Bubbling Over the Surface – Dealing with Price Spikes in the Commodities Market

In the current climate of increased industrialisation, commodities such as pork, beef and dairy products can no longer be managed in the same way as before. On-farm production of feed is gradually becoming history, meaning that the cost of the main ingredients required to manufacture feed are now more directly related to the price, cost and profitability of the final product (i.e. the resultant livestock). The question is – does this close interrelation between inputs and outputs mean that price peaks of these variables of an agro business may occur simultaneously? If so, how should professionals in the agricultural industry respond accordingly? These questions can be answered based on agro finance.

The price of commodities are, by definition, determined in relation to the market as a whole and are treated by market participants irrespectively of who produces them. As such, they are considered to be “fungible”, meaning that they are ultimately interchangeable. The challenge for agriculture professionals is to ascertain how much they need to invest in feed in order to, for example, double the size of their 350kg calves into 700kg cattle, or select the appropriate amount of corn and soybean-based feed in order to feed hog, as in the case of the pork meet industry.  In short, the input and output commodities (the raw materials and the livestock raised on those raw materials) quite literally feed off one another. However, farming is first and foremost a business. Thus, industry professionals need to know how to match input and output costs when sharp changes occur in the market.

A financialised market

It is generally accepted that the commodities market is now a highly financialised one, and that is no longer based purely upon the classic but old fashion theory of supply and demand. As a result, it is much more responsive to price “bubbles”, meaning points at which trading prices in a commodity far exceeds its intrinsic, (or fundamental or economic) value. The economic phenomenon behind these financial “bubbles” has been explained by what is known as the “Masters Hypothesis”, according to which the large growth in long-only money flowing into commodities since 2003 via commodity index funds can lead to the formation of price “bubbles”... However, this may lead to the hypothesis that price “bubbles” of inputs and outputs of commodities occur simultaneously.

Exploring “co-integration”

Given the above close relationship identified within the agricultural industry, a recent examination of the price “bubble” phenomenon between the corn and soybean used to make pig feed and the market price of hogs was carried out. The purpose of the study was to examine whether a time lag exists between the formation of input and output prices, or whether the co-integrated nature of the two related markets (hog feed and hogs) results in price synchronous “bubbles”. The study focused on lean hog futures and soybean meal futures over the period 1st January 2001 to 1st April 2016, using the daily closing prices for each commodity as the basis for the statistical analysis. The findings underlined the current sensitivity of hog producer margins to feed price fluctuations. This can be explained in real terms by the more industrialised approach being taken to hog production and supermarket demand for lower pork prices.

Two separate phenomena

The analysis carried out also sought to establish the respective timing of the various price “bubbles” and to what extent overlap occurred. The findings highlighted a clear discrepancy between the volume of feeding futures (corn and soybean meal) versus hog contracts, to the extent of 5:1. Just as importantly, only 10% of the time did hog and feeding “bubbles” occur at the same time (to be precise, feed prices bubbled on only 54 out of the 570 days that corn and soybean prices also bubbled). This would appear to disprove the above discussed Masters Hypothesis regarding the simultaneity of price “bubbles”, which could be explained by the time required to adjust hog prices in the event of fluctuating feed prices. Producers may also be able to  manage operations by using alternative feed sources, setting up long-term feed supply contracts, or adjust their herd stick according to market conditions.

Lessons to be learned in Brussels

The other main finding of the empirical testing and analysis revealed is that most “bubble” periods were generally followed by an immediate reversion of  price trends. While this may sound reassuringly less volatile a market situation, it should not be overlooked that the data used for the study was mainly from US. It is a widely-held belief that the US, New Zealand and Australia in particular are the feed-hog markets best prepared for the vagaries of the economy, meaning both peaks and troughs. European countries have been, to a certain extent, cossetted by the EU for the past 40 years or so and are maybe less apt to deal with not only the opportunities created by price bubbling but also how to manage operations in such volatile periods. Understanding the timing of these spikes is the first step in balancing market operations in a profitable manner. Being able to handle the ups and downs is the next step and one where EU-based countries still have room for improvement.

 


This article draws inspiration from the paper Do co-integrated commodities bubble together? The case of hog, corn and soybean, written by Dr Christos Alexakis, Dr Guillaume Bagnarosa, and Dr Michael Dowling and published in Finance Research Letters 23 (2017).
Christos Alexakis is an Associate Professor of Finance and Accounting at Rennes School of Business, France. His research interests include Asset Pricing, Behavioural, Corporate and Islamic Finance, and Health and Tourism Economics.
Guillaume Bagnarosa is an Assistant Professor of Finance and Accounting at Rennes School of Business, France. His research interests include Asset Pricing, Risk Management, Financial Econometrics, Asset Allocation, and Hedge Funds.
Michael Dowling is an Associate Professor of Finance and Accounting at Rennes School of Business, France. His research interests include Asset Pricing, SME Financing, Behavioural Corporate Finance, Investor Psychology, and Energy Finance.

 

Infographic vector powered by Freepik


Imbalanced supplier-customer relations and how to avoid them
Category: Human Resources

Imbalanced supplier-customer relations and how to avoid them

The old adage “the customer is always right” may apply in a retail shop but in the more complex world of business it is neither a universal truth nor even a desirable one. The dynamics of supplier-customer relations have for a long time been viewed purely from the customer perspective. However, by looking at ways to enhance the working relationship through the lens of the supplier and proposing a more strategic set-up based not only on the end product but also service and performance offers an alternative. Treating the supplier like a commodity might just become a thing of the past…