The geopolitics and digital future of agricultural commodities

Danny Crichton:
Hello and welcome to Securities, a podcast and newsletter devoted to science, technology, finance, and the human condition. I'm your host Danny Crichton, and today we are talking about food. No, we aren't pivoting the podcast from geopolitics to cooking recipes, but as should be obvious in 2022, food is suddenly on everyone's mind in a way almost unthinkable just a few months ago. The modern food system is truly a miracle and is about as close to a Star Trek replicator as we are going to get for the time being. Individual agricultural products like corn or wheat are traded in exchanges all around the world, grown in far-flung geographies, and then proceed to when their way from farmer to consumer through an ultra efficient yet Byzantine system of logistics. It is quite literally the finest example of the power of free markets and capitalism to coordinate decentralized actors in a precision economic system.

As always, though, there are problems. First and foremost, the antiquated nature of most commodities trading. It's not just paper and pen, it's also phone calls and emails that drive the most important industry for human survival. In fact, the UN estimates that more than 275 million emails are exchanged annually to ship about 11,000 vessels of grain across the oceans. And while 275 million emails is a bit fewer than the number of securities fan emails I receive, I can tell you that's a bruising communications burden for anyone or any company. The lack of digitalization in this critical industry is one that Lux is targeting head-on. Earlier this summer we led the $7 million seed round for [inaudible 00:01:34] to build the first digital agricultural commodities exchange and already the company's trading platform is being used to trade corn, wheat, soybean, palm oil, and 14 other agricultural commodities in a transparent and secure environment.

Yet there's also a huge challenge in commodities right now. Russia's war on Ukraine has stymied wheat exports and climate disruptions around the world are wrecking havoc on agricultural productivity. That's led to soaring inflation and far more tension at grocery stores the world over. Whether it's the micro challenges of digitalization or the macro challenges of war and peace, commodities trading rules our lives in. Its one that I wanted to dive in deeper on the podcast. Thankfully today, we have two of the most knowledgeable executives in the world joining us to discuss more about the industry's evolution, how it's handling risk, and the balance between logistics and finance as future profit centers. Joining me to talk more is Chris Mahoney, former CEO of Glencore Agriculture, and now known as Viterra, as well as Soren Schroeder, former CEO of Bunge. These CEOs read two of the largest commodities companies in the world and I am so excited for both of them to join us today. So I want to start our conversation by taking stock of what's been happening in 2022. Is it as bad as it sounds? Soren, let's start with you.

Soren Schroder:
It isn't the first time we've seen disruption and supply chains upside down in the agricultural world. Up until COVID, at least where we had the supply disruptions for all kinds of other reasons. Food was just there for most of the world. It was just available and now because of COVID to start with, but then subsequently various weather events and of course most recently the geopolitical issues in the Black Sea, all those supply chains have become strained as well. Add on top of that ocean freight and transportation costs in general, fuel prices, all of it adds on to the landed cost of these basic building blocks of nutrition we've just taken for granted for so long. So yeah, prices are up and everybody feels it. And on the other side I'd say that global agricultural markets as a whole has always had a way of sorting things out.

Chris Mahoney:
Yeah, I agree with that, Soren. I think there's a difference between agricultural commodities and industrial commodities including energy. I think for the commodities that are mine and for the energy complex as a whole, the back drop is sort of seven, eight years of underinvestment and maybe that's slightly true of agricultural commodities as well given the poor cycle that came to an end about the time we retired two or three years ago.

I think we had a prolonged period certainly as far as industrial commodities and energy are concerned with under-investment because investment was broadly discouraged. The CEOs of big companies and particularly big public companies just did not have the incentive to reinvest, that in the mining business in particular. And I think energy as well, I don't know it as well. There used to be the mantra that we have to maintain our reserves. If we don't maintain our reserve base, then the company is going to go into gradual decline in terms of production. But that mantra has gone, and I think I agree with you, I think agricultural commodities, they've always been cyclical. Prices have always had periods of high prices followed by bigger crops. There is underlying production growth and so I think agricultural commodities can settle back down again. I think for some of the metals it may be a bit more challenging.

Danny Crichton:
I want to talk about investor relations. Commodities, much like utilities and other infrastructure companies face incredible investor pressure to be highly efficient, to minimize long-term spending and to return profits to shareholders expeditiously. And there's a lot of tension there between short-term profit returns and long-term investment in resiliency and sustainability. And so how much did investor relations drive strategic decision making for your companies and did those relations impose limits of what you could accomplish?

Soren Schroder:
Because of the cyclicality of the commodity businesses in general, whether it's metals or whether it's agriculture, it's kind of the same thing. It is difficult to satisfy all investors at the same time if you're a public company. I saw many good cycles in my career and I lived through a really rough one towards the end where admittedly we were probably accused of vesting too much at a period where maybe shareholders would've preferred to see buybacks or bigger dividends or whatever. But it's also true that the best investments you make typically at the bottom of the cycle. And I think when you look back now, you would agree with that.

If you were to build a new export terminal, for example, in Brazil or in the US or in Europe or a crushing plant for that matter, the price tag is multiples of what it was just a few years ago. I would not be surprised if let's say a 5,000 ton crushing plant five years ago cost $250 million. Today, it'll cost you 500. Yeah, I mean, just order of magnitude. So these are becoming big decisions now. You invest in a piece of infrastructure is a 30, 40 year life that you have to try and model.

Chris Mahoney:
Yeah, I think that's a good point, Soren. And now also to be competitive, you have to build a bigger facility than you would've built 7, 8, 10 years ago.

Danny Crichton:
It's interesting, we talk a lot about the semiconductor industry on securities in that industry, very similar dynamics in some ways. The cost of a fab has dramatically increased from a billion, $2 billion maybe a decade or two ago to today a fab is 25 to $50 billion to make a single facility, and that's both a function of scale as well as sort of the technology, the extreme ultraviolet lithography or equipment which is in the hundreds of millions of dollars per machine today. What I find interesting though is unlike chips where there's huge cyclicality because consumers will buy a computer in 2020 and 2021 where folks were home because of COVID, now they're not buying smartphones and computers. Hundreds of millions of computers are not being built that were built two years ago and now there's looking to be a huge glut.

To me in food, in agriculture you have a very different scenario where you have a certain number of humans around the world they're going to eat mostly what they're going to eat. Diets are relatively static over... At least in the medium term, at least from my perspective. And so I find it very interesting how predictable in some ways this market is. Population just doesn't materialize. There's suddenly not a lot of demand and there's not a lot of substitutes. And so you have this way more predictable model.

Now that leads to a political question and a geopolitical question, which is obviously we've seen over the last year, particularly with the Black Sea and Russia's war in Ukraine, where we can have huge perturbations in the system where we sort of relied on Ukrainian wheat to be exported as a bread basket for much of the world suddenly kind of turning off for a couple of months. I'm curious, how much did politics play a role? Did you have a geopolitical strategy office? Were you getting advice on how things are changing or was this just enough resilience across so many different countries and opportunities that it was sort of like we can absorb the shock from any individual piece?

Chris Mahoney:
The trade in food, if you like, as it functions today, it requires free markets and that is a sort of vital underlying requirement because you are growing stuff where it's best to grow it and easiest and most efficient to grow it. And you're moving it to places which may be deserts, North Africa, the Middle East, where they can't grow it or you're moving it to places where they have very large populations and so they can't grow enough and the entire system relies on free markets. We have been faced on occasions over many years with issues where we have very high prices for various reasons, mostly weather, and then domestic governments get concerned and then they start thinking about export taxes, export quotas, even export bans in some cases and that exacerbates the problem. But at the moment we have a very unfortunate situation in the Black Sea, which is restricting supply.

But in the past we've had other events such as export restrictions, export bans that have restricted supply and exacerbated the problem, very difficult to predict. What did tend to happen is that the big businesses were big enough and sufficiently globally spread that if you had a problem in one particular origin, you would try and make up for it elsewhere. And obviously when you have that kind of disruption, that's exactly when the trade can step in and try to find a solution. If you can't bring stuff from the Black Sea, then hopefully you can from Australia or Canada or South America. So the situation is particularly bad at the moment, but it isn't anything new.

Danny Crichton:
Well I think what's interesting is I was looking at the consumer price index data for July, looking at all the individual categories for inflation and one of the things that was just amazing to me in food, when I think of weather events, you have a drought, but you have a drought in let's say Florida and you lose the orange crops, so orange prices go up, but it doesn't usually affect all things simultaneously. And I was walking through the data, I mean basically every food category, doesn't matter what it is, has skyrocketed this year. It's almost an incredible synchronization and I think for a lot of the reasons you mentioned, a lot of the inputs, fertilizers in particular have increased in price. Transportation is increased in price and so there's just no way to sort of deliver any food, whether it's bread through flour, whether it's corn, whether it's tomatoes, whether it's avocados. For us, millennials who need our avocado toast to get through the day, they're all going up.

We've talked a lot about the macro environment, so obviously lots of challenges, huge geopolitical concerns, but I want to bring it down to just the daily mechanics. I don't think a lot of folks in Silicon Valley and our listeners understand what is commodities trading like? My vision of it is sort of the Chicago Board of Trade, which is a bunch of folks sitting in a pit screaming at each other and I don't even know if they still do that, but when you think of about for your two companies, some of the largest in the space, how does a bushel flour, corn, I don't even know if that's right unit, but how does the flour that goes into the toast sort of arrive there? What are the mechanics? Are you using technology? Are you using, I don't know, pony express to deliver the messages? How do you get from farmers into the ships, into the countries, into grocery stores?

Chris Mahoney:
It's pretty straightforward. If you take the example of say Canada, you have a big farm in Saskatchewan, the farmer grows crops, he decides what to grow depending on the prices and depending on what yields he thinks he can expect. He doesn't grow the same thing every year. He may have to rotate the crops for the preservation of the soil, but he also pays attention to his prospective yield and of course to the prices that he can either get already by selling food or expects to get. So he grows the crops and then he will deliver the crop by truck to a local elevator. He'll choose whatever private company pays him the best price, so the company buys the goods and then it will organize the loading onto a rail car. In the case of Canada, the railroad is extremely efficient and the railroad takes the stuff to a port on the West Coast, a port elevator which will have some storage as well.

It'll go into storage and then it will go onto a large vessel, a panama vessel or a cape vessel it, or then it will be shipped to the consumer. So in the case of Canada, quite likely to be China. Along the chain, in that example, the buying from the farmer, the control of the elevator, the loading onto the railway wagon, the discharging and the loading into the port facility, the loading onto the vessel would be handled by one company. I think the facilities have got more efficient and bigger and the right location is key, but essentially nothing has dramatically changed 20, 30 years and maybe longer.

Soren Schroder:
It is pretty straightforward really. The tricky thing which is the role of many of the larger companies, ABCDs and also regionals, is to bridge the timing gap between when farmers want to sell for example, and the end consumer be that a flour miller or a chicken producer, that timing doesn't always match. So farmers like to sell when prices are high and consumers or the downstream part of the value chain like to buy when prices are low. And so in between you often have some pretty big timing gaps. The intermediaries help manage that risk of allowing farmers to lock in a good margin when he or she thinks it's time to do that and at the same time help the downstream end of the chain manage their risk. But that's a huge function, the middlemen so to speak play because all those decisions are made at different points in time.

Chris Mahoney:
It's really a big logistics game. Trading companies like Bunge and Cargill and ADM are not... Maybe a little bit of the time, but they're mostly not sitting around deciding whether the market's going up or the market's going down. They're thinking about how can they best move goods most efficiently. Everything has to be tied to perfection. It's a huge sort of complex logistics game looking at the whole globe and all of your origins and potential destinations and try to put things together in the most efficient manner and basically move stuff. It's not a game of speculation at its time.

Soren Schroder:
I think that's a good clarification because I think that's often misunderstood. That is not really the role. Yeah. I look at it as a giant optimizer. You have to optimize for logistics, quality, price, time, all at the same time, real time everywhere in the world at the same moment basically. Many pretty sophisticated tools have been developed over the years to help do that. The digital age is certainly facilitating that. We can do that now real time with not only huge amounts of historical data, but also the use of all the fancy tools including AI to make those types of decisions even better. So there are a lot of advances on that front too.

Danny Crichton:
Well, I think of market participants, I'm making consumer example, but I go to kayak.com, buy a plane ticket, I get a price. I know exactly theoretically when that plane is going to take off, when it's going to land, what seat I'm getting. When I look into the commodities markets, how digitized is it, how transparent is it? If I'm a farmer sitting in Canada, do I just get to go online and say, okay, I have five folks who can take this to the elevator, here's their prices, I can click a button, I've just sold my bushels, off they go. Or is it much more opaque for different market participants?

Chris Mahoney:
Look, I'm a couple of years out of date, but I don't think it's changed dramatically in the last two years. But there is some digitalization of course. When you have big companies like Cargill, Bunge, ADM, trading amongst themselves and indeed trading with big producers and consumers, there are still elements of it that are pretty archaic. At least that was the case a few years ago. You're still largely transacting on the telephone or maybe WhatsApp. In some cases you are sending and receiving hard copy signed contracts. Given what is happening elsewhere in the world and in other industries, there are, in my view, elements of it that are still pretty archaic.

Soren Schroder:
Yeah, there's no doubt about the fact that in some ways agriculture for all this sophistication is still behind the curve in terms of digitizing how business gets done. That doesn't mean it's super opaque. I think farmers in most parts of the world have a very good idea of what the best price is and so forth, but the way businesses transacted is still pretty dated and I think especially when it comes to global trade, it's pretty dated and so there's no doubt room for improvement there. And there are platforms that are being built around the commodity trade that facilitate execution, electronic documents, getting rid of all the paper. I mean, literally boxes of paper that were shipped all over the world to facilitate payment or customs clearance of cargo. I mean, that is disappearing and I suspect that the same thing will happen in how the business actually gets conducted.

Chris Mahoney:
Historically, there has been a bit of a culture in the industry, I think much better now than five, 10 years ago, certainly better than 20 years ago. But a culture of secrecy and opaqueness and lack of transparency. And I think if you go back eight or nine years, and I think there are elements of it still around today, I think the management of some big companies still try to protect that, still think that might be a good thing for them. I think it's much less so than it used to be because 20 years ago, 25 years ago, a much bigger proportion of their earnings came from pure trading. Not speculating in the futures markets, but trading physical goods, having relationships with governments in Russia for example, that China and traveling around the world and protecting your own information and sort of in-house information, even in-house weather departments and things like that were thought to be very valuable and were valuable 25 years ago.

Now of course the efficient running of the assets comprises a much bigger portion of the P&L. No, you still have to trade around the asset base, but it's the asset base itself and the logistics around that and the efficiencies around that that provide the greater part of the earnings. But nevertheless, I think still there are still elements of that old secretive culture. There are still pockets of that around in the industry.

Danny Crichton:
We've covered a lot of ground on the macroeconomics, on the micro side of here on individual traders. And if I had to summarize, 2010 seem to be relatively stable, some change in the business model, some change in the digitalization, some openness here. But now we've hit 2022, and to use your language, we've hit this perfect storm where we have sort of a climate change challenge in many parts of the world. We've had a war in Ukraine from Russia that has disrupted the Black Sea in a very crucial breadbasket. And I want to project forward over the next decade up until 2030. And two ways, one is what's going to change, what will change, what's already underway? This is going to continue in the industry in terms of transformation and how it's adapting. And then what do you recommend the industry do? What should it be changing even more that maybe it's not considering today?

Soren Schroder:
If there's one thing I think the industry, a agricultural food industry is not as good at it is adapting or adopting new technologies. It takes a long time from farm level through the whole value chain to embrace new technology. We'll still need soil to produce crops in 10 years, but how we do it will be quite different and the technology exists. How we trade in five years could be more efficient. How we manage risk in five years could be quite different than how it is today and better for consumers and better for farmers. I think it is really this openness to new technology and being willing to invest in it, takes the courage to put some money on the table and bet on some of this new technology to help advance agriculture and food trade. And then in terms of trading, we know of similar investments where we can help pave the way, make trade more efficient and so forth.

Chris Mahoney:
I think we're going to need more capacity in pretty much everything as we've always needed. Demand growth on the oil seed side of three and a half, 4% a year. People are beginning to start to look at adding capacity now. Personally, I'm very much against using food for fuel. I think it's a big mistake. The way that trade is approached, if you compare grain and oil seed trade simply to the way that we buy a pair of shoes or as you mentioned we book an airline ticket, it's pretty archaic and it can easily be improved and I think it will be improved in the next five or six years.

Danny Crichton:
Well, Soren, Chris, thank you so much for joining us on Securities today, obviously a huge topic with commodities. Not one we cover normally, but one that I think is going to be in our web of attention over the next couple of years, given all the dynamics in the world. So thank you so much for joining us.

Soren Schroder:
You're very welcome.

Chris Mahoney:
Thank you.