Futures Market in Grain sector Hedging process for farmers and french cooperatives. Agricultural Market Task Force 12 Avril 2016

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1 Futures Market in Grain sector Hedging process for farmers and french cooperatives Agricultural Market Task Force 12 Avril 2016

2 High volatil market conducts stakeholders to hedge their risks

3 Example : wheat market Encéphalogramme plat Transition Le mouvement perpétuel 3

4 Price Volatility The Volatility = the standard deviation of prices over a period. Ex : If the price of the day is 200 and a volatility of 30% over a period of 30 days => there is a two in three chances that the price vary between +/- 30% in the next 30 days (between 140 and 260 )

5 What to do? Volatility is greater than the margin of operators Risk aversion is different depending on the place in the supply chain, and for each compagny Needs for solutions to reduce risk Reduce risk exposure Transfer risk to third parties Using financial instrument 5

6 Farmers have new expectations More opportunities and, or more security

7 Position and role of cooperatives

8 Cooperatives : a link between farmers and users of agricultural products The cooperatives' aim is to collect products, to sort and prepare them for the different users, to store and deliver them to customers. They do it in order to provide the best price possible to farmers. FARMER FARMER Commodities trader Feed industry FARMER COOPERATIVE Food processor FARMER F F Fuel industries F Other industries Cooperatives rarely buy products from farmers at the same time as they sell them to customers. Their activities are more complex than a «back to back business». Cooperatives are exposed to price volatility. That s why they need to use financial instruments, and why they have been using them more and more since the rise in volatility in the grain sector (2007)

9 goods goods goods Flow of goods and price fixing Flow of goods FARMER FARMER FARMER COOPERATIVE Production Harves t Storage.. Delivry Customers need grain along the year cooperatives have to supply them 9

10 Flow of goods and price fixing Price fixing intention Moments when farmers want to fixe their price Moments when Industries want to fixe their price 10 Production Harvest Storage.. Delivry Buyer and seller have not the same price expectation / anticipation nor the same price risk exposition / price risk managment. The possibility to disconnect price fixing and flow of goods is positive for every counterparts Futures market allow to do it

11 Price fixing by farmers Price fixing timing Some farmers want to fixe their price when they buy crop inputs (mainly fertiliser and seeds) even if they will know the amount of their production only at harvest Some farmers fixe their price after harvest when they know quantity and quality of the grain Some farmers fixe their price when they consider that the price is good enough At the moment farmers want to fixe, buyers don t want Each participant has it s own price risk exposure, it s own risk aversion and own market anticipation Because of volatility, it s more and more difficult to find a buyer when you want to sell and to find a seller when you want to buy! Futures markets create an opportunity to get the price you want when you want. Cooperative offers different possibilities to farmers to fixe their price and hedges these positions in physical market or futures market. 11

12 Relationship between farmers and their cooperatives Concerning prices : cooperatives have different kinds of relations with farmers which could be separated in two categories: «campaign price» «fixed price» Price risk is not manage and assume in the same way by farmers and coops in these two systems Some cooperatives mix the two systems => in this case, farmers has to informe about their choice at the begining of the commercial year. Some cooperative have only one system

13 Relationship between farmers and their cooperatives and price risk managment I. «price of the day» or «firm price» or «fixed price». The purpose of cooperatives is to offer the best price on the market every day and the farmer decides if he sells or not. Cooperatives establish the price of the goods with the farmer and hedge this price on the physical or futures market (back to back business). In this type of relation, farmers keep the price risk for themselves. In this case some farmers are asking for tools to hedge their price risk. A minority of them do it directly with a financial partner, a majority do it with their cooperatives «fixed price» Classical goods contract price of the day Contract of goods where the price is set by reference to the futures market. - the number of these contracts is increasing because farmers want more transparency and predictability -small contracts -some contracts are very simple, some are more complex. They link the commodity and the hedging tool (basis contract without exchange, options, ) 13

14 Risk identification = individual managment Different Risks and price risk components : Climat (quality, quantity), custormer risk (loosing a client or a major contract), payment risks, delivry risk, currency risk, PRICE Risk Farmer exposure / expectation Margin = selling Price production cost Opportunity risk = by contracting a fixed price, the farmer is exposed to opportunity risk if the price of grain rise. If he sells his grain, and if the market is going up, the farmer will have «regrets» Hedging or staying in position is Farmer s decision Investing in option is farmers decision Coops are proposing solution to farmers. And then, cooperative s hedge the risk link to producer engagemen t

15 Contracts set in reference to futures market Farmer engage its quantity with coops, and decides to manage himself its price risk Flow of goods is manage in one side / price in the other side Farmer decides the time of selling Futures market give him information to decide The price is set in reference to futures market Futures Market Price +/ basis Basis = difference between the goods of the farmer and the underlying of futures market compose by : Quality Logistics Coop margin Balance between Suply & demand 15

16 Contracts set in reference to futures market Coops design different solution in adequation to the farmer s risk exposure and risk aversion fixed price fixed price with option (call) in ordrer to catch the price increase average price several others price formula Coops have the expertise and the access to futures market they give the tools to farmer ; farmer decides they give market information risk managment training should be developped 16

17 Example A : contracts set in reference to futures market Fixed price (A) II- option (A) I Fixed price (A) = FM X = = 165 II Fixed price + option (A) = (FM X) option cost = = 155 => No price complement j f m a m j j a s o n d j f m a m j 17

18 Example B :Contracts set in reference to futures market III- option (B) price complement I Fixed price (B) = FM X = = Fixed price (B) II Fixed price + option (B) = (FM X) option cost = = price complement ( ) II- option (B) III option price complement (B) = 20 ( ) Price = 147 j f m a m j j a s o n d j f m a m j 18

19 Example C : Contracts set in reference to futures market Average price The price would be the average price of the periode The price is fixed after the end of the period. In this example : = j f m a m j j a s o n d j f m a m j 19

20 Coop manages its own price risk Coop manage its own price risk on physical market or futures market (FM) 20 ON FUTURES MARKET Buying : FM - X (most of the time, basis is negative for farmers) Selling : FM + Y Margin = Y - X If coop does the two futures transactions at the right time (selling when it fixes the price with the farmer, and buying when it fixes it with the customers). If basis (X and Y ) are not set at the same time, coop is exposed to basis risk, Futures transactions and bases negocation are strategic

21 Relationship between farmers and their cooperatives and price risk managment II. «the price established by the cooperative along the campaign». The farmers give their production to the cooperatives and expect the best price as possible. They transfer the price risk to their cooperatives. Down payment fixed and paid just after the harvest. Considered as a minimum price by the farmers «campaign price» = + Price complement fixed at the end of the campaign and linked to the result of the cooperative These components of the price are set by the board of the cooperative. The members of the board are farmers elected by the general assembly. In this price category the farmers shared the profit and loss of their cooperative. If the result of the cooperative is not good enough, there could be no price complement. -Cooperative construct the campaign price along a periode of 12 to 18 month. In order to hedge the «down payment», and to manage the logistics, cooperatives begin to sell their goods before the harvest. After the harvest, they respond to user demand and try to take the opportunities on the grain market. -Selling and Price fixing timing is the decision of the cooperative. -Cooperatives are using financial instruments (futures and options) to hedge their commitments to the producers. -The campaign price could represent large amounts -The hedge position (which could be a profit or a loss) is completely included in the campaign price. 21

22 Campaign price The average selling price is estbalished along a period of 12 or 18 months. To choice the average price renounce possible highest market... to avoid the risk of having to sell at the lowest Moving average price Average price at the end of the campaign Average selling price Down payment Price complement

23 23 Risk managment Coop has to manage the risk for the producer The maximum risk Objectives and benchmark Rules, instruments, limits Deconnexion between goods flow and price fixing allow to manage easier both goals (an average price for the producer and supplying the market) With futures market or not : the time of selling (or fixing price) is a big challenge and is linked to the understanding of the market and risk aversion Set and decided by the board If you have no idea take no risk («back to back» or delegation) If you have an idea and capacity to support price variation risk exposure / risk managment

24 The relationship between the cooperative and its customers

25 Hedging in the grain chain One example of possible transactions in wheat market FM + x FM + y Env 70% Flour Price = (FM + z ) Farmer coop Milling industry Retailer cons umm er 25 For the intermediaries : even if the price is going down and up, margin could be hedged thanks to futures market. Each counterpart can fixed his price on the furtures market independantly (at different dates). The price of the grain is fixed for the farmer when he decides to fixe the FM and the basis (the timing of fixing FM is the most important). The margin is fixed for cooperative when the two basis are fixed (if only one is fixed, coop is exposed to basis risk). For the miller : a part of it s margin is fixed when he fixes the basis and hedges in FM

26 To conlude Today : only wheat and rapeseed futures market are enough liquid and allow farmers, coop and the stakeholders to hedge their price risk Some other grains and products are hedged with wheat market Feed Barley ; feed peas ; Stakeholders in the food supply chain need Financials to share their price risk. It is very important to have a favorable framework to developp futures market. 26