Here’s Why Wilmar International Limited Has a Less Risky Business Model in the Commodities Space

Commodity traders in Singapore’s stock market seem to have garnered a bad reputation in recent years.

In late 2012, investment research firm Muddy Waters shorted Olam International Ltd’s (SGX: O32) shares (when you short, you’re betting that prices will fall) and released a report criticizing the commodity outfit’s accounting practices and business model, among other things.

Then, just last month, Noble Group Limited (SGX: N21) fell into the cross-hairs of the blogger Iceberg Research, a little-known investment research outfit. Iceberg Research, which claimed to not have any positions (long or short) in Noble’s shares, had released two reports in February that were extremely critical of Noble Group’s accounting practices, amongst other issues.

I wouldn’t want to wade into the debate of who’s right or who’s wrong, but with two of the three major commodity traders listed in Singapore having endured short-attacks, is that a sign that these commodity traders are in risky businesses? What should investors make of Wilmar International Ltd (SGX: F34), the last of the trio?

Wilmar is actually the largest of them and has businesses operations that may be no less complicated than the other two. The company is also considered one of the world largest players in the palm oil, sugar, and oilseeds & grains industries.

With the huge volume of commodities being traded by Wilmar, there is no sure way of knowing that all its commodity contracts are being priced accurately when it reports quarterly earnings. But, there’s a key reason why Wilmar’s business may be less risky.

Asset heavy vs asset light business models

Generally, a commodity trader would buy and sell its products using derivatives such as forwards or futures contracts. The firm can buy the products that it needs on the spot market and then sell it off in the forwards or futures market, hopefully for a profit.

Wilmar’s business model on the other hand, is slightly different – it involves the company owning the whole value chain of the commodity that it trades in.

For example, for its palm oil business, Wilmar is actually one of the largest plantation owners in the world, having produced 4.3 million metric tonnes of fresh fruit bunches in 2014. This means that the company is selling products that it is actually producing instead of merely being a middle man matching buyers and sellers. This distinction is important.

Asset-light commodity traders can earn a profit simply by trading paper contracts that are tied to the physical commodities. Such traders can bet on rising prices by buying a futures contract in the hopes of selling off the contract for a profit at a later date. The traders can also bet on falling prices by selling futures contracts in the hopes of buying them back cheaper at a later date. These activities are more speculative in nature.

But for Wilmar, it actually has a fixed and predictable cost structure in its operations (of producing the commodity) and would thus be able to book a profit so long as it is able to sell its products at a price higher than its cost of production.

It is not to say that Wilmar does not engage in these paper trades at all. But, there is lesser incentive for Wilmar to engage in speculative acts like trying to predict the future price trends of a commodity. This is because Wilmar can ensure that it’s profitable as long as it enters into contracts with selling prices that are above its production cost.

Foolish Takeaway   

Trading in commodities need not necessarily be a risky business so long as the trader is able to control its risks by being conservative with its business practices, such as always netting off its contracts with buyers and sellers.

In doing so, the trader can earn a spread between the two parties and generate a consistent and somewhat predictable earnings stream, regardless of whether the price of the commodity has moved up or down.

The problem comes if a commodity trader would engage in speculating on the future prices of commodities. It is dangerous because the prices of commodities can be extremely volatile. (Just ask the oil traders!)

To learn more about investing and to keep up to date on the latest financial and stock market news, sign up for a FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore

Also, like us on Facebook to follow our latest hot articles.

The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim owns Wilmar International Ltd.