Joint Endeavour. Commodity Insights. Yearbook Global Products Global Practices. Sponsors

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1 A Joint Endeavour Commodity Insights Yearbook 2010 A bank of exclusive knowledge and information on commodities ecosystem Global Products Global Practices Sponsors

2 experts views Price Risk Management Instruments in Agriculture Dr. Panos Varangis acting head, ifc access to finance advisory products Commodity futures and options (F&O) contracts can be useful instruments for producers and other participants in a supply chain to manage their price risks. However, in the absence of liquid domestic commodity exchanges, basis risk makes F&O based on international exchanges less effective in managing local price risks. Over time, as markets, trading capacity and financial capacity develop, commodity F&O may become appropriate. 46 Commodity Insights Yearbook 2010

3 Prices of agricultural commodities are notoriously volatile and it is not uncommon to see the prices significantly as much as 30-40% fluctuate even within the same crop season. This volatility exposes producers (farmers) and traders who hold inventories in these commodities to the high risk of price declines. Significant increases in food prices also render the poor incapable of affording food purchases. For producers and local traders, price risks add significantly to the risks that financial institutions face in lending to them. Farmers also cannot optimise their planting decisions and brunt of price risk exposure. They always carry the same exposure: being always long, producers are worried about the risk of falling prices all the time. Unless they have fixed price contracts with buyers, producers in many countries have relatively few formal or market alternatives to managing price risk, compared to other participants in the supply chain. In addition, they face longer horizons of price volatility and uncertainty between planting and harvesting periods. This period of price uncertainty can be of much longer duration for perennial crops with long gestation periods, back to back. The impact of price risk exposure for this type of market actors tends to be felt on the margin i.e. the difference between the price at which a commodity is sold and the price at which it is bought. Management of price risks also depends on their ability topass on price changes to the next actor in the supply chain and, ultimately, to final consumers. End-consumers, even if they are highly diversified in consumption patterns, are exposed to price risk in many commodities, and like producers exposure to price risk this risk Varying exposures to commodity price risk Participant Type of exposure Magnitude of exposure Ability to manage risks Producers Long Full price Weak, mostly informal Traders/stockholders Long/short/neutral Margins/partial price Medium/strong Processors Long/short/neutral Margins/partial price Medium/strong Wholesalers/retailers Long/short/neutral Margins/partial price Medium/strong End-consumers Short Full price Through diversification Source: Commodity Insights Yearbook 2009 (published by PwC and MCX) are likely not to make substantial investments owing to high levels of uncertainty about returns on these investments. This results in a common problem of underinvestment in the agricultural sector something that has negative consequences on yields and environmental practices at the farm level. Varying price risk exposures of various participants Along the supply chain, various participants are exposed to commodity price risk in different ways (see table above). Of all commodity supply chain actors, producers bear the heaviest such as coffee, cocoa, rubber, palm oil-tree crops in general. For producers exposure to price volatility is exacerbated by perishability, cash flow needs, and lack of storage. Traders, processors, and wholesalers of final products to consumers, on the other hand, have a different kind of exposure to price volatility. Their exposure depends on strategic timing of purchases and sales and a constant shift in trade positions that needs to be managed dynamically against daily market swings. Traders, processors, and wholesalers can reduce exposure to price volatility in many cases by simply limiting the time between the purchase and the sale i.e. by buying and re-selling is unidirectional. Consumers, being always short, are worried about the risk of rising prices all the time. In low-income developing countries, this is particularly problematic for poorer consumers who tend to be less diversified, consuming only very few staple foods and, thus, highly exposed to price increases of those commodities. Managing agri-commodity price risks: Alternative mechanisms Agricultural commodity producers try to manage price risks in various ways. 1 First, they try to diversify their income by growing several crops, holding livestock, or engaging 1. For a discussion on risk coping behaviour see S. Dercon (2005), Risk, vulnerability and poverty in Africa, Journal of African Economies, 14, A PwC & MCX Joint Endeavour 47

4 experts views in off-farm employment. Producers income diversification usually comes in the form of lower returns because of non-specialisation in the area(s) they diversify into. In other words, producers who are genuinely diversified reduce income volatility but often at the expense of a higher average income that could be earned from better investments and specialisation in a single activity or crop. Second, commodity producers may also rely on informal schemes, such as local money lenders, village-level emergency funds, networks of relatives and friends, to borrow funds to smooth their incomes. These mechanisms may prove costly as the borrowing cost or commitment to sell the produce through certain channels can result in large hidden costs. Third, producers in some countries do use formal mechanisms to manage risks. This can be done on a physical basis by forward-selling the crop and, thus, locking in a future price. The downside of this strategy is that if prices subsequently rise producers may be tempted not to deliver on the previously agreed contract and try to sell elsewhere at the higher price. Forward-selling, thus, creates performance risk and is, therefore, more effective in tight supply chains where producers have to deliver through a certain channel, either because it is very difficult to physically deliver elsewhere (e.g. sugar cane) or because there are additional benefits to that supplier agreement (e.g. price premiums, receipt of inputs, technical assistance) or because they are dealing with highvalue and specialised commodities that rely on specialised channels and close supplier relationships (e.g. high-value perishable crops, fairtrade commodities). One drawback of forward-selling through tight supply chains is that producers may potentially become too dependent on a single buyer. In addition to forward-selling, and in order to address the counterparty or performance risk associated with physical trade, established commodity (derivatives) exchanges offer commodity futures and options, which can be used by the various participants in a commodity supply chain to manage price risk exposure. The fundamental component of a commodity derivatives exchange is a well-established clearinghouse that becomes the counterparty to any transacting party (to any buyer or seller). Clearinghouses generally evolve in markets where there is sufficient two-way trade (i.e. high volumes of trade and a large number of counterparties trading between one other) such that those involved in the trade see benefit in pooling the counterparty risk and establishing a clearinghouse to make transactions more efficient. For its essential function, a clearinghouse depends on the support of its members (trade participants) who agree to share the risk of counterparty default. Once a clearinghouse is established, it acts as the counterparty to all transactions, and a margin system is created to monitor, manage and limit the financial cost of the performance risk between transacting parties. Exchanges that offer commodity futures and option contracts have existed for more than 100 years. Large commodity traders and large buyers have at times used commodity futures and options to lock in their margins and hedge their price risks. Even in developing countries it is not uncommon to find this practice. Coffee exporters in Central America, for example, use futures contracts at the ICE Futures U.S. to hedge their coffee price risks, and maize and soybean traders and processors in Brazil use futures and options at Brazilian Mercantile & Futures Exchange (BM&FBOVESPA) in Sao Paulo. It is also not uncommon to find large commercial farmers in developing countries managing price risk exposure for certain crops 2 either through fixed price forward contracts or futures and options. In Brazil, for example, the Cedula de Produto Rural is an innovative tool that combines elements of forward contracts with price hedging and collateral for bank financing. The price hedging is done through domestic commodity exchange BM&FBOVESPA, though most users tend to be large commercial farmers. 3 What is more difficult to find are examples of small- and medium-scale producers in developing countries using commodity futures and options to hedge their price risks. Generally, factors such as government intervention in markets, weak markets, low liquidity, and low capacity related to trading and finance act as major constraints. Additionally, though the recent food and oil price shocks have had serious impacts on the budgets of governments that have been forced to react to them, it is difficult to find examples of sovereign hedging programmes, even for countries significantly exposed to food imports. Use of commodity F&O in developing countries Several efforts have been made at the global level to find marketbased risk management instruments to help producers and local 2. Mostly internationally traded crops or crops that are traded in liquid domestic exchanges 3. For details on CPR and analysis of the main users/beneficiaries see S. Marzo (2010), The Brazilian Cedula de Produto Rural: Performance, Lessons and Replicability Potential Outside Brazil, SYPA paper, Harvard Kennedy School, March. 48 Commodity Insights Yearbook 2010

5 traders manage their price risks. They attempted to bridge the gap between markets, where these instruments are traded, and producers. However, weak markets and the small scale of producers and local traders, coupled with their low level of knowledge in these instruments, hindered these efforts. Individual producers generally do not have enough volume to fill the quantity represented in futures/option contracts, nor the sophistication to transact hedging contracts. One way to address these problems is to introduce local contracts in domestic exchanges, starting with forward physical sales contracts, which, over time and with growth of the trade, could evolve to become futures contracts and, then, options. However, the evolution from physical exchanges to futures/options exchanges may not be possible since futures/ options markets need not only wellfunctioning and liquid physical commodity markets but also deep financial markets and the interest of institutional investors (pension funds, mutual funds, speculators, etc.) to provide the necessary liquidity. Another potential solution is to have local financial institutions (banks) that finance producers and provide intermediation in accessing risk management instruments on behalf of their commodity clients. 4 Banks should have strong incentives to do this because they share the price risk of their borrowers: if producers are not able to cover their costs and maintain revenue because prices have moved against them, they are not likely to be able to repay their loans, which means a financial loss for banks as well. Many organisations have attempted to address the issue of know-how and capacity building for farmers and farmer organisations through intensive technical assistance programmes. These programmes were aimed at improving the knowledge of the producer groups in risk management and, at some level, contributing to better overall financial management by them. However, the depth of financial skills needed by producers and small/medium local traders still proves to be a stumbling block on their way to using futures and options markets, even if these markets could be found locally. Additionally, small-scale producers lack the financial resources necessary to hedge using futures or options contracts. While a steady cash flow is needed to manage margin calls on future contracts, an upfront sum is required for paying the premium on an option contract. Adequate access to credit, often in foreign currency, is also required before taking futures positions or buying options. In many countries, private entities, particularly farmers and local traders, do not have access to adequate credit something that makes it difficult to take such positions. Finally, there is the important issue of basis risk, which arises out of the usually imperfect correlation between local prices and international prices. Many commodities produced and traded in developing countries have a relatively weak correlation with the futures prices on most commodity exchanges in developed countries. Basis risk is lower for commodities that are mainly exportable and linked to prices at international commodity exchanges (e.g. coffee and cocoa), for commodities traded at liquid domestic exchanges, and in countries where local government policies do not impede the transmission of international price signals to local markets. Some of these impediments could be addressed by futures and options traded in local exchanges. The use of local commodity exchanges could potentially provide several significant advantages to domestic users. These are: Lower basis risk since futures and option contracts are based on local types and qualities of the commodity and are closely correlated with domestic spot prices Transactions are carried out in local currency Quantities represented in the size of futures and options contracts better reflect local practices Physical deliveries against futures and option contracts could be possible No differences in trading hours and time Proximity makes it more convenient to resolve problems as and when they arise Perhaps the main drawback of using domestic futures and options markets is the potential for lack of liquidity in contracts. As indicated above, the more established exchanges that trade commodity futures and options tend to have large volumes of transactions that ensure price transparency and the ability to enter and close positions without affecting prices. This is because in addition to producers, traders and consumers, there are financial investors and speculators in established exchanges that are willing to take positions and, therefore, the demand and supply of futures and option contracts is high. In large emerging markets with significant commodity activity, a 4. For example, the case of Tanzanian coffee and cotton presented in J. Dana and C. Gilbert (2008), Managing Agriculture Price Risk in Developing Countries, University Degli Studi di Trento, Dipartimento di Economia, Discussion Paper No. 19. A PwC & MCX Joint Endeavour 49

6 experts views growing number of financial investors, and an appropriate enabling environment (e.g. appropriate government policies and regulations), liquidity in commodity futures and option contracts is quickly building up making them a viable risk management instrument for local users. 5 But even in these markets, the use of futures and options, particularly by small and medium size producers, remains a challenge due to lack of skills, size of production, and access to credit. Therefore, efforts to support the development of commodity exchanges should focus on the fact that markets and market tools evolve over time, and in a stepwise fashion. Developing country commodity exchanges should generally focus first on physical trading mechanisms, strengthening market infrastructure, and helping to develop a large number of buyers and sellers with strong trading and financial capacity. Futures and options contracts may possibly follow when these aspects of the market are in place. Use of options for commodity price risk management The use of options, particularly the purchase of options, has certain advantages. Unlike futures, the purchase of options does not require posting and management of margins. Purchasing options requires an upfront payment of the premium and enables the holder of the option to derive the benefits of prices increasing (buyer of puts in the case of a producer or holder of stocks) or prices declining (buyer of calls in the case of a buyer of physical commodities). This way, the purchase of options works like price insurance for producers and holders of stocks (the minimum sale price) and for buyers (the maximum purchase price). In particular, out-of-money put options have a relatively lower premium and may, thus, be attractive to producers and producer organisations interested in locking in the minimum price at which they will sell their crop. This requires payment of a premium. Similarly, out-of-money calls could be attractive to a public agency in charge of importing food in a developing country to ensure they do not exceed a certain budget for food imports. In such cases, the objective is to provide a level of protection against the risk of future price shocks. However, while the use of options could be attractive to certain types of commodity price exposures, such as exposure faced by producers or food importers, it may be less suited for others such as intermediaries in commodity supply chains who wish to protect their margins (the difference between the price they buy and the price they sell). Also, producers or food importers are concerned about both price volatility and the absolute level of prices. Options deal with the price volatility issue but not the level of prices. If prices are already low, producers will only be able to lock in the low price as their minimum price. During the past ten years, a few pilot projects and transactions mainly with producer organisations in Africa, Latin America, and Asia have tested the use of options mostly as a means of managing commodity price risk. 6 While these transactions showed the overall feasibility of the approach for certain commodities, they did not lead to sustainable and scalable transactions, most likely because: Transactions may have been perceived as opportunistic: generally, interest in buying protection against price declines is only evident when producers have a perception that prices will decline further. In some cases, commodity prices were already low, and producers considered the cost of options too high given the prevailing low commodity price levels. Alternatively, when commodity prices were high, producers did not feel they needed the price protection. The level of premium for option contracts was for some participants considered to be too high. Small farmers with little disposable income may lack the ability to pay. Linking the purchase of price protection to better access to finance provided an incentive but it was not sufficient. Banks require more than price protection in order to provide finance to producers and local traders. Building the necessary knowledge and skills requires significant long-term efforts and resources. While the concept of options may be understood, it requires more than this understanding to be able to use options effectively. Managing the transactions themselves proved challenging as well KYC (know-your-client) requirements are more difficult for entities in developing countries, and institutional capacity is needed to manage and monitor hedge positions, foreign currency exposure, and basis risks. The conclusion of many of these experiments was that a focus on 5. See for example commodity exchanges in Argentina, Brazil, China, India and South Africa, among others. 6. see a summary of early findings in C. Gilbert (2002), Commodity risk management: preliminary lessons from the international task force, in R. Garnault ed., Resource Management in Asia Pacific Developing Countries (Essays in Honor of Ron Duncan), Canberra, Asia Pacific Press. 50 Commodity Insights Yearbook 2010

7 strengthening physical trading mechanisms, for example, forward contracts, is probably a more appropriate intervention, particularly in weak market environments. On the food import side, call options can be a useful way to make procurement for contingent food security imports more flexible and perhaps even cheaper. 7 The World Bank and donors worked together to help the government of Malawi purchase call options for maize in With fears of drought and food shortages, the government of Malawi decided to use call options for white maize at South African Futures Exchange (SAFEX) to limit the cost of maize imports. Due to concerns over logistics and price, the government decided to use an over-the-counter (OTC) call options contract. First, this contract provided price protection on delivery to Malawi basis. Second, the options contact carefully specified terms for physical settlement so it could be used for contingent imports if needed. The government of Malawi concluded an agreement with a commercial bank to provide the OTC call option contract. This was the first time an African country used markets to hedge its macro exposure from rising food imports. In late 2005, as prices increased and food shortages were growing, the government exercised the call option, electing for physical settlement, and allocating the majority of imported maize for humanitarian operations. Conclusion Commodity futures and options contracts can be useful instruments for producers and other participants in supply chains to manage their price risks. In well-developed markets, futures and options contracts supplement other methods that About the Expert Dr. Panos Varangis, Acting Head of IFC Access to Finance advisory products, also leads International Finance Corporation s advisory services for financial institutions in agriculture finance and NPL management. Before joining IFC, Dr. Varangis, a PhD from Columbia University, New York, served as Deputy CEO of the Agricultural Bank of Greece for five years. Prior to this, he worked for 17 years at the World Bank in various positions related to agriculture, rural finance and risk management. Dr. Varangis may be reached at pvarangis@ifc.org producers and other supply chain participants exercise to manage their price risks. The other methods generally rely on physical trade contracts and mechanisms that work within the supply chain itself. For commodity producers and local traders in several developing countries where markets are not well developed, the use of futures and options is very limited. There are significant needs for capacity building and technical assistance in using these instruments and credit is a precondition since funds are needed to manage margins and premium payments. In the absence of liquid domestic commodity exchanges, basis risk makes futures and options based on international exchanges less effective in managing local price risks. Experience over the last few years has shown that price risk management, particularly for producers and local traders, requires a more integrated supply chain solution that focuses on physical trading mechanisms as opposed to financial instruments such as futures and options. Over time, as markets, trading capacity and financial capacity develop, futures and options may become appropriate. Work in these areas, however, is critical since reducing exposure to price volatility can help strengthen the resiliency of producers, consumers, and other market actors, improve the functioning of the supply chain, and strengthen access to finance. In many developing countries private sector entities lack the expertise to assess price risks and come up with appropriate tools to manage them. To assist them, a first step would be to help them in identifying and quantifying their price risks. A second step would be showing the entities how to set up risk-monitoring and -reporting systems necessary to operate an agribusiness, including farming, and that would also help the banks that lend to them. The third step would be to develop risk management solutions and tools that should be highly customised to specific country and commodity market conditions. Finally, access to these risk management tools would depend on the various market participants (farmers, local traders, exporters, processors, etc), the way the participants interact, the specific commodity supply chain, the level of sophistication and organisation of these participants, and the degree of development of the local financial markets. 7. See discussions in Milken Institute (2009), Feeding the World s Hungry: Fostering an efficient and responsive food access pipeline, Financial Innovation Labs Report, Vol. 9, October. A PwC & MCX Joint Endeavour 51

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