In this Q&A, we sat down with Doug for a deep dive on weather's impact on commodities, and how traders typically position their trades around weather events.
Hedder: How do weather patterns and forecasts impact agricultural futures?
Doug: With ag commodities being dependent on weather conditions to grow and be produced, obviously an understanding and appreciation for what weather can do is a critical feature for the ag markets. This is an area that has really developed a lot over the last few years where weather data is more broadly available than it ever has been. There are many good, incredible sources that provide weather forecasts globally. Satellite data is cheaper to access and more broadly available than it ever has been. Weather has always been important to markets and it's of critical importance today. For people that are participating in the markets, there are lots of sources for forecasts and weather data; both historical and forward-looking data. Having said that, I'm not sure that anyone is better at predicting the weather than we used to be.
Two aspects of weather events
Weather remains a big swing factor in markets and it's one that's keenly anticipated and keenly watched. When we look at weather and particularly price impact from weather events in markets, there are really a couple of different aspects to focus on. One is a forward-looking forecast. So what do we think the rainfall profile is going to be over the next couple of days during critical growing periods in the year? Looking at those short-term forecasts, people will focus on what's going to happen immediately. But you also have a secondary aspect here – a forecast which maybe is for rain, and the market will participate or anticipate that rain and prices will move accordingly. Then you have the reaction after the rain has come and then it's looking at how broad was it? Did it cover enough areas? Was it a long soaking rain?
So was it an inch that fell over a long period of time and really nourished plants, or was it a downpour that happened and there was a lot of runoff and there wasn't really maybe the proper time to absorb that moisture? Interpreting weather data before and after the fact is really critical. Markets will oftentimes do a better job of anticipating than they do of reacting. So in ag markets and in weather, particularly, a lot of times people will say, "You should buy on the forecast and sell on the fact." If the forecast is for something to happen, lots of people anticipate and take an action to the market. After it has actually happened, maybe there's a kind of a pressure release valve and markets kind of subside a bit. So both the before and after for weather events is really critical.
Case study: hurricane
The phenomenon of a weather event and this before and after reaction, you can see that pretty clearly in something like a hurricane. So hurricanes tend to be forecast pretty well in advance. There's a forecast path for the storm, so it gets onto people's radar screen pretty early. You know that a hurricane is coming. And then as it approaches, there are a lot of questions about what the strength might be. Will it land in an area that's particularly susceptible to crop damage? And then you can see even the secondary impact of a storm.
So let's take an example of a couple of years ago. There was a big hurricane in Houston that impacted the cotton market and the hurricane came into an area where there wasn't a lot of cotton produced. There was some cotton produced there, and it was late in the season, so it was somewhat vulnerable and the hurricane was strong.
There was initially a big impact anticipated that, that might wipe out some crop and cause some damage. What ended up happening, the hurricane came through, there wasn't so much crop damage, there wasn't a significant amount of wind with that storm that created a lot of crop damage in the field, but there was a lot of flooding that happened, and some of that flooding actually impacted warehouses where cotton was stored.
We lost more supply out of storage than we lost out of production in the field. And so that's an example where a weather event can be widely anticipated, closely followed, but the real ultimate impact isn't known until after the fact.
There are lots of opportunities for traders or market participants to have positioned or have executed a bias based on their weather view. And the market provided a lot of volatility throughout that whole time. That's a great example of where weather drove markets and different actions could have had different outcomes or different results based on the timing and the execution of the trader.
Hedder: Are there specific commodities that are more susceptible to weather related price fluctuations, and how do traders position their trades around weather events?
Look for concentration of supply
Doug: Weather clearly impacts all crops that are produced. But some of the areas where we see the greatest impact is where there's a highly concentrated supply in a particular geography. So a couple examples of that might be in the case of orange juice. About 70% of global orange production is in Brazil. A weather event in Brazil will have a huge impact on the orange market. Another place where you'll see a highly concentrated supply is in the case of US cotton. About half of the cotton in the US is produced in Texas, and that cotton is highly dependent on timely rainfall to be grown.
So any kind of weather event; a drought in Texas or a hailstorm in Texas will have a disproportionate impact on the cotton market. You can contrast that with something like corn, where corn in the US is grown across a really broad cross section of the country. Both east to west and north to south within the country, corn has grown in a lot of different states and a lot of different areas.
In that case, you might have a really strong localized weather event that could create a lot of damage in one area. But because the production base is very broad and very diverse, it won't have a big significant price impact. For something like corn in order to have a bigger price impact, we need to see a longer or more sustained weather pattern that would drive a price reaction.
A longer sustained drought across a large portion of the country, or a hot dry summer consistently across a large portion of the country will have a strong impact on corn because it's a more sustained event. It really depends on whether you're talking about a localized production and a single event that can drive prices, or a longer, more sustained weather pattern across a broader cross section that can have a more sustained impact.
How traders can participate in weather events
For those changes or those weather events that can drive prices, traders can anticipate or participate in that in different ways. It's very difficult to position for a one-time event. You just need to be mindful that something like the cotton crop in Texas is vulnerable to a weather event at harvest. So what markets tend to do for something like that is they will build in what I'd call a risk premium. So the fact that weather events could happen elevates prices because people have a lingering concern about it coming at some point. The longer that time goes by, longer that you have good weather conditions and a lack of a negative event, that can eventually erode that price premium. So one thing that traders often are trying to look at is to what extent is there a risk premium priced into the market today?
How much are prices reflecting the view of current conditions and how much are they reflecting the anticipation of a potential risk going forward? One other way that traders can either try to participate or insulate themselves is just to reduce risk or reduce positions during particular vulnerable times. An example of this that we see in a small way is when you go into a holiday weekend in the summer – for example the 4th of July weekend or labor day. You've got more weather over that period than you do trading days. And so often you'll see a reduction in positions going into those weekends or kind of a risk off mentality because people are uncertain about what might happen over the course of a longer weekend where the market isn't there to trade and act immediately on a Monday. So short term, one reaction to weather risk or the perception of weather risk is just to deescalate positions.