Pete Nessler, CEO of FCStone Group, was raised in Chicago but earned his stripes in the grain fields of Iowa. Working with elevators and farmers, he helped turn Farmers Commodities Corp. from a group of co-ops into the international brokerage firm INTLFCStone that it is today. Along the way Nessler was a commodity trading advisor, jump started the firm’s move into ethanol and opened and nurtured the firms’ global presence from South America to Europe to Australia. We spoke with him about how the agricultural markets have changed during the past 30 years, and how a small Midwestern firm grew and changed with them.
Futures Magazine: You grew up in Chicago but went into agriculture?
Pete Nessler: I went to the University of Illinois [for engineering] but I was looking for something more, and met some guys in agriculture. I [then] started taking Ag Econ and Ag Industry courses, which were trading, hedging and basic marketing. I had great professors, like Hieronymus…all the old guys who wrote most of the books for futures trading were the professors and the people I got to deal with.
From there I went to Agra Industries and did cash trading. At the time Agra Industries, which was one of the big regionals, owned Farmers Commodities Corp. That’s where I learned hedging; it was at the height of the Falklands crisis so gold and silver were going up and down, soybeans were going up and down and with England and Argentina [at war], we had all the vessels trading prices going up and down. So it was learning by fire. [I had] to make decisions, as small as they were, [quickly], but it did give me a chance to do see how hedging, trading and the markets really worked.
FM: How long were you at FCC before you started the commodity trading advisor?
PN: As the markets started changing, I was trading a little bit personally. I went to our CEO at the time and said, ‘what would you think if we started a commodity fund?’ We did…I was still an employee of FCC...and did that for about seven years.
FM: What was your trading methodology?
PN: I’m a fundamental approach trader, and I look at leveraging options. I learned that optionality in the physical market hedging and within the speculative market gives you more leverage, at least a pre-notion of your risk. I’d trade a lot of long options, three-way options, vertical call spreads, trading maybe shorter dated options [during] crop reports, things like that.
FM: How new were ag options at that point?
PN: They started in the mid-1980s. I really looked at it as I looked at fundamental analysis, for where the market can go and from there, looking at what position can be enhanced by going out longer term. I also traded the spread relationships and the cash market. And that is a big market that you don’t get a lot of big traders in anymore because there isn’t enough volume. High frequency could never trade spreads. That’s more the fundamental trader. There is a cash connection to spreads, in theory,to the underlying commodity.
Then I went back into the elevator hedging world, and the evolution of ethanol started. I went to the CEO and said ‘this is a big business that is going to change how U.S. ag markets look,’ and a colleague and I literally got on the road and started [visiting] the new wave of ethanol plants around 2000, 2001, and grew that business for the company.
FM: How did you recognize that opportunity?
PN: When we looked at ethanol plants and really [reviewed] the potential green sites that were going to be brand new and how many plants were going to be built, we started [noting] the impact locally, that is, how much corn wasn’t going to go to export or wouldn’t go to an end user. We knew that there was going to be a disallocation, number one, and number two, [there would be a change in] the supply and demand curves [if] we met the RFS (renewal fuel standard). I don’t think people fully understood the implications of how much more corn was going to be used locally, domestically. A 100-million gallon plant uses almost 40 million bushels of corn; that literally is one county in Iowa production, and that county was feeding hogs, cattle and everything else. So once (I) started going through the numbers, [I thought] something is not going to add up; corn is not [going to continue to] sit at $2.50 [a bushel] anymore. That was the beginning.
FM: So the ethanol business in the United States is still growing?
PN: It’s actually developed into a crush margin, like how a refiner looks at a crack spread. In an ethanol or bio-diesel plant, with corn you’re making ethanol, DDGs (distillers dried grains), and if you have the third aspect, CO2. [Those are] the three products that come out of [the corn]. And you get corn oil off the DDGs, which they’ve now refined, and corn oil can go into bio diesel or feed or pharmaceuticals. So the basic premise of an ethanol plant from where it started to where it is vertically integrated, and at the end of the day it’s all margin related.
And now with more plants than 10 years ago, there’s more competition. And pretty much we’re at full usage from a corn basis; we’ve hit the top of what was mandated for corn for ethanol. We’re not in an upward slope anymore; we’ve peaked out at 5 billion (bu.) of corn for ethanol.
But the rapid transformation on the upside is what I think surprised everyone in the corn market because the demand was so exponential. And the mandate is nearly negligible now. When you look at ethanol [the last few years], it was as big as the feed number. And this year it is projected to be four times the export market. Projected for ethanol in 2013-2014 [is] 4.9 billion bushels of corn; exports projected for corn are 1.225 billion bushels. So ethanol is now a driver. And with all the arguments of the RFS, and all the good and bad and big oil, we now have out of the demand base of 12.6 billion bushels of corn, almost 5 billion in ethanol. So if we got rid of ethanol, agriculture would have a [crash] and the land prices and everything [would drop]. So we had to live through some of the heartache and misery, but now it’s just part of the equation.
FM: So is food for fuel a bygone argument, like peak oil?
PN: I think it is. Out of ethanol you do get distillers grain, and that is fed to cattle and dairy, and now it’s even having inclusion rates in hogs, and [we’re] getting corn oil off the back end. And depending on [type of plant] we get CO2, that goes into hydroponics and such.
And when you look at it, it was a local product; it was done by a local community with local farmers, it was financed by Midwestern banks and such so it is exactly the root of what we dealt with. [And] it has reinvigorated middle America. We’ve lived through the hysteria because we have globalized commodities, [for example] we have corn being grown in Brazil and all over the world.
FM: What about the financialization of commodity markets? Are you seeing an impact on price discovery?
PN: We are into a carrying charge market now. The backwardation or inverted market we had was just fine when the carry out usage ratio charge of corn was 5%, now all of a sudden we’re projecting 14% carry out to use. So we are building carries.
I’m not one to be a demagogue on high-frequency and algos, they have their places, and within agriculture, we don’t have the depth of the market you get in the dark pools in equities. We will get some spikes and literally the market comes back. More than not when you see that big trade blow in, as soon as they’re done, the market goes back to where it was. You don’t see that overall manipulation, [especially] with the CFTC and the oversight today.
We had more issues back in the 1980s with some grain companies and different trading houses trying to corner soybean markets, and the soybean trade. Remember the name Ferruzzi? You had more of that happening with squeezes in the market. A high-frequency trader is just that, he’s in and he’s out. He’s not a position trader for more than a nanosecond. HFT is there just to trade in and out, and in a commodity market where you have an underlying physical asset that is there, I don’t see it as a big issue. I mean, [HFT] is part of the market makeup.
FM: Beyond HFT, what about other players coming in, like investment banks?
PN: Within agriculture, I don’t think you’ve seen as large of a change by the investment banks. The investment banks are more in the energy sector, which is a much larger globalized commodity. Beside your ABCDs, which all have a place in the business, you see new companies emerge that are into that, like the Nobles, Olams, Glencore…you’ve got a lot of different trading houses and they are all part of the equation. At the end of the day, none of them predetermine what the price of corn will be three or six months from now. They are hedging, doing risk management or trading on a perception, but [bottom line], agriculture is a fundamental market and if we have another drought and less acres, or big acres and a big crop, that will [determine the price].
You can get into how the world globalized soybeans, or the inverse or backwardation of soybeans this year. That’s something that [we may be concerned with] because delivery points are within the U.S. [although there’s] as big of a supply [of grain] now in South America as [we have] in the U.S., even bigger. That’s more of a fundamental key. It’s projected now that next year Brazil will have 88 million metric tons of soybeans, which would be bigger than this year’s crop in the United States. Then you throw in Argentina at 50-60 million metric tons, yet we’re all trading Chicago, [and the] delivery points [are a problem]. So like this past year, we may not have had a lot of soybeans here, but they’re somewhere else in South America. That’s where you get the disallocation. [We don’t] have a true delivery point.
FM: Is one problem that the delivery mechanism isn’t set up in Brazil?
PN: There are two ports being built in northern Brazil, the other port in the southern part in Santos. When these northern ports [are complete] it will work, but [Brazil needs] railing and trucking infrastructure. They are growing [all commodities] but they don’t have the [ports] like in the U.S. And we see cash basis swings in Brazil. I’ve been there three times in the last five months , and the infrastructure [is not there yet]. Brazilian farmers are driving 1000 kilometers (about 600 miles) to deliver soybeans, where in the United States that doesn’t happen, it’s on a railroad or a barge. But this is actual farmers in trucks driving for a day to deliver soybeans because of this disallocation.
FM: It seems agriculture has been U.S.-based, but now is global. Was it always there and we weren’t paying attention?
PN: [One reason for global growth] is we had very high prices in 2005 and beyond that brought in more production globally. Plus new players that didn’t really exist 15 years ago and players becoming larger have helped, such as Glencore, Noble, Olam, Gavillon, to name a few.
We differentiate our firm where we started as a clearing firm office in Chicago, but we were based in West Des Moines, Iowa. And then we opened offices [throughout the Midwest]. We have taken an approach as a firm that we go to where the customers are. Instead of trying to pontificate from an ivory tower somewhere, we get people locally in that area, we teach them what we do as a firm. We’ve got guys from elevators, customers, farm kids, on the agricultural side at least. So when we went down to Brazil, we hired people from customers from that area. We put a big emphasis 10 years ago on Brazil; we saw the evolution and [now have] six offices, 60-plus employees down there. In the last three years we opened two offices in Paraguay, which is [the] third largest bean producer [in South America].
Also in Brazil, for instance, with the capabilities of the firm we are doing the forex risk, and that differentiates us from other people. So what we do is besides the risk management of the soybeans through our typical FCM unit, in our consultant unit we now are utilizing our FX services to lock in forwards on them. We have a lot of customers that are shipping overseas or buying, and our global currencies[unit] is a treasury function within the company. This is the integration of the FCStone per se with the legacy INTL business. So now we have a solution for the customer that is not just going to the firm to clear through the firm, but is there also to partake in FX risk, forwards risk and anything like that.
We trade 150 currencies — more than any bank. We have a lot of relationships; many tier-one banks utilize us because it’s not worth their time to have these relationships; we do $2 billion a month of global payments.
FM: FCStone saw the global expansion a long time ago?
PN: When we did the merger (with INTL) on Oct. 1, 2009, INTL pre-merger was in Argentina, London, Dubai, Singapore, and in New York with their FX business. What we had in Brazil, they had put part of their business in Brazil that we had started. They had Singapore and we took part of our business and put it back into Singapore. It worked well, there was no overlap.
FM: Can you explain INTL?
PN: Before INTL, it was called International Assets Holding; it was a public firm doing precious metals, base metals, FX and equities. They do in equities what we do in futures. They are extremely large in the equities business [in ADRs]. They were ranked the number one market maker in dollar volume in 1,700 securities in 2012. So if you’re looking at a foreign stock, we are the market maker in that. It’s based out of Florida, and they make markets in 10,000 securities. In precious metals, they did $67 billion in turnover last year.
When we merged four years ago, INTL had about 180 people, we had 420. Today we sit at 1,050. So it wasn’t one of those put two together and cut half out; we’ve almost doubled in size in almost four years. And that’s where the synergies work: We weren’t into (forex) and they weren’t into ag.
They are trading in the debt market that’s down in Florida. It’s the same thing to a degree of what our swap dealer does…but they’re doing it in the securities world.
FM: What about other groups entering the ag business, like hedge funds and private equity buying land, trading firms buying processing…has this been good for your group?
PN: Institutional land purchase is overblown; big farmers incorporate anyway for tax purposes. I don’t see investment banks owning a bunch of ground [a problem], I mean they still have to hedge. That hasn’t hurt us at all. New players in the market? Not a big deal. What we have to offer as a swap dealer, we can offer a whole suite of services. That’s a big plus for us.
Of the original 65 swap dealers, we were the only non-bank. …because we make markets in the FX world and within our ag side, so we met the criteria of being a swap dealer. In talking to people in that world, they’re seeing that, yes, they need to be swap dealers as well. So besides big energy companies, I think you’re going to see big FCMs [become swap dealers as well].
FM: Your strength has been agriculture, but you’ve moved into softs markets?
PN: Yes, we felt expanding into Brazil was a core area of growth. So we looked at different firms (and continue to do so), smaller niche entities, and purchased a softs group and now we’re one of the largest coffee traders. And piggy-backing off that, we purchased a group that just does coffee, so now we’ve covered both entities. In natural gas we picked up a group [FC does 20-25% of natural gas commercial and residential consumption in U.S.], so now we work with the big gas companies.
I’ll be very honest, when you look at FCMs today — the grain markets for the last two to three years: We’ve had three years, almost four years of smaller crops, there’s no carrying charge market, low open interest and we don’t have the carry for the elevators. So what [FCStone has] done is disperse ourselves, and now all of a sudden we’re a large player in coffee, sugar, palm oil, cotton — all the other areas that are agricultural baskets that aren’t Midwest-, U.S.-centric. We had to [get out of being too focused on grains] because if that’s your only card on the table, you’re not going to survive [because] you’re at risk of weather, and you’ve got other parts of the world that are going to be as big or bigger than the U.S. in, for instance, soybeans.
FM: What are three biggest changes in clearing and brokerage over the last 30 years?
PN: Obviously the notable fall of one FCM. There’s a lot of reputational risk at stake for everybody and the institution itself. So that gets people worried: Is their money really safe, is it really segregated?
The lower interest rate environment the last several years; we have to diversify because in the old days we could break even but make money on interest income.
And the new Dodd-Frank compliance residual interest deal is a major discussion point of how soon margin calls or the T or T+1. We’ve been, along with our cohorts here, trying to explain why we feel T+1 is suitable because from a credit line facility, you can’t have enough money [for] a one-day exceptional call, doesn’t matter if you’re a big bank or a mid-size firm.
It’s really the last four to five years [that have] been the largest change. Computers really came in, electronics really came in, Dodd-Frank’s implementation going on right now, the rule making and then the couple of defaults by FCMs [haven’t] really helped the case.
FM: Let’s talk about that; you folks were using Sentinel as a custodian, and that didn’t end well.
PN: I can’t get into that much because there’s still legal issues, but that was a customer seg issue and that’s why we have lawyers.
We’re Midwest-based and I can tell you going way back we carry credit insurance on many firms. Back when Enron was the soup du jour, and when they went under, we had a small trade we had done with them, nothing major, but guess what? We had insured [ourselves] against Enron. People asked us ‘why do you do that?’ and it’s because the structure of our board, if it’s not too cost prohibitive, why not insure it? It’s a very different thought process than some of the other [FCMs].
FM: Seems like you guys took a different path to growth than the MF Global mad dash.
PN: We take an approach that may be more costly in [the] beginning, but we’ve realized that as we go into new frontiers the barrier of entry is either buy into it and either be right or wrong real quick, or take your time with some prudence and build up, learn the business, know the local trade and work from there. That’s our approach; it’s a little more pragmatic. We realize you don’t always get the bang for the buck right away, but as a public company, we don’t look at the day-to-day, quarter-to-quarter earnings because [of] our structure and ownership. It’s more of a year-on-year growth, building something that will be there two to three years out.
FM: Do you feel customer confidence has come back?
PN: When you talk to the ag side, they’re just as brow-beaten over the last few years because of the smaller crops. We’re starting to hear that this year’s corn crop has really done well. That’s a new beginning, and a new dynamic of where prices may go. Last four years’ farmer always saw $7.00 corn. If you put a decent crop on top of this year’s crop, farmers will have to start looking at things differently, [like] valuation of land. From the ag side, the morale was down because we’ve had two to three years of unprecedented droughts. This year we’ll get back to normal, and elevators will have carrying charge markets. And we get back to a normalized industry of the early 2000s. But the last three years have been tough on the whole industry.
FM: Does the Farm Bill still have impact?
PN: The Farm Bill has turned into a political volleyball because [it’s] got food stamp programs and everything [included]. From the Farm Bill loan rates [view], corn is $1.95, soybeans are $5.00 and your target price within the Farm Bill is $2.63 for corn and $6.00 for beans. We’re so far above that it’s not even an issue. I don’t see [the government] increasing target prices.
When we went to Freedom to Farm in the Farm bill, it was a good move; it probably got exacerbated by the ethanol curve we talked about, but that’s settled down, unless they were going to mandate new bushels, new gallons that are corn-related, but, in this political environment, it would not pass.
[And] we are getting new areas of growth globally...if you look at the balance sheet, next year we probably [will] have to get rid of 4-5 million acres of corn because we have that big of supply on hand. At the end of the day it’s going to be about price discovery…and the relationship in the Midwest between corn and soybeans. Right now soybeans are gaining on corn quite a bit, and that will give farmers an indication of what they want to plant. Go back to Nov. 2012 and the ratio of Nov. 14 soybeans to Dec soybeans was 2.12 to 1; it’s now 2.44, so what you’re seeing is we’re incentivizing farmers theoretically to plant more soybeans next year and less corn.
FM: What new trends, U.S. or globally, do you see in the ag business in the next 5-10 years?
PN: Continuation of the global trade in respect to production that is not just U.S.-centric but global: Brazil corn, Black Sea wheat, etc. The U.S. will be a cornerstone but we now see other countries able to produce, not yet at the rate of yield per bushel the U.S. has, but growing. There also will be continued consumptive growth in China and other countries as dietary needs come more in line with first-world countries. And new and improved infrastructure in Brazil will be a huge factor to move product quicker to export. That will take time but will be huge down the road.