Friday, May 25, 2012

Back to the Futures

The Way We Were

Supporters of the CWB single desk often draw our attention to the past – not so much the recent past – rather, to the era of our great-grandfathers.  They say that without the CWB single desk, the market will revert back to those dark days.  Back to when pioneering farmers would harvest their crop and deliver it to the local elevator only to find that everyone else was delivering at the same time.  The elevators could handle only so much at one time and with so much being offered and poor communication and uncertainty of prices in distant markets, the price at the elevator would drop.  

There are stories that, at times, there would be no room at the elevator and farmers would go home without being able to deliver anything.  After collapsing at harvest-time, prices would rebound, climbing much higher later in the year as the demand for wheat was still there but there was less to deliver.  Two things were missing in this early market: effective communication and a structure to provide effective prices for later delivery.

It would be many years before the communication problem was solved.  But in the early days some progressive grain merchandisers came up with the idea of forward contracts – an agreement to deliver at a later time.  Typically, that meant a higher price than at harvest; “I can only pay X now, but if you commit to deliver later in the year, I can give you X+Y”.  These contracts gave incentives to store grain – actually paid to store grain – through higher prices and provided more certainty of market values allowing greater forward planning.  

These forward contracts increased in popularity and the notion of standardizing them to make them more liquid led to the development of futures contracts.  With futures, more than ever, grain merchandisers could set a price more closely related to the market in distant locations.  And there was a mechanism to reflect the value of grain for different time frames.  The “market” value of storage was now exposed for all to see and gain from.  This would have huge implications regarding grain pricing, handling and logistics.

The Day the Earth Stood Still

When the CWB Single Desk was established in 1943, the government simultaneously closed down the Winnipeg Grain Exchange wheat futures market.  Since all grain was to be sold through the CWB, it was felt there was no need for the services of a futures market, showing an abysmal misunderstanding of what its value and purpose was.

(Here’s a little irony; when the CWB single desk was established in ‘43, it was estimated that 500 people in Winnipeg would lose their jobs.  Now that the CWB is losing the single desk, supporters of the CWB have lamented the loss of the CWB’s 430 jobs.  So, apparently, both the establishment and the end of the Single Desk caused job losses. That would be quite a feat if it were true.  The fact is that although the CWB’s payroll is shrinking, many CWB employees are getting new jobs in Winnipeg, both within the grain industry and elsewhere.) 

With the end of wheat futures trading in Winnipeg, wheat prices were pooled among farmers, presented as an Initial Payment on delivery with a final payment some time later – a system that remains until July 31st of this year.  Benefits of the futures market such as independently and openly identifying prices and market-based values of storage, movement and logistics were totally lost, sending the industry navel-gazing through studies and numerous Royal Commissions in an attempt to figure out how to make the market work better.  Unfortunately, whenever a different role for the CWB was suggested, it was always ignored by the government of the day.  Changing the way grain was marketed was never seen as an option to improve how grain was marketed.  Go figure.  

A few months ago I asked a senior executive at the CWB what he felt was the most important part of pooling.  His answer came quickly: “Getting the same price regardless of when you deliver.”  This goes completely contrary to the efficient use of the grain handling system.  Arbitrarily setting prices and centrally controlling access to the system, ultimately ends up making the system less efficient, raising the cost of the system to farmers.  It seems that to those that believe in the single desk, “equity” trumps efficiency.

Back to the Futures

With the end of the Single Desk, Western Canada is entering a much less regulated, open market.  Pricing of what were once called CWB grains will be determined by the natural interaction between producers and merchandisers and will be a function of demand, system capacity, transportation capacity, and hopefully – forward prices and storage.  Competition will play a role reducing costs. 

Futures play a fundamental role addressing many of the issues with moving to an open market.  The primary value of futures – what we are all familiar with – is in risk mitigation, or hedging.  A close second is price discovery.  However, the reduction of margins (costs) between the primary producer and the ultimate end user is often overlooked; fully functioning futures contribute substantially to getting lower prices for the end user and higher prices for the farmer. 

Another fundamentally important aspect of futures is the provision of independent market-based values of storage and by extension, logistics.  Through carrying charges the futures market signals that the market will pay to store grain.  (Even farmers can take advantage of this.)  When the market is inverted – the nearby month higher than the later months – the market will not compensate you to store grain; it is signalling to sell and move grain.  Responding to these types of signals makes the whole market and grain handling system work more efficiently.

Most, if not all, grain merchandisers have position limits that dictate how much price risk they can take on at any given time.  Without a mechanism to lay-off some of the risk (futures) merchandisers are limited to the amount of business they can take on at any given time.  With the flexibility from futures, the marketplace will present greater opportunities for more firms – big and small.  Futures allow more players of more sizes to participate on a more-or-less equal footing.

The new CWB is entering a market that is somewhat foreign to its well-established culture.  It will do well to reject its standard view of the value of pooling and embrace a more market-oriented view of futures markets and what they do for the efficient use of the grain handling system.  If it doesn’t, it will struggle to succeed in a market with merchandisers and farmers that do.

Saturday, May 19, 2012

Risk Management in the New Market

As we enter the new "un-CWB" market, we will be looking at marketing grain in a familiar way – but there could be substantial differences to what we know.  The recently announced CWB pools look to be similar to their previous offerings - and there may be more pools offered.  But I'm talking not talking about pooling; I’m talking about the open market.  And marketing wheat in the open market could be quite different than what we are used to.

We already have experience in marketing canola with futures and basis – and a wee bit with other crops like barley and domestic feed wheat (and, if you've been around as long as me, flax and rye too).  But with wheat and durum, in western Canada we could be faced with a difference that we will be well-advised to think carefully about.

There are many aspects about this market that will be new - real protein spreads (not muted by pooling); grade and protein discounts or premiums that can't be locked-in with a forward contract, and new delivery opportunities, unfettered by Contract Calls.  Also, we will see real market pricing in the form of futures and basis.  

One of the biggest challenges could be using Minneapolis wheat futures – a US dollar futures contract – to hedge and manage price risk on wheat priced in Canadian dollars.

First, using any US dollar based futures contract, there is price risk in Canada simply due to the fact that the Canadian dollar is not at par with the US (most of the time).  And second, there is basis risk that comes from a change in the exchange rate.  Neither of these will be familiar to most people in Western Canada.

Let's look at the first one.  If Minneapolis wheat futures are at 7.90 and the fob basis on the west coast is 80 over, then the flat price on the west coast is $8.70 US fob.  Assuming an exchange rate of 0.90, and assuming US and Canadian west coast values are the same, this translates to a Canadian west coast value of $9.67 Cdn.  If futures drop to 6.90 US but the US fob basis remains at 80 over, the US flat price is now $7.70 US, and assuming no change to the exchange rate, the Canadian flat price changes to 8.55 Cdn.  Futures dropped $1.00 but the Canadian price dropped $1.12/bu.

The lesson here is that a conventional 1:1 (or pound for pound) hedge will not provide the coverage you might expect.  Even though the exchange rate didn’t change, you have a foreign exchange based price change; it’s what is called “non-volatile foreign exchange risk”.  The answer is to include a foreign exchange position to your hedge – and here’s where the complication just begins.

The second oddity is the impact of foreign exchange on a basis contract – just one aspect of what is called “volatile foreign exchange risk”.  In Eastern Canada, the foreign exchange rate (and risk) is imbedded in the basis.  For example, if CBOT corn futures are at $5.00 US and the local cash basis is 1.25 over, the corn cash price (futures plus basis) in Ontario is $6.25 Cdn.

Note I didn't say whether the basis was in US dollars or Canadian.  That's because it's neither.  If it was in USD, then the resulting cash price would be $6.25 US.  If the basis is in Canadian dollars, then you'd be adding a US dollar amount to a Canadian dollar amount and you can’t really do that and still make sense.

Imbedding the currency rate in the basis makes it really easy to talk about cash grain prices in Canadian dollars – it’s as if they assume the futures are in Canadian dollars – but it adds a risk component to the basis unfamiliar to most people in Western Canada and complicating risk management processes.
For example, let's say Dec Minneapolis wheat futures are at $7.90 US , the Cdn/US exchange rate is 0.92US (one Canadian dollar = 92 cents US) and the cash market in Western Canada for fall delivery works out to $7.00 Cdn.  Using the Eastern Canadian approach, this would mean the cash basis is 90 under. (7.00 - 7.90 = -90)

Now, what happens when the exchange rate goes to 0.98 but the Minneapolis futures remains at $7.90 and the world value of wheat doesn't change either?  The change in the exchange rate alone would mean that cash wheat in Western Canada would change from $7.00 to $6.57 (Canadian dollar strength means commodity prices weaken in Canadian dollar terms – something we’re all used to).  But what we’re not used to is that this would translate to a change in the basis – in this case, to 133 under, down from 90 under.

In this example, even though the underlying fundamentals of the wheat market didn't change at all, the basis dropped 43 cents per bushel.  To most of us, that’s counter-intuitive.  Think about the same situation with canola; when the Canadian dollar strengthens (pushing the flat price of canola lower), the canola basis remains unchanged.  In other words, the exchange rate has no impact on the canola basis.  Clearly it has an impact on the flat price - just not the basis. 

So there's the difference.  A weak Canadian dollar will impact Canadian cash prices, but if we use a US futures contract, the impact on the cash price would be found in the basis.

All this would make life somewhat more complicated for both the farmer and the grain merchandiser.  For a farmer it will be more difficult to effectively manage the price risk of wheat using a US-based futures contract and get the result he wants.  Same goes for a merchandiser who will necessarily need to add a risk component to his pricing.  Both will need to understand the foreign exchange implications to their marketing strategies, and just as importantly, they will need both the facilities and knowledge of how to manage that risk.

ICE Futures

I have heard people questioning why the new ICE futures contracts are not listed and trading in US dollars.  The value of Western Canadian wheat is determined globally and so some think the futures contract should reflect that.  However, as described above, that would just complicate life (and increase costs) in Western Canada.  Even though the value of the majority of Western Canadian canola and its products are determined globally, the ICE canola contract is in Canadian dollars and works extremely well for Western Canadian interests as well as for foreign buyers.  The same could not be said if it was traded in US dollars.  

Trading spring wheat futures for Western Canada in Canadian dollars just makes common sense.  It reduces risks and avoids unfamiliar risks as outlined above.  There are many reasons why the new ICE contracts should be supported.  The potential impact of foreign exchange on our competitiveness is just one of them.

I’ve been asked why I haven’t been writing as much as before.  This and other aspects of risk management have led me to work on developing new marketing tools and techniques that will address these new factors – taking time away from my blogging.  I plan on writing more as things come up, but my focus has been on these new tools – details of which I will share as soon as possible.