Tuesday, January 4, 2011

From Bits to Weather Risk Management

There is no shortage of news that attempts to discuss the potential for disruptions to the global food supply chain, as well as the subsequent financial and social effects of such disruptions on a global scale.  Most of the news which garners the headlines in the agricultural commodity sector deals with topics including low physical inventories, floods, drought, food inflation, China (and the rest of the BRICs), and supply-induced riots; weather is often, but not always, deemed one of the triggers.  While the root causes of these and other related food supply stories are usually grounded in truth, what usually gets more attention turns out to be, more often than not, the sensational fallout from what truly are problems with the global food production and distribution supply chain.

Looking at cereals as an example, while the global 2010/11 production and ending stocks estimates are higher than they were a couple of years ago according to a September  2010 FAO update, the stocks-to-use ratio is lower than the previous crop year (see FAO chart below).  Current flooding in Australia is driving speculation into poor wheat crops for 2011, but it will be several months until the market 'realizes' the true impact on yields from this event. 

cereal balance

Further, the September 2010 estimate for production is down from the previous quarterly estimate, so when global balance sheets are assuming a certain production level, any downward shift in potential supply can lead to price ramifications for the following year.   We are seeing similar trends regarding estimates for global wheat, corn and oilseeds.  In addition to balance sheet revisions, futures prices react accordingly when there is news in the market concerning short supply, as the recent price charts below highlight.

price charts

As potential food supply threats are usually identified and translated to public knowledge after a shortage is confirmed, what tools are available for the proactive risk manager who wants to identify possible supply disruptions ahead of the official confirmation?  The Weather Trends forecasting process coupled with satellite-derived crop data provided by NASA can start to provide some advance warning tools which help to answer this question.

In numerous public papers and client studies, our applied research team at Weather Trends has provided information for our customers  and prospects which demonstrates how the approach of combining our proprietary long range weather outlook with analysis of broad atmospheric, oceanographic and land-surface indices can result in a useful suite of tools for  (a) identifying opportunities and threats to commodity supplies, and (b) constructing price risk management strategies which incorporate information that has not yet been ‘priced’ into futures and physical contracts.  A recent example focusing on the behavior of the Indian Monsoon and the relationship to year over year crop potential regarding sugarcane production (and the price response) underscores the usefulness of this approach.  Looking to 2011, what can we start to infer from the current and developing weather pattern, and where might these opportunities and threats present themselves?  While methods discussed here can be developed and refined for numerous geographies, we will take a closer look at an example in Australia.

Weather followers are well aware of the La Nina pattern that has exerted effects, both positive and negative, on crop production origins around the world.  There are no two La Nina or El Nino events which are exactly alike.  So while generalizations can be made regarding what to expect in a given La Nina or El Nino year, these analogs can be only used as a starting point.  As of late December 2010, we are still technically in a La Nina pattern, but indices and most seasonal models are pointing at this event to start to move to neutral in the coming months.

The maps and charts below highlight the current state of two widely used La Nina indicators: positive Southern Oscillation Index (SOI), cool equatorial Pacific Ocean Sea Surface Temperature anomalies.  Statistically, this correlates with the potential for higher precipitation for December through February for AsiaPac into northern Australia, and cooler, wetter conditions in northwestern North America.

SST anomaly

I discussed in a previous post how an analysis of the ENSO cycle can be used to construct estimates on milk production and yield in the Australia/New Zealand producing region.  At this stage in the global crop cycle, users may now looking at potential for the grains sector, from both a food and feed perspective.

In looking at the vegetation charts below,  we can see that the crop health indices for the growing regions in New South Wales is favorable when compared to both last year and normal; primarily a result of the heavy rains which Australia has been receiving this year, easing or ending the drought conditions which have been pervasive across many of the continent’s key agricultural producing regions in recent years.

veg index

As conditions have improved in Australia's southeast, we are starting to assess crop potential for Australia’s 2011 grains, oilseeds, groundnut and dairy/livestock industries.  Specifically, for livestock and dairy, we are particularly interested in assessing the impact of the pattern on grazing conditions.  As Southern Hemisphere summer is upon us, a pattern that comprises a combination of mild temperatures and ‘normal’ rainfall is best suited for optimal grazing conditions.  If there is too much heat, livestock tend to slow down, with extreme heat leading to heat stress, limiting yields.  When there is too much precipitation resulting in soggy fields, this also decreases grazing activity.  So an optimal seasonal summer pattern for both the crop and the grazing subject tends to be one that is mild and moist, within typical seasonal parameters.

So where are we at the start of 2011?  In general, field and
pasture conditions have improved significantly over the last several years, particularly across New South Wales and Victoria, as rains over the recent month or two have stimulated healthy vegetative growth.  This can be verified by the active photosynthetic activity and favorable soil moisture values that are extracted via satellite image analysis.  While eastern Australia has benefitted, the grain regions in Western Australia are still moisture deficient, and stress
due to a lack of rainfall is still evident through lower Normalized Difference Vegetation Index (NDVI) values across the region. 

For the coming months, the overall outlook for the region is for a beneficial pattern to emerge for both crop production and livestock; however, the potential re-emergence of El Nino conditions to return in late 2011 will heighten the risk for a shift back to a warmer and drier pattern.  While it is too early to confirm this shift, it is a factor that we are monitoring for next year.

While we will not be discussing the forecast for El Nino conditions, the following pages demonstrate how a seasonal precipitation outlook across Australia can be related to vegetation health at the Earth’s surface, and from this we can start to identify potential threats or improvements to crop conditions which have consequences for the agricultural supply chain.  Using this method, looking at an individual year or season in isolation does not provide much useful or actionable information.  However, when viewed as a time series, we can start to assess the relationships and build expectations around the long range forecast.  As we can see from 2005 through 2009, during the well-documented dry years, when seasonal rainfall was low, the corresponding vegetation indices tended to be low as well, indicative of plant stress, yield limitations and poor seasonal numbers.  Looking at the past year where seasonal rainfall in many growing regions rebounded, the final vegetation index image highlights the marked positive response in plant health via photosynthetic activity and higher moisture content.

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While the heavy rains have had acute effects from some growing regions suffering the effects of too much rain, the broader effect for growers and land managers will be positive.  Regions that have been dry for between five and seven years have received much needed moisture over the last couple of months, and the positive crop response as seen in the improvement in the vegetation index values will translate to wider margins for Australian growers, particularly in light of supply shortages in other origins such as Russia, Brazil and Argentina.  

The next step for the proactive manager is to apply the Weather Trends long range outlook for the coming year.  As mentioned earlier, this long range view is useful in order to assess year-over-year conditions that carry financial risk into 2011 and beyond.   As we stand behind the accuracy of our outlooks, utilizing the long range forecast is a useful first step in building a risk profile for the coming year.   The two charts to the left show how our seasonal year-over-year forecast verified in Australia between November 2009 and February 2010.  The bars highlight our y/y outlook by week, and the solid line represents the observation.  

As the relationship between seasonal weather and vegetation response is documented via production statistics and price fluctuations for numerous commercial crops, we encourage readers to learn more about to develop a competitive market advantage by utilizing our services, including the long range forecast, incorporation of satellite derived information, and detailed subjective knowledge around the global agricultural supply chain. 

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