A new approach to price risk

A Conversation with Joe Brooker

Good morning, Joe, and welcome to Commodity Conversations. Could you tell me about your career so far?

I started in commodities as a market analyst for ADM, then moved on to ED&F Man and Platts. I have been with Stable since 2019. Somewhere in the middle, I took a year out to travel. I wanted to travel before settling down. My wife and I expect our first baby later this year.

Congratulations on the new baby! I hope it all goes well. Could you please tell me about Stable?

Our CEO, Rich Counsell, the son of a UK farmer, founded Stable in 2016. He realised that hedging price risk was a complex, risky, and intimidating experience for businesses more interested in safety than speculation. He also realised that the futures markets provide an inadequate hedging mechanism for many agricultural products.

He looked at an insurance model and how insurance companies price contracts through actuarial data science – and wondered if the model would work in hedging agricultural products. He got in touch with the universities of Liverpool, Harvard and Lisbon and built out an academic bank of research. In 2019, the company launched ten products working with farmers in the UK.

That was when I joined the company. My job was to build out our suite of reference prices for expansion into the US and expand from our farming customer base. We contacted food businesses, manufacturers, and processors active in markets with an inadequate hedging mechanism – any market with a significant basis with the existing futures contract or where there was no futures contract. There are a lot of them!

We now have over 500 prices on our platform and offer hedging for protein cuts (beef, pork, and chicken), organic grains, lentils, pulses, fruit, and vegetables.

What was the most challenging contract to write?

We have written contracts for a Californian guacamole manufacturer. It was challenging for our risk managers because avocados are highly perishable, and storage is limited. Most avocados come from Mexico, and the manufacturer relies on a narrow supply chain. It is sensitive to any kind of demand shift, supply shortfalls, or changes in customs regulations; prices can double in a week. It is challenging, not only for the algorithm but also for our underwriters.

What's your business model?

Stable works between businesses and reinsurers to offer a solution, essentially put and call option contracts across 6 to 18 months.

Within that, we must pay our pricing partners – the PRAs, Price Reporting Agencies. We're already working with FastMarkets and Mintec and are continually expanding. We pay them a percentage of the premium.

So Stable takes on some of these risks and transfers the rest to the insurance companies?

This year we became a fully-fledged insurer in Bermuda. It's a big step, as you might imagine. The reinsurance companies take 95 per cent of the risk, with Stable taking 5 per cent, using capital from our last round of funding when we raised $60m

How does the insurance company evaluate the risk, and how do they cover it?

Stable sources the deals worldwide and prices the risk; we share in the annual performance of the portfolio.

Can you give me an example?

A US construction company came to us to hedge its lumber exposure. We agreed, and as part of our partnership with RISI, now part of Fastmarkets, a publisher of lumber prices, we offered them some call options on lumber prices. Lumber prices had recently exploded following the COVID-19 pandemic, but they had since retraced. There had recently been a hurricane, but we studied the correlation between hurricanes and lumber prices – which showed minimal correlation - and put a price on the risk.

After our work in lumber, we have expanded to the paper and plastics packaging market.

If I understand correctly, insurance companies take on these risks but don't hedge them. They just say, "We're going to win on some and lose on the others." Is that what they're doing?

Exactly.

Our data science team in London has built an algorithm that prices the initial premium based on historical volatility using traditional options pricing methods.

The data science team prices risk mathematically, but we also have an underwriting team, including economists and quants. We then add commodity market knowledge, working with market experts. For example, we have an expert for each of the fruit and veg, nuts, dairy, proteins, and grains markets. We ask our market experts for their opinion. You could call it a quantitative and qualitative approach.

We're building out an almost trading mindset alongside our panel of reinsurers. We assess each type of risk individually and ask how it will fit in our portfolio.

How do you build a diversified risk book?

We offer a broad range of products across puts and calls; it helps to balance the portfolio. We also diversify our risk geographically, with imminent expansion to Europe to balance our presence in the US and Australia. We've got US risks across hundreds of different markets, and there's time diversification within that.

Is it a new business for the reinsurers?

Yes, it is a new venture. Some already have exposure to energy products, but agriculture is a new risk for them - none ever had exposure to avocados! The more niche we become - and the further removed from the markets correlated with futures contracts - the more diversifying we become for the reinsurers.

The insurers think about diversifying their risks and see Stable's risk pool as one aspect among their different books.

Do you hedge in the futures markets?

We don't. As our energy and petrochemicals book expands, that may change, but there's no good futures hedge for fruits, vegetables, and organic grains.

Do you work with trading companies?

No, we only work with companies that have genuine physical exposure. It takes away the portion of the market that wants to trade rather than insure its risks.

Do you work with multiple reinsurance companies? If you only work with one, there's a risk that they have a significant loss one year, decide they don't want to do it anymore, and then your business model is ruined.

We began as a Lloyd's cover holder but now have a panel of five or six reinsurers. We are a regulated insurer ourselves.

Have you considered working with hedge funds as well as insurance companies?

Perhaps in the future, but Reinsurers will always be the most important component of our capital pool.

Some of these markets are small and specialised. How do you deal with that?

There are a couple of things that we can do to mitigate risk. We always look at the market size and the competition within that market. Some of these markets are oligopolies.

We also look at how the prices are reported for that market. The crucial thing is to understand who the contributors are to the price used as the settlement mechanism.

We are not so concerned about the mandated markets. The US pork and beef markets are under livestock mandatory reporting. Every US slaughterhouse that sources over 150,000 head must publish the price they sell every cut of pork or beef in the morning and the afternoon – a fantastic plethora of data.

We have built a grading system for published prices. We work with BDO*, which helps PRAs comply with IOSCO, the International Organization of Securities Commissions, to ensure that their price reporting is regular, transparent, and traceable. IOSCO shores up methodologies to prevent any form of manipulation.

We work primarily with IOSCO-compliant PRAs as they have the paper trail to understand how they report prices.

We also have a strenuous onboarding process to ensure we're working with people genuinely trying to hedge their physical exposure and not just trying to trade with us.

It's a minor revolution for people to hedge their avocados, proteins, and organic grains without using the futures markets. An organic barley producer might previously have hedged in wheat on the MATIF, but now they would come and hedge with you. Is that a fair statement?

Yes, that is correct. We want to help businesses reduce basis risk and offer liquidity against the price they are exposed to. Our aim is not to take business away from the futures contracts. They are there to serve a real need and are effective. However, many new futures contracts don't get the liquidity they need. It's a massive logistical effort to simultaneously get the buyers, sellers, and speculators. It takes time to build up. We aim to sit alongside the futures markets and supplement the existing risk management tools. We aim to offer market participants a hedge where it previously has not existed.

Do you offer risk management tools on a basis against the futures, or do you only work with outright prices?

It's all outright now. We may look at options against a basis.

Do you only offer option contracts?

Yes.

What about counterparty risk? Some potential clients may be concerned that you're too small and you might not be able to honour the contract if there's a big market move. Is that an issue?

Our reinsurers (with colossal balance sheets) set our precise risk limits, so we operate very clearly within those boundaries. We also limit our loss on any contract by selling call-and-put spreads, not outright options, so our potential losses are limited, especially with such a diversified book.

Ahh, I had missed that. You sell options spreads, not outright options. It limits your potential loss on any deal. *

Correct.

Do you sometimes have to educate your clients on risk management?

Our commercial team comes from risk management consulting firms, food businesses, and trading companies. Our people know how risk works. They do a lot of listening and are highly knowledgeable.

Education is crucial. We've held various workshops to help our clients understand their risks so that we can work out the most suitable products for them.

It's often a question of language and terminology. Hedging can sound more complex than it is, so we work hard to simplify it all in terms of structure, language, and user experience.

How do you see the business developing?

We have recently launched into the US Sugar, US energy (biodiesel, ULSD, methanol), and packaging (paper, plastic). We will enter many other markets in the coming months.

The opportunities to help businesses with unmanaged commodity price volatility are enormous and, in some ways, overwhelming!

Thanks, Joe, for your time and input.

Notes

BDO is an acronym for Binder Dijker Otte, an international public accounting, tax, consulting, and business advisory network. It takes the PRAs through the IOSCO compliance process. IOSCO validates and certifies the PRAs' processes, shoring up methodologies to prevent manipulation.

A call option spread is where you buy one strike price and sell a higher one. Buying a call option gives you the right but not the obligation to purchase at the strike price. When you sell a call option, you must sell at the strike price if the option buyer demands it. By selling a call spread, Stable limits its payout to the difference between the higher and lower strike prices. The same works the other way around when they sell put options to a producer to protect them against a price fall. For a fuller explanation of options trading, please see my book Commodity Conversations – An Introduction to Trading in Agricultural Commodities.

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