The National Oceanic and Atmospheric Administration’s (NOAA) latest El Niño update, released Monday, put the chance that El Niño conditions will continue through the winter at 90% and into early spring at 85%.
The destruction a severe El Niño can wreak is staggering. A prolonged episode from 1789-1793 has been blamed for a famine in India that killed 600,000. Between 1997 and 1998, an especially severe El Niño caused an estimated 23,000 deaths and $35 billion in damage worldwide. Given the sheer destructive potential of El Niño, it should come as little surprise that it can have a significant economic impact, particularly on commodity prices.
Unto Us a Child Is Born
First, what is El Niño? Spanish for “the boy,” the name was coined by Peruvian fishermen in the 17th century and refers to a rise in eastern Pacific ocean temperatures. The name is a nod to El Niño’s timing: it often arrives around late December, coinciding with the birth of the Christ child.
In “normal” times, trade winds push warm eastern Pacific water westwards, allowing cold water to flow upwards along the coast of South America. From time to time, however, and to varying degrees, these winds slacken. The result, as the satellite image below shows, is a band of anomalously warm water that menaces the equatorial Pacific.
Source: NOAA; SST = sea surface temperature in ºC
The consequences of this ocean temperature shift are global and frequently catastrophic. Floods tear into the Andes. Droughts parch northeastern Brazil, Australia and Indonesia. The monsoon, on which hundreds of millions of people in South Asia depend, is disrupted. Yet there are modest silver linings: winters in the American northeast are less severe, and California might be in for some much-needed rain—or severe flooding. More than anything, El Niño’s precise effects are difficult to predict.
Source: NOAA via Wikimedia
The El Niño conditions currently brewing in the Pacific invite comparison to the infamous 1997-1998 episode. A NASA climatologist has dubbed the current El Niño “Godzilla,” and as of Tuesday, headlines are touting it as “the worst ever.” Exaggeration or not, this one is unlikely to be a repeat of last year’s non-event.
The Commodity Crunch
It is no secret that commodities have taken a beating as of late, chasing oil prices to the bottom of the barrel and receiving none of the usual help from China, whose now-sputtering economy had provided a voracious source of demand for years—not to mention the Fed.
That rout could reverse itself later in the year, however, as El Niño disrupts mining and agriculture in a number of tropical economies. An IMF working paper from 2000 states: “A one-standard deviation positive surprise in ENSO [El Niño Southern Oscillation], for example, raises commodity price inflation about 3-1/2 to 4 percentage points. Moreover, ENSO appears to account for almost 20 percent of real commodity price inflation movements over the past several years [1963-1998].”
Eight commodities in particular, whose generally dismal performance year-to-date can be seen in the graph above, might (emphasis on might) appreciate in price.
The International Cocoa Organization estimated in 2010 (pdf) that El Niño events, on average, reduce world cocoa output by 2.43%. The effect of individual events, however, vary wildly, from a 15.0% decrease in production in 1951-1952 to a 0.3% increase in 2002.
Prediction is complicated by the fact that the crop is primarily grown in West Africa, where El Niño’s effects are indirect. In general, rainfall is lower in Côte d’Ivoire, with an average 2.03% drop in cocoa production; Ghana, with a 1.72% drop; and Nigeria, with a 1.15% drop. Cameroon is largely unaffected. Indonesia experiences an average 2.39% drop in cocoa production, and lower rainfall is a more reliable outcome there. Brazil’s cocoa-growing regions are mostly unaffected, but production in Ecuador—where seven years’ worth of rain fell in four months between 1982-1983—drops a steep 6.16%.
Cocoa futures are up for the year, partly due to expectations that chocolate consumption will increase in China. Rosy predictions from Hershey (HSY) have fed that narrative, though increases in cocoa processing capacity in Asia may threaten price gains.
Vietnam and Indonesia are fretting over their robusta coffee harvests, due to El Niño-induced dry weather. Robusta is a bitter, lower-price variety found in blends and instant brands.
In Brazil, a producer of higher-quality arabica coffee, the coffee harvest may actually benefit. The states with the most production, Minas Gerais and São Paulo, will probably experience warmer weather, but not necessarily more rainfall, according to Reuters. Heavy rain has damaged crops in the past.
In East Africa, coffee exporters Uganda and Kenya may see lower crop yields due to flooding, but Tanzania is expected to see a bumper crop.
Copper, Nickel and Zinc
Copper, nickel and zinc may all be hit by El Niño. Standard Bank analyst Leon Westgate told the Wall Street Journal that Indonesia’s Fly River could be rendered impassable by drought, halting copper transport. Many mines are also dependent on hydroelectric power, which dries up along with the rivers. At the same time, mines in Chile are vulnerable to flooding. According to Société Générale, copper prices rise an average of 7.9% during El Niño events.
Nickel miners in the Philippines may be able to operate longer than normal, since the rainy season won’t be as severe. Nickel Asia has brushed off concerns about hydropower scarcity, saying the company can generate its own electricity. On the whole, however, the nickel price is extremely sensitive to El Niño, rising an average of 13.9%, according to Société Générale.
The price of zinc is less sensitive to El Niño, but production can suffer due to flooding in Peruvian mines.
This year’s South Asian monsoon, which began in June and goes through September, may drop to just 87% of the normal level, which will likely reduce the outputs of a number of Indian crops, including soybeans. Due to El Niño, next year’s monsoon may also be weak.
Any damage to the Indian soybean crop, which was 11.9 million tons in 2013, may be offset by improved yield in the US, which harvested 89.5 million tons in 2013. AgriBank has found that El Niño conditions are “strongly correlated with positive yields for both corn and soybean crops.”
As for Brazil’s crop—81.7 million tons in 2013—Reuters reports that above-average rains may boost the crop in Mato Grosso, Paraná and Rio Grande do Sul. Dr Nick Klingaman of the University of Reading told the BBC that, on average, El Niño raises the prices of soybeans, coffee and cocoa between 5% and 10%.
Sugar’s price may see a considerable boost as a result of El Niño. Drought conditions in Thailand and India will likely hurt the sugarcane crop, and increased rainfall in Brazil threatens to reduce the sugar content of the sugarcane harvest. Sugar is currently trading at levels not seen since 2008 due to a glut in global supply.
Looking at Société Générale’s data, El Niño’s effects on wheat prices are a bit of an enigma. The median price move is +1.0%, but the average is -5.0%. Drought could have a negative effect on the wheat harvest in India, which produced 93.5 million tons in 2013, and Australia, which produced 22.9 million tons. Increased precipitation in the American Midwest has already hurt wheat crops and put upward pressure on prices.
How To Invest
For those who do not trade futures, there are exchange-traded products that mirror their returns. The iPath Bloomberg Sugar SubTR ETN (SGG), for example, tracks the Dow Jones-UBS Sugar Subindex Total ReturnService Mark, which aims to replicate the returns from unlevered sugar futures contracts. For wheat, there is the Teucrium Wheat ETF (WEAT). For coffee, the iPath Bloomberg Coffee SubTR ETN (JO). Similar products exist for cocoa (NIB), copper (JJC), nickel (JJN) and soybeans (SOYB).
These products have vulnerabilities, however, which should be taken into account. ETFs’ prices can fail to track those of their target indices during times of high volatility. ETNs are technically debt and therefore carry credit risk.
El Niño has the potential to disrupt the supply of a number of commodities, boosting anemic prices and providing a buying opportunity. However, many of El Niño’s effects are contradictory—causing drought in one region and floods in another—making the net effect on some commodities difficult to predict. More importantly, predicting global weather patterns is a crap shoot, and even the most sophisticated models can err wildly. Investors should probably not make bets on the received “El Niño raises commodity prices” wisdom alone.