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.

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