HardAssetsInvestor

Written by Amine Bouchentouf  |

October 16, 2011

The Commodity Investor: Archer Daniels Midland Needs More Than Growing Population

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Simplistic approach to commodity trading overlooks complexities that commonly trip up investors.

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 their 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 Ain’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.