Friday, May 13, 2011

Moving Forward: grain merchandising and risk management

This is one of a series of articles taking a close look at some of the issues around the removal of the CWB single desk.  These issues are real and need to be addressed; they are not road blocks, rather they are simply issues that I am presenting for discussion along with potential strategies or solutions. 
Grain companies earn revenues from handling CWB grains in a number of ways. For example, the CWB pays over $80 million annually in storage payments to both country and terminal elevators and over $175 million in terminal charges.  Additionally, farmers pay elevator companies an estimated $300 million in country elevations and cleaning for CWB grains.  Collectively, these are important revenue streams for grain handlers.  Moving forward, these revenues will be replaced by more market-driven revenue streams.

Depending on how the transition from monopoly to voluntary is executed, companies that rely on CWB grains could struggle unnecessarily; a hang-over from the establishment of a voluntary CWB should not be the loss of competition for farmers’ grain.

There is no doubt that grain companies will be able to survive and compete in a market with a voluntary CWB; they will simply need to adjust to the new reality of grain merchandising and risk management. 


Grain companies currently handle CWB grains on a toll basis for the CWB (they buy the grain on behalf of the CWB as an agent); they charge farmers a set elevation and cleaning charge through standard tariff deductions.  Throw in other factors such as multi car rail rates and the periodic trucking premium and you get a rough idea of what grain companies can make handling CWB grains.

In a competitive environment, some of that would change.  The marketing and merchandising of wheat and barley in Western Canada will likely gravitate toward the way just about all other major crops are handled and traded.  Elevations (and cleaning) will be earned through merchandising (buying and selling) rather than through toll charges (tariffs).  Alternatively, smaller elevator companies who do not have an export arm will negotiate terms with an exporter or with the CWB; going with this approach, they may continue to earn elevations through a set fee structure.

So, depending on the individual strategies by companies, their revenues will be either from merchandising, from negotiated terms with an exporter and/or the CWB, or some combination. 


Storage revenue from the CWB has been an important revenue stream for grain companies.  Although through negotiations this may continue, there are other approaches that could prove to be an effective replacement.  In markets where there is an effective futures contract, hedge strategies that consider intermonth spreads (the difference between two futures contract delivery months) are used to effectively earn storage for grain being held over time.  It doesn’t show up on the financials as cash flow quite the same way as periodic storage payments from a third party, but it’s effective none the less.

An added benefit of this approach to pricing and risk management is the extension of effective price signals for spot delivery versus deferred delivery.  Do you store or do you ship?  This applies to farmers as well as grain merchandisers; those that understand the markets this way will be able to offer farmers a much better price signal. 


With a voluntary CWB and the expected competition for farmers’ grain, Western Canada should have its own futures contract for wheat.  I understand ICE Futures Canada is developing a milling wheat contract and will be ready.

Some have looked to oats as an example of why we don’t need a Canadian wheat contract.  Winnipeg Commodity Exchange (WCE; now ICE Futures Canada) tried to rejuvenate an oats futures contract after oats was released from the CWB single desk.  As much as 95% of all Canadian oat exports go to the major buyers in the US like Quaker Oats and General Mills, among others.  These buyers were already trading the Chicago oat contract and when it came to buy Canadian oats, they were not interested in trading another futures contract.  A common technique when buying a commodity is for the buyer of the cash grain to “give up” an equal amount of futures (the seller of the grain “takes” the futures), allowing both parties to be perfectly hedged through the transaction.  US buyers did not want to “give up” WCE futures because then they would need to keep two trading books – Chicago and Winnipeg.  Moreover, they recognized that trading another contract would cannibalize the Chicago contract, diminishing its effectiveness.

Wheat is quite different.  First, in tonnage terms, the Western Canadian wheat market is much larger than the oat market - 25 million tonnes vs 4 million tonnes.  Also, whereas the oat market is dominated by the US, Western Canadian wheat goes to many countries; out of as much as 20 million tonnes of exports, only 2 million or so goes to the US.  And domestically we use as much as 4 million tonnes (including feed usage).  Many companies in Western Canada don’t handle oats; just about everyone will handle wheat, creating a wide base of buyers of wheat (and therefore sellers of futures).  Many buyers and many sellers make for a robust futures market.

Using the Minneapolis futures contract for risk management in all this business would add a level of complexity and risk for Canadian participants because it is denominated in US dollars and it prices US wheat in US locations, thereby increasing basis risk for Canadian players.  Although this can be managed, it gets complicated and effectively adds risk unnecessarily.  Interestingly, the flip side to the foreign exchange argument is that, if a Western Canadian contract were launched by ICE futures, there would be a compelling draw for traders to trade both Minneapolis and ICE, arbitraging the two as a foreign exchange trade, as well as trading relative spreads between the two markets.

The added benefit of having a Canadian futures contract (in Canadian dollars) is that it can be very effective in allowing Canadian firms to manage their risk as well as draw storage revenue from the futures market when applicable.
One more thing; with canola and wheat as major crops in Western Canada, having similar contracts (Canadian dollars, Canadian delivery, etc) and effective price signals for each, makes relative farm-marketing decisions of each much more meaningful and effective.  If the market signals tell farmers to sell wheat and store canola, that’s what they can do (unlike the current situation where, even when market signals indicate selling wheat, farmers are forced to sell canola). 

Why does this matter?

Whatever steps the federal government takes to achieve the goal of improving the market structure should not have a negative impact on competition for farmers’ grain.  Fundamental to this whole exercise is competition.  Right now there are an estimated 20 small grain companies that rely on the CWB for over 75% of their volume – some are over 90%.  The interests of these companies (as well as the larger ones) must be taken into consideration; we want more competition, not less.  We need to make sure that the necessary tools are available and effective, particularly as the industry is weaned off the CWB structure.

Next:  Farmer advocacy; the CWB or something else.

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