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Could we see a Lehman Brothers-style collapse in grain markets?

There's a big difference to market noise and market reality. We ask Errol Anderson, is it all just talk?

At the heart of the issue is something known as a letter of credit, or LOC. These are essentially promissory notes that are backed by a financial institution with credibility, and their purpose is to ensure the money is there.

Now there’s a question hanging over global commodity markets in the form of the Anglo-Swiss commodity giant Glencore — you know them in Canada through Viterra. Market watchers are buzzing that they’ve overextended with a poorly timed expansion strategy that’s soured as commodity prices have fallen

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When a big player like Glencore and its finances come under the microscope, this system can be disrupted until trust can be re-established between buyer and seller.

It’s not going to be 2008 all over again, by any stretch, but it could mean commodity markets and their global movement slow or even seize up for a time, especially if Glencore unwinds in a less-than-orderly fashion. If that happens, everyone is going to be glancing around, wondering who has been left holding what, and if they’re still good for the paper they’re issuing in the form of LOCs.

It all adds risk to a global commodity system already under pressure. It also raises a series of interesting questions: how can you tell when something like this is for real, or if it’s just market noise? What does it mean for your marketing plan?

We asked Calgary analyst Errol Anderson for help making sense of it all.

COUNTRY GUIDE: People  are likening Glencore to Lehman Brothers. Is it really that serious?

Errol Anderson: It is definitely a big deal from a global trade point of view, and with a company as massive as Glencore, a crisis for traders could slow the recovery of commodity prices. Also seriously, it could hamper movement of all commodities including agriculture from country to country for a time. This could definitely affect us, especially in Western Canada.

CG: You’ve talked to us in the past about market noise and how to filter it out. Does that apply here?

EA: No this isn’t market noise, this is a real issue that could delay the recovery of global commodity prices. But the effect on local grain movement hopefully is going to be relatively short. It should not impact the underlying fundamentals of the market.

But make no mistake: I do hear market noise every day. I describe it as whatever the issue of the day is that’s capturing a lot of attention, but doesn’t truly affect the overall situation in a large or meaningful way.

I’ve been analyzing markets for 30 years, and when I started, my tools were a calculator, a transparent ruler and a copy of the Wall Street Journal. That’s how we analyzed supply-and-demand fundamentals and their effect on price direction. These days, commodity funds can execute thousands of trades a second based on technical chart signals, exerting a huge impact on price direction, certainly in the short term.

You can analyze a market fundamentally all you want, if these funds take the opposite technical view, it can be like getting run over by a freight train, at least in the short run. Funds have a huge say in price discovery and market volatility. So you can either grump at them or view their price power as an opportunity to add profit to farm production.

A helpful illustration might be looking at the way a weather event can affect today’s market.

Late spring, there was a lot of excitement over flooding in the U.S. Midwest. We did see corn and soybean prices move higher over a short period, mainly on commodity fund buying activity. But flooding doesn’t alter the underlying production of the market because, in reality, it doesn’t affect that many acres — when it does flood in the Midwest, it of course only floods along the rivers, not the whole region, plus it offers an excellent start for crops outside the flood zone. I call this market noise. The media is hyping the event. Fund money pours into the long side of the market. But the impact of the flood is always short lived.

However, it may turbocharge the futures market at least for a short while. The underlying fundamentals hadn’t changed. Excellent yields were on the way as a result of this heavy rainfall. As a farm manager, if past experience allows you to realize this as a short-term pricing opportunity, you may price a portion of your crop often above what the true-value market fundamentals suggest.

CG: Is that why it’s so important to separate what’s real and what’s just noise?

EA: Yes, but you also have to understand the speed at which information instantly impacts prices and triggers almost immediate market volatility. Often markets react to news before the impact can really be understood.

That’s because of the speed of trading, human emotion, and the power of commodity funds. These are speculative investors who don’t necessarily understand agriculture. What they’re trading is really immaterial to them. They could just as happily trade cardboard boxes if a futures market existed for them. So they’ll react and market prices may overreact. But from a farm manager’s perspective, this fund trading activity often provides excellent pricing and hedging windows.

The risk is that you get caught up running with the herd, but commodity markets without fund activity would be a lot less exciting with fewer pricing opportunities.

CG: You talk about the emotions of a market, but at the same time a market can be pretty unemotional, can’t it?

EA: The underlying fundamentals of a market have no emotions. But markets are made up of nothing but people and their emotions, and they can be highly emotional. These emotions affect the market for a short time, with movements well above and well below the true value of a commodity.

If you don’t get caught up in this whirlwind of emotions, market noise and the volatility, it can represent real opportunities for a farmer looking to price their crop and manage risk.

Of course, farmers can have their own emotions too. You may get caught up in the hoopla of a rally and let your guard down expecting that higher prices are here to stay. During the last U.S. drought, some growers really did think $17/bu. soybeans were just a fact of life now, and $10/bu. corn too.

However, farmers have already accepted the market has moved on. Farmers are really sharpening their pencils both in terms of their marketing plan and cost side of the balance sheet. It really is during tough times that good farm managers distinguish themselves.

They’ll be the ones who have a marketing plan and stick with it, pricing on upticks in the market that they know offer better returns and often are short lived. Now more than ever, having that plan and executing on it will be vitally important.

As a good marketer, you really need to strip the emotions out of the equation and be analytical, calm and clear headed, with ice water in your veins.

CG: Are there any reliable indicators for farm managers?

EA: When markets act like a caged animal, whether up or down, one of the most telling indicators is open interest. Open interest is the total number of contracts for a given commodity that remain open in a trading month. When you get a lot of open interest in any given contract, it acts like the gas pedal for prices.

Here are some scenarios:

Let’s say the futures are surging into record-breaking territory. No one knows where the top is. Everyone’s a buyer, there are no sellers and the open interest is climbing. This situation suggests prices can go even higher yet. More buyers continue to pour into the heated market. But suddenly open interest drops off. This may be an early warning signal that a price peak is near. Long liquidation is beginning to take place.

But let’s flip this bull market scenario to a bear market. Let’s say futures are in a dive and cash prices are plunging. If open interest is rising, this suggests more sellers are entering the market. Prices can fall further. But should open interest begin to decline, this now suggests the shorts or sellers are starting to buy back their positions. This is called short-covering and it is an indication a market bottom is near. This is not much different than pilots watching their gauges in crazy weather. Open interest is a technical gauge when price volatility becomes extreme.

CG: What about the saying that if prices seem to be too good to be true, they probably are?

EA: Unfortunately, that is most often true. There’s been some wild price experiences in commodity markets over the past few years that have generated some amazingly bullish talk — $6,000 an ounce gold for example, or $10 per bushel for corn. It’s the sort of thing that’s easy to put in print, and hey, anything is possible. But market noise is easy to produce and its shelf life can usually be measured in a few days.

CG: This is complex stuff for those not familiar with the impact of market noise and volatility. It seems experience can be a real benefit — what about farmers newer to the game? Any suggestions for them?

EA: I think younger market participants, regardless of the sector, are at a disadvantage. Nothing beats experience when it comes to markets. Take interest rates, for example — we’ve had low rates for many years now and arguably there’s an entire generation of traders that haven’t ever seen a period of even normal interest rates, much less a period of rising rates.

Younger traders and younger farmers should draw experience close to them. It can be a market adviser, but it doesn’t necessarily have to be. It might be a government or university extension person or even an older farmer in their own community who has gone through the world of pricing knocks and is willing to share that experience.

From there it’s really going to all be about understanding market fundamentals, understanding when you may be hearing market noise, and learning to take advantage of it. Having a plan and the discipline to execute it and not be distracted from it by market hoopla is advice that applies to all of us, regardless our experience.

This article was originally published as “Market noise” in the December 2015 issue of Country Guide.

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