AGRICULTURE: an industry ripe for disruption
The growing demand for agricultural products is increasing the complexity of production, trading and risk management amid continued price volatility that is being driven by a variety of macroeconomic and environmental factors. As the agricultural industry enters an era of digital agriculture, firms today are making the transition from “price takers” to “price optimizers” while facing ever-increasing risk as they strive to gain more from their existing assets and optimize their supply chains. Jake Riley and Pranjal Srivastava explain how innovative firms are taking advantage of technology to leverage the disruption in agriculture by essentially creating a new class of commodity management systems to help firms leverage operational intelligence, build supply chain efficiencies and manage risk exposures across the enterprise.
The need to find a solution for our world’s insatiable appetite for food has been well publicized. It is driven by a seemingly exponential population boom that is expected to exceed nine billion people by 2050, as roughly 230,000 new human beings are born each day—and more than 1.6 million people each week.1 As emerging nations amass wealth and manifest themselves in the global community, the population of those nations typically transitions from staple diets to those that include more protein and processed foods. Alongside population growth, increasing demand is underpinned by the development of marketing infrastructure, such as roads, storage, and even refrigeration. Increasing income in developed countries is also driving demand for more processed food.
This change in demand will have a dramatic effect on agricultural production and add complexity to an already complicated industry. Population growth and economic development create a parallel need for more sustainable, efficient and stable forms of food supply. In fact, the United Nations estimates that by 2050, we will need roughly 70% more food than we produce today.2 This need has undoubtedly driven the agriculture industry into the forefront of technological innovation.
As supply and demand fundamentals alter the agricultural landscape, three major challenges naturally materialize for companies in this industry: asset optimization, price volatility and risk management.
The limited availability of arable land and fresh water for farming has reached capacity around the world, challenging producers to optimize their yields amid ever-growing production constraints. To meet this challenge, producers are optimizing their increasingly global and complex operations through the use of “digital agriculture.” To meet demand and adhere to sustainable agricultural practices, companies are rapidly investing in the collection, storage and management of data, as well as analytics and decision modeling tools. In fact, the world’s production of coarse grains (corn, soybeans and sorghum) has dramatically improved as a result of technological advances, despite limitations and variations in the global quantity of acres harvested.
Technologies such as precision farming are helping farmers make better decisions that will lead to operational efficiencies, lower input costs and productivity gains. As shown in Figure 1, a farming operation may utilize water sensoring technology to optimize its water application on its crops, using a combination of centralized data in the cloud, communication with the farmer’s production equipment and GPS coordination systems. The result is the optimized use of a scarce resource, benefiting both the company’s bottom line and the environment.
As the agricultural landscape evolves, leading and innovative technology firms, inclusive of crop and seed protection companies, should be focused on creating integrated digital ecosystems that enhance the farming experience by optimizing data through the use of advanced analytics. These tools and technologies should also be able to maximize the profitability and simplify the operations of nearly every aspect of the farmer’s business.
As a result, farmers should benefit from reduced complexity, actionable decision-making, and agronomic empowerment. In addition, firms that integrate and employ strong digital strategies into their product offering will be able to build greater customer engagement, satisfaction and brand loyalty. Disruptive firms will have an acute focus on the digital interaction of customers with their product portfolio—the new medium for competitive firms to deliver their products to market.
Globally integrated firms are largely exposed to commodity prices and foreign exchange fluctuations. In the past decade, the agricultural sector has weathered major swings in volatility, predominately driven by macroeconomic policies, disease outbreaks and inclement weather. Anticipating political risks as in the recent example of Brazil, which increased price fluctuations between Brazilian Real and USD, also causes significant price volatility. Because agriculture has gone through multiple cycles of price fluctuations over the past decade, firms must be able to predict and capture this volatility and drive higher profitability by maximizing profit per ton. This is compelling firms to make the transition from “price takers” to “price optimizers” in the marketplace.
At the farm and producer levels, input price changes affect profitability to a large extent. Smaller producers and farmers don’t have the necessary wherewithal to hedge input commodity costs and traditionally have had to rely on merchants or large integrated companies for their hedging needs. Optimizing and managing price volatility at the farm level has a cascading impact on costs and margins across the value chain.
Firms today are facing ever-increasing risk as they try to squeeze more from their existing assets and optimize their supply chains. At the same time, the growing use of technologies exposes firms to a number of new risks that were non-existent just a decade ago. Innovations such as precision farming and farming data in the cloud have resulted in heightened competition to maximize profit per ton. Macroeconomic factors, such as agricultural policy changes, international trade agreements and global gross domestic product (GDP) fluctuations, also expose companies to increasing price volatility. As a result, a sound risk management strategy is urgently needed to help firms manage market, credit and operational risk.
Due to the diverse geographical nature of the agriculture commodities business and global supply chains, companies today are exposed to currency fluctuations and price volatility. Recent trends have shown cases of depressed earnings due to currency movements even though the underlying business was strong. Companies need a mechanism for managing this market risk by not only having a view into the current exposure, but the ability to predict future exposure based on market variables and respond to it in a timely manner.
Firms in the agriculture business transact with small farmers in remote locations to big integrated companies. Working with such a diverse set of counterparties presents challenges in terms of managing credit exposure and risk. A globally integrated supply chain makes it a challenge for companies to understand areas in their supply chain that are most vulnerable to credit risk. Increasingly, commodity producers are entering into complex credit arrangements as they directly deal with buyers to reduce their dependence on merchants and traders. However, merchants and brokers also play an important role in reducing market risk for farmers through the use of forward contracts and other alternative marketing arrangements.
A system that manages credit limits must also take into account external factors such as sovereign risk, ratings from global rating firms, and sector risk. At the same time, a good credit rating system should allow the company to manage their credit exposure in an efficient manner by generating a credit profile for any customer. The system should also enable the company to accurately pinpoint credit risk across the supply chain, and credit managers to mitigate their risks through corrective actions.
Operationally, agriculture is a globally integrated supply chain across diverse geographies, and each participant has its own set of challenges. Many of these geographic regions may be starkly different from each other and lack the robust infrastructures needed to efficiently move product to market. For example, corn sourced in India may be more difficult to procure, transport and export than corn produced in the United States. Firms that transport products by rail might be at risk due to the possibility of derailment, accidents or breakdown, and can therefore be held responsible for delays in product shipment, leading to financial penalties (called demurrage). Agricultural firms also face contract performance risk, which may be significantly reduced by analyzing or predicting data related to contract non-performance or breach due to non-delivery of product.
Agricultural commodities are severally exposed to the vagaries of weather. Weather can cause disruption across the value chain beginning from production to processing and transportation. Weather-related disruptions manifest themselves into not only operational risk but also market and financial risks. Today more than ever, companies need an integrated view of weather-related risks along with their global position to hedge weather using weather derivatives. Weather derivatives are financial instruments that can be used as a means of risk management hedge against losses due to adverse, unpredictable weather. Unlike other derivatives, the underlying asset, such as frost, rain, temperature or wind, is something that has no direct value with respect to the price of the weather derivative. Weather derivatives are like insurance instruments and one of the main difficulties in using weather derivatives as a commodity hedge is in deciding the model risk inherent in determining how much of the risk can be effectively hedged using a weather contract. Systems and processing that can model this risk by analyzing underlying crop and weather data can provide an edge to companies.
Disruption Meets Technology Innovation
Innovative firms are taking advantage of technology to leverage the disruption in agriculture. These firms are utilizing their existing investments in enterprise resource planning (ERP) and supply chain systems, and adding functionality to help them better manage their commodity operations—in essence, creating a new class of “commodity management systems.” Unlike traditional commodity trading and risk management (CTRM) systems, commodity management systems offer a comprehensive view of the entire supply chain, beyond just the trading aspect. They enable firms to track price volatility, build supply chain efficiencies and manage risk at both the enterprise and commodity levels.
However, the market for these solutions is highly fragmented, with a multitude of niche players and no clear leader. In fact, a 2016 research survey by the Commodity Technology Advisory found at least 34 potential system vendors operating in the agriculture commodities space. Each player positions itself to attract the attention of niche commodity traders given the complexities of individual supply chains and quality characteristics of underlying commodities. As a result, many integrated agricultural firms with exposure to multiple commodity types use a variety of programs that are loosely stitched together to manage risk exposure. They lack the ability to provide a holistic view of risk exposure and instantaneous visibility to treasury and trading operations. In addition, firms layered with multiple CTRM programs often must manually manipulate outputs from these programs to build an enterprise-wide view of the firm’s risk exposure.
For example, a large multifaceted snack food processor might enter into a variety of long-term supply contracts that reduce risk exposure in corn, sugar and even foreign exchange rates. Each of these commodities may be managed through a distinct and unique software system that requires financial teams to manually aggregate silos of data and form an enterprise-wide assessment of the company’s risk. This process is both cumbersome and highly prone to user error. Alternatively, an all-encompassing system able to aggregate, metabolize and transform large sets of financial and physical transaction data could accurately monitor the enterprise-wide risk exposure for that firm at any given point in time.
Now, more than ever, companies need to invest in integrated solutions that globally optimize their market, credit and operational risk exposure. Existing systems may lack sophistication and integration, and require manual processes that are prone to error without any consistent control and support.
Because risk management continues to be a key success factor for firms in the agricultural commodities space, risk management tools will become crucial to a firm’s ability to mitigate its market, credit and operational risk exposure—and add significant value to the bottom line. Rising above the limitations of current CTRM systems is the emerging commodity management system, which enhances decision-making by delivering greater visibility of risk exposures and meaningful operational intelligence across the enterprise. Companies that invest in integrated technologies will be strategically positioned to command significant returns in the future as unpredictable demand and supply conditions, political instability and climatic uncertainty dominate the market place.
- Our World in Data, World Population Growth, Esteban Ortiz-Ospina and Max Roser, https://ourworldindata.org/world-population-growth/.
- Food and Agriculture Organization of the United Nations, 2050: A third more mouths to feed, http://www.fao.org/news/story/en/item/35571/icode/.
Jake Riley is a Manager of Business Consulting specializing in the agricultural and petrochemical markets. Based in Houston, Jake is an experienced business professional with a proven, strong track record in commercial management, strategic planning, and supply chain development in commodity markets. He leads cross-functional initiatives and untangles complex challenges in today’s dynamic business environment. Jake received his Bachelor of Science degree in Agribusiness and Agricultural Economics from Texas A&M University and is completing his Master of Business Administration (MBA) at Rice University.
Pranjal Srivastava is a Senior Manager of Trading and Risk Management specializing in the commodities market. Pranjal has over 10 years of experience advising clients on complex business problems involving trading operations, supply chains and risk management. He has led complex transformational programs for clients in Asia, Europe and North America that delivered each client significant cost savings and increased business value. Pranjal has a Master of Business Administration from the Indian Institute of Technology, Bombay and a bachelor’s degree in Information Technology from the University of Delhi.