On March 28, Diana Henriques examined the weird phenomenon of futures prices expiring well above cash prices in the agricultural-commodities market. Today, she returns to the same subject, from the point of view of farmers, who can be significantly damaged by it.
Historically, a farmer could lock in a price for his crop by selling it forward: he’d enter into a futures contract to sell his wheat, say, for $1 million. Come expiry, so long as his crop didn’t fail, it wouldn’t matter what the price of wheat was. If he ended up selling for $500,000, then he’d get another $500,000 in cash settlement of his futures contract, and if he sold for $1.5 million then he’d be the one paying $500,000 to settle the contract.
But now the difference between the cash and futures prices means the farmer can lose on both legs. If the futures price rises, he will need to come up with more cash to settle the contract, even if he can’t raise that kind of money by selling his crop in the cash market. This wouldn’t be a problem if the futures contracts had the option of physical delivery rather than cash settlement, but they don’t.
What’s more, as the price of the crop rises, the farmer’s broker will make a series of margin calls on him, because the value of the futures contract is moving against the farmer. It’s a hedge, that’s what’s meant to happen: as the price of the farmer’s crop goes up, then the value of the hedge goes down. But historically individual farmers didn’t have to worry about things like margin calls: they’d just contract to sell their crop to a grain elevator in advance, leaving large grain elevators to worry about the futures and options market. Now, however, grain elevators are ceasing to offer that service, buffetted as they have been by volatility in the derivatives markets.
The one sliver of hope in the article comes from AIG, which is offering to buy commodities and sell them back at a fixed price in six months. But that has a systemic downside:
Private deals like these do not provide pricing data to other farmers and to the rest of the food industry that has long relied on the Chicago Board of Trade as the best measure of supply and demand. If such bilateral contracts become more common, it will be harder for everyone in the industry to anticipate costs and potential profits — which could also push prices up.
This growing uncertainty about prices and hedging “just makes the market less efficient,” said Jeffrey Hainline, president of Advance Trading, an agricultural advisory and brokerage service in Bloomington, Ill. “And anything that makes these markets less efficient increases the cost of food.”
In economics, it’s often hard to disentangle causes and effects. If commodity-derivative volatility is causing high food prices, might there be some kind of mechanism working the other way too, so that higher global food prices are causing volatility and basis risk in Chicago? I’m still just as puzzled as I was last month, but I do suspect there’s some kind of explanation somewhere.