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The El Niño effect: What it means for commodities

The odds of extreme weather this year have crept up to around 80 percent in favor, according to forecasters, posing a very serious risk to the price of soft commodities.

EL Niño, a climatic phenomenon caused by warm waters in the tropical Pacific Ocean can trigger downpours or droughts and affect temperatures, threatening crop yields and prices.

Investors are now weighing how to be positioned ahead of a possible event.

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El Nino related flooding, Salinas, California, February 1998
Paul Sequeira I Getty
El Nino related flooding, Salinas, California, February 1998

The International Research Institute for Climate and Society at Columbia University reported a 70 percent chance of El Niño occurring in August, rising to a 75-80 percent probability by October. That could result in weather conditions likely to affect commodity prices generally, particularly softs such as cocoa, coffee, cotton and sugar.

Analysts have been using the ENSO (the El Niño Southern Oscillation Index) an indicator of El Niño events which measures the surface air pressure, as a gauge. Commodity strategists at Societe Generale have found a correlation between commodity prices and the index.

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"Considering the recent shifts and extremes in global weather patterns over recent periods, it is not unreasonable to suggest that should an El Niño event develop this year, it could be significant," SocGen cross commodity strategist, Mark Keenan said.

El Niño events tend to develop between April and June and reach their maximum strength during December and February.

Conditions usually persist for nine-12 months, but can occasionally last for up to two years, according to Columbia University.

Keenan said sugar, cotton and cocoa prices all respond positively within the first month of a weather "shock", all increasing roughly 1 percent immediately.

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Sugar prices after that are set to be volatile for six months. Dry weather in India and Thailand, brought by El Niño conditions, often threatens the sugar crops there, reducing global production.

"Our current price forecasts had us neutral on sugar prices in the current quarter, but bullish in the second half of the year. If an El Niño does materialize, this would add additional support to sugar prices from July to December," said Keenan.

Using the index price movements as a benchmark, Arabica coffee beans, the base for most coffee drinks which have doubled in price since December, are expected to fall after a shock. Their price will not return to pre El Niño event levels until nine months later, according to SocGen.

Nicholas Brooks, head of research & investment strategy at ETF Securities, said investors are seeking agricultural exposure ahead of sowing season as the probability of an El Niño weather event continues to increase.

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"Earlier this month the Australian Bureau of Meteorology forecast there is a 70 percent chance Australia will be affected by this summer for the first time in four years. With prices of many agricultural commodities likely to rise as weather extremes disrupt production, investors favored positions in diversified Exchange Traded Products (ETPs)," said Brooks.

Agriculture, corn and soybeans ETPs all saw inflows this month, he said.

Cocoa prices, which have surged to near record highs this year, are also expected to firm in the second half of the year. Drier weather in West Africa as a result of El Niño and a second consecutive global deficit in excess of 100,000 metric tons set to be recorded for 2013/2014 means prices are likely to strengthen said African bank, Ecobank.

Michael Landymore a fund manager at Impax Asset Management who invests in food and agriculture said he was avoiding certain companies on fears of an El Niño event.

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"I am aware of it as a risk factor, if companies have got a high exposure to the monsoon not happening in India, then I am going to avoid them," he said, adding that he was looking at a viscose producer, but felt cautious as viscose is sensitive to cotton prices.

"The group where I think there is the biggest single factor risk is the palm oil growers and traders. It is concentrated so heavily around Malaysia and Indonesia they can't not be impacted one way or another, whether that is lower yields or higher prices," he added.

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