What We Do -- and Don’t -- Know about Commodity Markets
Mar 07, 2011
If we recognize that we can’t beat the market, then we’re well on our way to developing a hedging program that seeks to smooth out the bumps in the road rather than pick every top and bottom in the market.
By Will Babler, First Capitol Risk Management, LLC
This is one in our series of articles written to aid dairy producers in moving up the learning curve toward a structured hedging approach. We believe this approach is necessary for producers to succeed and compete going forward.
Your hedging philosophy is the most basic philosophical foundation for future hedging decisions. The temptation for commodity producers to move from a basic understanding of hedging tools straight into a trading (or speculative) approach is often too great to resist. This speculative desire to “be right” and “beat the market” often leads to ruin and typically stems from having the wrong initial philosophical mindset. Taking a step back and making an honest assessment of what we know about commodity markets and what we should expect from a hedging program is a great way to maintain a hedger’s mindset and avoid the traps of speculating.
What We Don’t Know about Commodity Markets
It may be unexpected to initially focus on what we can’t know for certain about commodity markets. With market pundits making bold claims about market turning points and price objectives, it’s easy to overlook the fact that very few people, if any, can consistently out-guess the market over the long-term. If the historical empirical record isn’t sufficient to demonstrate this, then it should only take an individual a matter of years (or weeks) attempting to successfully speculate in commodities to realize this fact.
With this in mind, consider this abbreviated list of what we, even as market professionals, have come to learn over the years that we don’t know about commodity markets:
· When they will peak
· When they will trough
· When they will turn around
· How high they will go
· How low they will go
· How long they will stay where they are
In case we haven’t made it clear, the main point here is that trying to outguess the markets consistently over a long period of time is a fool’s game, and producers and other commodity traders should be careful not to confuse skill with luck.
What We Do Know about Commodity Markets
While we freely admit we can’t know what commodity markets will do with certainty, it’s still useful to understand their characteristics. We can use the following short list of things that we do know about commodity markets in order to define potential risk:
· Markets are unpredictable. Even though “black swans” may be in vogue, it hasn’t become any easier to foresee outlier events that will drive commodity markets. Factors such as weather, geo-politics, technology and human behavior will continue, until further notice, to be wildly unpredictable. Still, an understanding of fundamental supply and demand trends and emotional tendencies is useful for projecting risk boundaries, as long as outliers always remain in consideration.
· Markets follow patterns . . . until they don’t. There are many regular cycles in commodity markets related seasonally to production, processing and consumption patterns. There are also longer term cycles in investment and the business cycle. These patterns can be useful for defining risk, but shouldn’t be relied on in their entirety. Markets behaving contra to their cyclical tendencies need to be taken at face value, and producers should move forward with a hedge that appreciates the possibility that the typical pattern may not unfold during that cycle.
· Markets are indifferent to your circumstances. As volatility unfolds in commodity markets, often the pricing and supply and demand dynamics are set on the margin. Whether or not your circumstances place you on the right side of the margin is difficult predict, but, regardless, any one producer is not big enough to influence the market. Therefore, those engaged in commodity businesses should be prepared to deal with volatility forces they can’t control by working on factors that they can control, such as managing the cost of production, maintaining liquidity and executing on hedging programs.
Objectives and Expectations for a Hedging Program
We would like to reiterate that commodity markets (and dairy production margins) have been volatile and will continue to be volatile. If we recognize that we can’t beat the market, then we are well on our way to developing a hedging program that seeks to smooth out the bumps in the road rather than pick every top and bottom in the market. Consider the following specific objectives of a hedging program that is operated by a producer with realistic goals:
Margin Management Hedging Objectives
· To minimize risk
· To capture opportunity
· To smooth out earnings
· To avoid disruptions to operations
· To execute on long term business plans
With these objectives in mind, a hedging program can be developed that utilizes the appropriate tools for a given producer. Our next article in this series will dive into more detail on how to choose the appropriate tool.