as lambs, driving global prices higher.
There appears to be a lot more interest in hedging weather-related risk today. What is driving this?
NL: I think there are two factors here. Firstly, the increased frequency of severe weather events and related increase in volatility of agricultural commodities has in general raised awareness of the need for risk management and its importance. Another factor is there are now much better quality weather forecasts available because of technology advances, which have improved dramatically in the past 10 years.
There have been big leaps in the sophistication and footprint of weather prediction as the number of satellites has grown. Coverage of Asia and South America weather has grown in tandem with the traditional American and European forecasts. In addition, we are now seeing crop forecasting where you can access satellite images of crops to compare the visual intensity against previous harvests. Imagine using a variation of the Google Earth service.
The advent of more reliable and geographically-specific weather forecasts across different continents means market participants now have much greater confidence to put on hedging or speculative positions, compared to the past. Increasingly, having an edge in weather forecasting seems to be the path forward.
One example of this is we are now seeing banks, hedge funds and even agribusinesses begin to hire their own in-house meteorologists instead of relying on a third party weather forecaster alone. To meet the demand for more weather risk-management, CME Group provides a suite of weather related derivatives from temperature, rainfall and hurricane contracts, so they can not only hedge weather related harvest risk, but also the actual weather itself.
Would you say that hedging weather related risk is becoming mainstream?
Indeed. When talking to listed firms, where regulation requires them to disclose any and all risks to future performance, the management of a number of these firms strongly believe that the ability to manage these risks can only serve their shareholders well. In addition, there is some evidence that investors assign a premium to firms that have shown to include weather-related risk, in their risk management activities.
I would say that weather-related risk management is fast becoming recognized as a best practice.
Are there opportunities to use CME Group weather derivatives to hedge the weather impact in Asia?
HC: Our Asian weather products are specific to temperature, so they would not be an obvious choice regarding weather. We have contracts in Asia that would be useful to hedge temperature related risk in Hiroshima, Osaka and Tokyo. These tend to be used more in relation to energy demand with very specific temperature risk. In time to come we hope to add to this range of products as the market evolves.
Can U.S. weather products be used as a proxy to hedge weather risk in Asia?
HC: We do have a much bigger variety of weather products in the U.S. But I do not believe they would be a good proxy for weather risk in Asia. For now, I would recommend our flagship grain, oilseed, livestock and dairy futures and options contracts are most effective to hedge weather-related risk in Asia.