What’s the first thing you talk about with a stranger? The weather. Why? Because it’s constantly changing and meteorologists are poor predictors. It’s part of what makes global weather so volatile, and what makes those commodity futures markets that need such weather to grow so non-correlated to the equities. If we need any further proof of this, look at the 2012 drought and the current drought issues in California. We won’t get into global warming (because scientists speak pretty loudly to that) but we do want to discuss the return of the natural phenomena…. El Nino.
What is El Nino:
We could try and tell you all these fancy definitions (or the definition when you Google it), or you can just watch this video by a grade-schooler — who does a better job with construction paper:
When does it come?
This one’s a little complicated, because it is the weather, after all, so there isn’t an exact pattern. But over the last 60 years, they tend to pop up every 2 to eight years, on average – with the last very strong one in 1997-1998. Somewhere, a cycle trader we know is overlaying a nice sine wave type cycle graph on top of the chart below, but you’re going to start seeing more mentions of it, because it seems to be happening again right now!
Chart Courtesy: GG Weather
What does it do?
Here’s what Wikipedia says on that:
In the US – During El Niño, the northern tier of the lower 48, as well as southern Alaska, exhibits above normal temperatures during the fall and winter, while the Gulf coast experiences below normal temperatures during the winter season. There are excepted to be less Atlantic Basis hurricanes threatening the US, and with the jet stream oriented across the southern portion of the United States, that region is more susceptible to severe weather outbreaks.
During an El Niño, snowfall is greater than average across the southern Rockies and Sierra Nevada mountain range, and is well-below normal across the Upper Midwest and Great Lakes states.
The effects of El Niño in South America are direct and stronger than in North America. An El Niño is associated with warm and very wet weather months in April–October along the coasts of northern Peru and Ecuador, causing major flooding whenever the event is strong or extreme Southern Brazil and northern Argentina also experience wetter than normal conditions, but mainly during the spring and early summer.”
And here’s a nifty map from the Financial Times showing what it does.
(Chart Courtesy: Financial Times)
Bottom line: it messes with the typical weather, causing some areas to be wetter, some drier, some warmer, some colder. Which in turn messes with things that grow based on the weather. The big thing is that it is a significant change in the weather for the areas it hits, or more specifically – significant enough to alter yields on agricultural crops.
What’s the forecast for this time:
It seems that the weather experts are gearing up for one of the strongest El Ninos in years. Back in March, the NOAA announced we would be experiencing El Nino this year. Fast forward to this month, and the Australia Bureau of Meteorology declared an El Nino event this year. But how strong is strong?
“For the first time since 1998—the year of the strongest El Niño on record, which played havoc with the world’s weather patterns and was blamed for 23,000 deaths worldwide—ocean temperatures in all five El Niño zones have risen above 1 degree Celsius warmer than normal at the same time. That’s the criteria for a moderately strong event, and the latest forecast models are unanimous that it’s going to keep strengthening for the rest of the year.”
But beware of sweeping statements about El Nino. If you’re in tune with the El Nino weather, and specifically how it might affect markets, you’ll know that there were warnings of El Nino last year, but it didn’t pan out. Financial Times talks a little about what they call “the boy who cried wolf,” affect.
“However, some investors may be hesitant to react, after the false alarm in 2014, when weather forecasters warned of a potential development of El Niño, say commodity brokers and traders.
In March last year, weather experts pointed to the rapid warming of the tropical Pacific, the key signal for El Niño, only for some of the conditions to peter out.
With sea temperatures rising again since the end of 2014, the US federal National Oceanic and Atmospheric Administration announced that El Niño had developed, in February this year.
Some commodity market participants are suffering from “’the boy who cried wolf’ effect”, says Jonathan Parkman, co-head of agriculture at commodities brokers Marex Spectron.
“The threat of El Niño has been in the market for a year and as a result, people have tended to take it less seriously,” he adds.”
What’s the link with commodities?
Here’s where things get interesting from our little part of the world investing in the commodity markets (both long and short). We’re talking actual grown in the ground commodities here, mainly. Gold doesn’t much care about how much rain there is. But Palm Oil sure cares how much rain there is in Malaysia. And Soybeans and Corn sure care how much rain there is in the US and South America. Which brings us back to a confusing part of El Nino. It can mean more rain in certain parts of the world while less rain in other parts (and even within the same country). So we might see less rain in the Southwest, but more rain in the Southeast (where Cotton’s grown). Or more rain in the US wheat fields, but less in the Australian ones… Here’s AgWeb with a nice job showing how El Nino can affect crop prices:
“Specifically, we noted that the soybean market has a pattern of lower prices in the first few months following the event,” Narayanan wrote. “In addition, soybean meal prices are pulled down alongside soybean prices and follow an almost identical path over the 12 months after the shock. Soybean oil, on the other hand, takes a distinctly different path with prices rising for the first four months post-shock reaching a maximum 3% increase by month four, as Asian palm oil production is adversely affected and greater demand for soybean oil ensues.”
He noted a “similar” effect for corn, both in corn production and the grain markets. “Corn yields are usually improved in an El Niño, and prices tend to drop for the first few months only to recover slightly, then drop dramatically into harvest and then eventually recovering seasonally,” he said.
Other crop prices typically fare better.
“Wheat, a more global crop, sees support for the first three months as yields in eastern Australia are dramatically hurt due to drought conditions,” Narayan said.
Cotton also typically gets a bounce. “Cotton prices respond positively within the first month, increasing roughly 1% immediately,” he wrote. “… Dry weather in India, the world’s second-largest cotton producer and exporter, helps explain the rise in cotton prices during an El Niño event.”
And here’s a study by Yosef Lefkovitz at NYU looking at overall commodity prices:
“Academic research has indeed found that ENSO significantly impacts global commodity prices. For example, Alan Brunner of the IMF found that a one-standard-deviation positive shock in ENSO increases overall commodity prices by 3.5-4 percent.28 According to Brunner’s findings, ENSO variation has the largest impact on the prices of coconut oil, palm oil, soybean oil, groundnut oil, rice, wheat, soybeans, corn, rubber, iron ore and copper. This conclusion is intuitive, as almost all of the aforementioned commodities are significantly sourced from tropical regions, where ENSO’s impact is most direct.”
Finally, in contrast to our line above about this mainly affecting grown in the ground commodities – extreme weather can have spillover effects in other markets we wouldn’t think as connected to the weather.
“Indian farmers are large buyers of gold, and analysts at UBS last year raised concerns that a potential weak monsoon could hit purchases of the precious metal.”
In the past, droughts in Indonesia, a leading nickel and copper producer, have led to output declines as hydroelectric power facilities were affected as were the water levels of inland waterways used for ore transportation. In Peru, heavy rains flooded into zinc mines, triggering price spikes.”
In the end, this is one of the reasons we’re in this space. Because there are things like the sun heating up the Pacific Ocean that are return drivers for alternative investments. And warm ocean water is about as far from costs per unit and revenue streams on Wall Street as you can get. Well, this picture from space actually might have been further – but you get the point.