Friday, March 28, 2008

Why my markets aren't working well...

First, this e-mail from a USFR viewer:
Moves like those have crimped farmers' ability to manage risk in volatile grain markets. "I never really saw this coming," says John Phipps, a farmer in Chrisman, Ill., who learned recently that his largest customer, Cargill, would no longer take his grain under previous terms. "Forward contracting is such a basic, fundamental and routine exercise." Now, "My entire marketing plan fell apart. [WSJ quote]
Shouldn’t someone who is the host of a farm program, and spokesman for an industry have had some clue that this was a concern. You had no idea that the volatility in the market might be causing problems for your local elevator. Maybe someone should be concerned with their local market and do all they can to support these markets rather than just expect them to be there for your convenience.
The correspondent is referring to my quotes in this WSJ article [Alas, now gated for non-subscribers][Update: A buddy found a work-around to see the article. Click here. Dude!!]

The important point right now is the author quoted me correctly. I do rely primarily on forward pricing for my marketing and I am temporarily flummoxed as to how to proceed.

But let me make one point clear: I am not, nor have I ever pretended to be a "spokesman for agriculture". In fact, the concept is repulsive to me.

I speak for my farm. Period. And I believe you should be the spokesperson for your farm - not some organization president, FFA contest winner or celebrity. Agriculture is far too diverse for any one voice to capture it accurately or fairly.

My views on subsidies (short version: hate 'em), mandates (ditto), and trade (the freer, the better) place me in a tiny minority of producers. While many who have been reading for some time realize this, I do not resent the majority who disagree with me. In fact, I am quite willing to be proven wrong, but few seem to offer any hard data to the contrary.

Now as to the forward pricing debacle. The commenter likely has not read my thoughts on this unfolding problem here in the mangled syntax and unedited text of John's World.

This will likely sound defensive, but here is why I was caught off-balance by Cargill's refusal to forward price: I believed in them. I did think this outcome was possible, but I thought they would be the last institution to buckle under difficult market conditions. Furthermore, I work hard to maintain good relations with my number one customer.

Scroll your memory back. The first hint was The Andersons, shortly followed by ADM. My assumption - since proven totally wrong - is this would spread completely to smaller grain originators.

But as this survey shows (albeit unscientifically) the refusal to forward price seems to be a problem for just some producers like me. The question is begged: How can small elevators boldly go where no big merchandiser will go?

Some backstory: I get my information from my Cargill service reps, Amy and Paul. We've been through a bunch of situations that required cooperation to adjust to unforeseen circumstances. We found answers to all of them over the years. And as I have written before, I like dealing with Cargill. Plus I really don't have many local options. Jan and I simply can't spend time hauling.

Meanwhile, something weird is definitely going on the at the CBOT.
Whatever the reason, the price for a bushel of grain set in the derivatives markets has been substantially higher than the simultaneous price in the cash market.

When that happens, no one can be exactly sure which is the accurate price in these crucial commodity markets, an uncertainty that can influence food prices and production decisions around the world.

These disparities also raise the question of whether American farmers, who rely almost exclusively on the cash market, are being shortchanged by cash prices that are lower than they should be.

“We do not have a clear understanding of what is driving these episodic instances,” said Prof. Scott H. Irwin, one of three agricultural economists at the University of Illinois at Urbana-Champaign who have done extensive research on these price distortions.

Professor Irwin and his colleagues, Prof. Philip T. Garcia and Prof. Darrel L. Good, first sounded the alarm about these price distortions in late 2006 in a study financed by the Chicago Board of Trade. Their findings drew little attention then, Professor Irwin said, but lately “people have begun to get very seriously interested in why this is happening — because it is a fundamental problem in markets that have generally worked well in the past.”

Market regulators say they have ruled out deliberate market manipulation. But they, too, are baffled. The Commodity Futures Trading Commission, which regulates the exchanges where these grain derivatives trade, has scheduled a forum on April 22 where market participants will discuss these anomalies and other pressure points arising in the agricultural markets. [More of a superb article that demonstrates why we need subsidy hatin', liberal newspapers like the NYT - they have got the world class journalists]
This event has left me speculating, especially with Cargill's tight-lipped non-explanation. Some thoughts I have entertained:
  • Cargill/ADM/TA could be in bigger financial trouble than smaller merchandisers, and be unable to handle additional margin risk. Man - that's hard to believe!
  • Cargill/ADM/TA are thinking even farther ahead. What if smaller competitors struggling to maintain hedges do fail. How cheap would they be to acquire then?
  • Cargill/ADM/TA thought the industry would follow them, like airline companies trying to raise prices.
  • Cargill/ADM/TA have better forecasts of a possible train wreck coming and choose not to be involved. I can see that as a likely reason.
  • Cargill knows I'll be back, regardless. The consequences of unilateral action are deemed small. Probably good logic, but not a congenial thought.
  • Cargill/ADM/TA are using me to help them protest the above convergence problem to the CFTC or anybody else who will listen.
  • Cargill is leveraging this bizarre market to induce more interest in their contracting programs. I grow non-GMO, and IP corn for them. Both are still contracting out into 2010.
  • Cargill/ADM/TA have made a strategic mistake that will complicate their efforts to source grain. If this corn crop especially looks iffy, what will they do to nail down supplies?
Any or all of those ideas could be right. I'll probably never know.

But the important thing is what has to happen for forward contract to return. Not knowing what criteria prompted the decision leaves me with even more wild guesses. But one thing is certain. My ideas of a "deeper" relationship with my customer (Cargill) has proven to be pretty naive. And such step changes in market practices tend to take some time to "live down" - assuming we will get back to former practices.

My job (as I see it) in the value chain for grain is to stand in the "risk gap" for the production phase. Weather, bugs, etc. are my risks and how I derive compensation from my market. I have relied upon Cargill to arbitrate the marketing risk as their specialty - offering simplified ways for me to take advantage of price opportunities and for them to nail down supplies.

I did not whine about the enormous basis supposedly needed to offset the volatility in forward contracts, but find it hard to swallow that 70-80 cents doesn't provide them enough cushion. However, my job is not to tell them how to do their business, it's to decide to do business with them.

Nothing is more unnerving than to look around in uncertain times and see an empty space where your partner used to be. As one correspondent pointed out, maybe the old adversarial approach is the only realistic one.

So I need to belatedly look for new customers for my soybeans. It has also slowly dawned on my that this abrupt change in policy now throws doubt in my mind on all Cargill's warm, fuzzy words about "helping me prosper". Perhaps if they add "usually" on the end.

Don't get me wrong. We'll adjust to this curve ball. But if the report Monday proves to be bearish for beans, I'll probably grouse about my inability to sell ahead of the report - which I had planned on like I almost always do. And market advisers who had incorporated forward pricing as part of their strategies (almost all to some extent, IMHO) will likewise have to scramble to find another tool. What is funny is Cargill had been flogging the use of Market Pros to sell part of your grain as a marketing service.

I think this decision will have long half-life, especially in the minds of producers. It will in mine.


Anonymous said...

Nice response John.

I read the WSJ article on Thursday as well. My opinion comes from the perspective of being raised on a cattle feedlot in Nebraska where futures contracts play an important role in hedging price action for cattle and corn (but likely much shorter duration hedge than grain production hedging for you), and then recently working in the asset management world of a large institution.

In summary, the same credit crunch cascading through the financial world while deleveraging takes hold and "the brake becomes the accelerator" is simply catching up with grain market participants during the same week daily price limits, and therefore additional margin requirements, are being raised on grain contracts.

The need for larger price limits is very likely the result of the well known presence of institutional investors in commodities (that ethanol and developing country induced pop in grain and land prices doesn't go unnoticed.) Existing producers need to factor in the technical impact of these large players and adjust their market monitoring indicators, not only expanded COT reporting for example but also credit/financing costs for your institutional partners.

At the end of the day if your institutional partner can't provide the margin financing required for their short futures used to lay off your forward contracts, perhaps producers will need to go to the CBOT directly. Very carefully of course, since now taking on the basis risk/reward, margin posting requirements (access to financing) and other futures rolling management your partners no longer can, at least right now.

You have a right to be ticked and ask the skeptical tough questions of your institutional partner. How they respond and the level of tranparency and committment would be my guide. But also recognize the extreme tight financing conditions they and all financial institutions are facing. Look only as far as the unprecedented Fed liquidity facilities being introduced for the magnitude of the issue. I have been following these developments closely and while I didn't expect the impact to hit agricultural commodity financing, it is completely understandable given the events.

For what it's worth, say $0.02, I think the Fed is doing a great job to respond to this unprecedented environment in very direct and focused areas where help is needed. The latest Primary Dealer Credit Facility was latest program that provided the liquidity needed beyond banks to primary dealers and expanding the type of collateral accepted. I hope it is felt in your institutional partners soon.

Keep up the great weekly show for this farmboy turned actuary, portfolio manager and now wealth manager... but always a farmboy.

John Phipps said...


Thanks for reading and for your insights. Please see the next post for more.