The great challenges of price volatility in agriculture

Summary

The volatility of the prices on agricultural markets is an ever-increasing issue, that reaches the most fragile countries in terms of food safety, but also the developed markets. This phenomenon poses threats in economical and social terms and, says Paul Gardner, in charge of purchasing of direct material categories for the Dairy Division within Danone, must be addressed by the companies in a sustainable way.

25Mar.
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In October 2012, the French Ministry of Industrial Renewal issued a study on price volatility in the agro-industrial sector. The FAO defines this as a variation in price that is both rapid and significant: “volatility is linked to the concepts of variability and uncertainty”, i.e. when prices vary in an unexpected way or in unexpected proportions. The French study established that this was likely to be a long-term phenomenon, driven by an increase in the world population – and thus of demand –, by the mutation of international markets, which are increasingly integrated, and, to a lesser extent, by climate change, which makes dramatic climatic events (such as droughts) more frequent. The stakes induced by this volatility are many. First in terms of food safety and supply, especially in the poorest countries, where weather variations have the most impact.

The FAO explains that price volatility takes a greater toll on the poor, who can spend up to 70% of their income on food and whose diet is not diversified, meaning that they cannot necessarily switch to other foods when needed.

In economic terms, price volatility is also a challenge for agroindustrial companies. As explained in the study commissioned by the Ministry of Industrial Renewal, these companies are “stuck” between two constraints: on the one hand, they need to take volatile prices of raw materials into account and handle them; on the other, they need to ensure that their products are cost-competitive on the market and that consumers are not too much affected when raw materials suddenly get more expensive. To get a clearer picture of this crucial and complex topic, we talked to Paul Gardner, in charge of purchasing direct material categories at Danone.

What is your general view on the price volatility phenomenon?

Let us start with milk: in Europe between 2000 and 2006, the prices were relatively stable, notably thanks to the export subsidies and the quota controls that were enforced by the European Union. Over the past five to seven years, the loosening of these controls and the removal of some of the European subsidies have made the prices of milk and skimmed milk powder fluctuate much more closely to the Worldwide price movements. Outside of Europe, there is a strong volatility of milk prices, driven by the balance between offer and demand.

If you look at things from the farmer’s perspective, the equation is simple: they look at how much income they get from their milk, versus how much it costs them to produce it.

The price of animal feed (that has doubled between 2009 and 2012) impacts them very much and puts a lot of pressure on their margins. They start to feed the cows less well, which means that they produce less milk, supply reduces  and prices of milk go up. In all regions, there is also the weather factor: milk production is particularly sensitive to weather extremes, especially to hot climate and droughts, which affect the feed and create heat stress for the cows.

Drought leads to poorer crops, lower yields, less milk availability, and if demand remains strong, to higher prices.Another important commodity for Danone is sugar. In Europe, the quota is strictly controlled, which maintains the prices at a stable but high level. In other regions, such as Brazil – a key sugar producing region –, harvests depend again on the weather. Adverse conditions, coupled with the traders’ speculations, can amplify the volatility.

Then comes packaging. All our plastics are indirectly affected by the price of crude oil, which we have seen move from 30$ per barrel to a peak of 140$/barrel and is now in a range of 110-115$/barrel.,  It too can be indirectly impacted by the weather – for instance, the refineries of the US Golf can be hit by hurricanes or other extreme weather conditions.

How does Danone address these issues?

The response varies market by market, and we are in the process of taking our risk management strategy to the next level. One option is to put in place a pricing lag, that allows us to delay paying today’s price; for example with a 3-months price lag, we pay today the price that the commodity was three months ago. It does not reduce the impacts of volatility but it delays their arrival and gives us time to anticipate them. Where possible we use this mechanism, but it is not available in all markets.

Another option is to buy in the future’s markets: based on the probable evolution of the market, we can buy an option for a future price for corn, sugar, etc. This forward-buying mechanism has positive effects (it ensures better predictability because you know what the price is going to be) and negative ones (if the market goes down, then you risk to be disconnected from it). Again, not all markets have futures contracts so we use them when and where they are available.But the most important thing is to build a complete Market Risk strategy, that combines different measures and options, and creates a portfolio of risk management options.

 

In its recent study on the subject of price volatility, the Ministry of Industrial Renewal suggested three main courses of action: handle volatility with more appropriate tools, set up regulation mechanisms and accompany the structuring of the supply and production chains. You have addressed the first point; what is your view on the two others?

 

Firstly, we can say that regulation has worked in the past: prices were much more stable in Europe. However you could argue that Europe was not driving itself to be competitive, compared to the world market, because this stability was relying on subsidies. As the market opens up, Europe has to be cost-competitive. And there are benefits to having the markets more structured and open, because it drives the supply chains to be more competitive. There is a flip side: open markets become more volatile and more exposed to financial traders, speculators, which in the end increases the volatility of the prices. And ultimately, the consumers are impacted  because it often has to be reflected in the prices.

 

What would you say are the main challenges for the future?

There are now 7 billion people on the planet, and there will be 9 billion in 2050. As we go forward, the challenge is to ensure we have access to the materials that we need. This applies to fast-growing emerging markets, but also to mature markets such as Europe. We have been experiencing  a comfortable supply situation, but if demand is rising, and others need to source materials and are willing to pay a higher price, we might not be able to secure the materials we need. We are working on understanding our needs market by market. This is about sustainability, competitiveness and security.

We are working with our suppliers to ensure that what we are taking from the Earth is minimised: we are looking at our footprint all along the supply chain, from forest management to soil management, from our CO2  emissions to our use of water supplies, etc.

These environmental issues are now in the middle of the sourcing battlefield. This of course has implications on our local ecosystems. More than ever, our role as social partner is key toCo-build sourcing strategies that benefit our communities as well as address our business needs. Then we use these unique sourcing strategies and connect them to our consumers. Danone is in a unique position in this regard. Sustainability is an important issue for the planet, it is important from an economic perspective, from a social perspective, and also from a “citizen of the planet” perspective.

Photo © Shutterstock / Tish1