The current political instability in the Middle East is sparking fears among traders of a surge in demand for wheat from unstable governments in the region.
Wheat futures prices, however, have remained reasonably stable since the start of political unrest in Egypt.
Current political instability in the region, however, could encourage traders to increase inter-commodity hedging in order to reduce risk levels.
Massive imports to avert political instability
There has been concern on trading floors about the potential impact that massive wheat imports from unstable governments in the Middle East and Africa could have on wheat futures contracts. On 26 January, local sources stated that Egypt might have secured enough wheat for six months of use.
In addition, Iraq and Lebanon announced tenders for wheat worth 100,000 and 22,500 tonnes, respectively, to avoid potential shortages.
Subsidising food staples like wheat has traditionally had a stabilising effect on developing economies, particularly among low-income population segments. In Egypt, for instance, a recent report released by investment bank Credit Suisse estimated that 40% of an average Egyptian's income is spent on food.
In lower-income segments World Bank statistics estimate that around 20% of Egyptians live on less than US$2 a day – and this percentage could well soar beyond 85-90%.
Local wheat production is of strategic importance to Egyptians and the government encourages wheat production by paying high prices to local producers. In addition, the Egyptian authorities import large quantities of wheat to make the heavily subsidised “baladi” bread for low-income consumers.
According to the US Department of Agriculture (USDA), Egypt is estimated to have imported 10.2 million tonnes of wheat in 2010, which is more than half its actual consumption needs. Interestingly, Euromonitor International projects that total volume sales of bread in Egypt will grow by just 1% in 2011, to reach 9.7 million tonnes.
Wheat futures prices show resilience in the face of uncertainty
Trading prices are showing some resistance to the recent dramatic events in Tunisia and – perhaps more importantly - in Egypt. Wheat front month futures contracts on the London Stock Exchange stood at US$8.39 per 60lb bushel (31 January close).
This represents almost no change on pre-uprising levels, when futures were quoted at US$8.32 per 60lb bushel (25 January close). This relative stability can be explained by both real (ie related to actual wheat demand) and market (ie trading related) issues.
As for market-related issues, periods of political instability usually result in a surge in currency trading. This is because institutional investors shying away from riskier commodities take refuge in anchor currencies by going long (buying US dollars). Unsurprisingly, the US dollar saw a strong appreciation against the euro (+1%) on 28 January.
This appreciation was partially a result of the massive political demonstrations on 28 January during Friday prayers in Egypt, which increased existing political uncertainty across the region.
Demand factors for wheat are also keeping support levels (lowest trading projections) relatively stable. Romania announced in the last week of January plans to import some 400,000-500,000 tonnes of wheat this year to provide a consumption buffer until its new crop is available.
In addition, Russia may eliminate a 5% import tariff on wheat and other markets as of 1 March. However, the impact of these events was eased by higher expectations for US grain crops after weather forecasters indicated increased chances of significant moisture and snow cover for the winter wheat crop.
Lessons to be learnt from the current situation
While predicting future movements in the midst of current political turbulence remains extremely difficult, there appears to be consensus among traders that lessons from the political events of the present and past week can be learnt.
Political turbulence in countries where a significant part of the population relies on wheat-based subsidised commodities is theoretically bound to put real pressure on demand for this commodity. However, commodity markets are highly complex and trading movements are interconnected with a wide range of factors. The current surge in oil prices, for instance, is linked to the fact that Egypt is a key transit point for oil.
As a result, Brent crude oil futures have increased by 4% since 25 January. This has contributed to divert not only part of the attention but also an important volume of trading from agricultural to energy commodities, thereby easing upward price pressures on the former.
Moreover, the influx towards the US dollar at the height of the crisis (28 January) helped slow agricultural commodity trading even further. US dollar appreciation encourages traders to liquidate long positions in dollar-based commodities like wheat and cocoa and invest in assets nominated in weaker currencies or simply to cash in their profits. This inertia contributed to a reduction in demand pressures for agricultural commodities.
Finally, not all events linked to civil unrest result in increasing demand for subsidised grains. In Egypt, for instance, slower activity in ports has resulted in weaker demand prospects in the short term as wheat imports find it increasingly difficult to find their way into the country.
From a trading prospective, the recent turbulence in the Middle East and Africa highlights the need for cross-commodity hedging during periods of political instability. Traders going long (buying) on the highly volatile agricultural market could opt to spread the risk by entering futures contracts in other commodities, including energy, currencies and sovereign debt.
One of the many options available to traders going long (owning future contracts) in wheat is to take long positions (buy) in energy commodities like oil. This strategy could help them to provide a degree of hedging for prospective lower wheat prices if the strengthening dollar trend and slow transit in crisis countries continues in the coming weeks.
If the current trend reverses and wheat futures rise in parallel with energy prices, those traders short in wheat (having sold) and long (having bought) in oil might well transfer contract positions from one commodity to the other once the market becomes stable again.
Finally, if both energy and wheat futures prices start to go down as a result of political stability, stop-loss orders should be placed for traders that have gone long in the former to hedge against an escalation in the latter.
Overall, there is agreement that inter-commodity hedging between wheat, energy and sovereign debt are complex and wide ranging transactions. However, if monitored closely, they provide moderate hedging in situations of civil unrest like those currently being witnessed in the Middle East.
Analyst Insight by Francisco Redruello.
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4 February 2011