Whenever we come across markets with great fluctuations, as it has happened recently with commodities headed by coffee and sugar, the famous tail risk comes to mind. This denomination refers to events whose probability of occurrence is small.
On a market whose return obeys a normal distribution, the tail risk is that event considered very unlikely, because it is beyond three standard deviations, something around 0.3% of chance to occur. For example, it is the probability today that the futures sugar contract for October/2017 will trade at 24 cents per pound. For the purpose of showing what I would like to demonstrate I will next use something between 2.5 and 3.0 deviations.
Because this small probability exists, we forget about this risk. However, some risk managers with a more modern approach recommend that the hedge of the tail risk be made within the premise that the market does not follow a normal distribution and the tail can be fatter than what we thought, that is, with a greater possibility of occurrence. I will get back to that soon.
The Lebanese essayist, trader and risk analyst living in the USA, Nassim Nicholas Taleb, author of the book “The Black Swan”, has pondered, in another one of his heterodox attacks about risks and uncertainties, about the concept of anti-fragility. Fragile is what breaks easily, what shatters, what damages easily, without solidity. The opposite of fragile is robust, strong, and solid.
Taleb, whose seminar about the theme I attended in NY last February, defends that since we cannot predict large fluctuations on the market, the use of the concept of anti-fragility helps us take stands on the market which would benefit from an eventual chaos. In other words, anti-fragility (a neologism, by the way) is that structure in which someone benefits monetarily from a chaotic situation, from an unlikely event.
Let’s look at the sugar market. Who would dare imagine, four months ago, in their right minds, that the futures sugar market would trade below 13 cents per pound? July 2017 closed this Friday at 12.97 cents per pound after having traded at the 12.76-cent-per-pound low, the lowest quotation since February 2016, and the smallest value in real per ton since September 2015.
We have already spoken here about the various reasons, with their different magnitudes, which helped the market plummet so strongly. The physical sugar delivery at the maturity of March futures contract by a great producer has flung open the weakness of the physical market and was a game changer in its trajectory. This was followed by events which sped up the fall: the funds decided to go short (and today they are 94,000 lots short), the physical hardly gave any signs of recovery, ethanol import occurred at a delicate moment and the oil barrel price reversed a possible trend there was of less sugarcane allocated for the sugar production. It is almost like a perfect storm.
To make matters even worse, in a market trader’s view, a lot of counter operations which had disappearance levels were triggered. That is, companies that used the so-called accumulators as hedge tool counted on having a volume of tons of sugar with fixed prices in NY which ended up not coming into being, since new lows were achieved and limited the volume of price fixations or set off triggers which canceled these structures. It’s crazy stuff.
Back to the fat tail – early in February second fortnight, when the market was still above 20 cents per pound, if someone had spent US$100 thousand on the purchase of puts at the exercise price of 15 cents per pound, maturing in October/2017, financing this purchase with the sale of just 137 lots of the call at the exercise price of 22 cents per pound, which represents only 7,000 tons of sugar, based on the week’s closing now he would have US$10.8 million in the pocket, enough to compensate for all the fall for a volume of 70,000 tons. That’s a huge insurance.
The readers will say that is it easy to talk after the accepted fact, right? Well, it so happens that more and more efficient risk management seeks to protect the company not only from unlikely events. Much better and more efficient than to have a robust structure is to have an anti-fragile structure, the one when you are strengthened at a chaotic moment. The hard thing is that companies prefer exactly the opposite. The so-called accumulators done uncontrollably, and many times without any criterion or full knowledge about the risks, simply maximize the disaster exactly when the disaster occurs. The holder exchanges being run over by a bike for being run over by a concrete mixer truck.
When the market falls shamelessly like now, panic sets in and any logic argument dissipates. It takes serenity. Low prices such as the ones now cannot sustain themselves in the long run. The production cost of sugar in the Center-South is 13.73 cents per FOB pound. Thailand’s cost is 15.49 cents per pound. If last year, even with good prices, what we saw was a renewal of only 12 of the sugarcane field at the well-capitalized companies, at these levels it is expected that we will have a lower renewal.
Working for a fall towards 12 cents per pound are the short position of the funds, the repurchase of hedges by the mills, oil close to 40 dollars per barrel, the extreme pressure on the commodities (sugar, coffee, and orange juice lead the falls in the yearly accumulated) and real worsening against the dollar. Both in sugar and in coffee, the funds are heavily short and doing great damage.
Anhydrous ethanol today pays better than sugar, NY + 23 points equivalent.
Arche Consulting 28th Intensive Course on Futures, Options and Derivatives – Agricultural Commodities (in Portuguese) will be held on September 19 (Tuesday), 20 (Wednesday) and 21 (Thursday) 2017 from 9:00 am to 5:00 pm in São Paulo, SP at the Hotel Paulista Wall Street. The course is 3 months out and already 1/3 of the openings have been filled. Don’t leave it to the last minute.
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Have a nice weekend.
Arnaldo Luiz Corrêa
