A good piece in the New York Times today, “Price Volatility Adds to Worry on U.S. Farms,” describes how the runup in agricultural crop prices is making life harder for farmers.
The recent upswing, and the entry of speculative capital, has led to a sharp increase in volatility (note that that’s the reverse of what theory says you ought to expect. More liquidity is purported to lower volatility). And that has created new problems, Crop insurance is more expensive when prices are erratic. Worse, grain elevators refusing to buy crops in advance, forcing more farmers to hedge themselves, which is particularly risky since they might not have enough cash on hand to meet margin calls.
Aside: would a forward sale to a grain elevator be counted as inventory by the elevator company? If so, some of the apparent inventory tightening might be an accounting phenomenon (although the US may not be a big enough player in the commodities in which this is happening for that factor to have much impact).
Aside from the difficulties that the farmers are facing, the article does contain signs that speculation is overwhelming fundamental activity. One big warning sign mentioned in passing: trading has outgrown the delivery system. If I read this correctly, it means that the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won’t force convergence of futures prices to cash prices at contract maturity.
The article notes that some farmers who cannot sell to elevator companies and are frustrated with the ways the options and futures markets are misbehaving are doing deals outside the exchanges, directly with sponsors of commodity funds such as AIG. AIG buys the commodity, the farmer stores it for a fee, and the farmer buys it back later at a pre-set price.
Again, does the inventory held with the farmer by a commodity index fund get recorded anywhere?
Paul Krugman asked in a post yesterday, if speculative activity had anything to do with the commodity run-up, where were the inventories? Others had commented that speculators were carrying inventories without describing a mechanism. Looks like we’ve found one.
From the New York Times
Fred Grieder has been farming for 30 years on 1,500 acres near Bloomington, in central Illinois. That has meant 30 years of long days plowing, planting, fertilizing and hoping that nothing happens to damage his crop.
“It can be 12 hours or 20 hours, depending,” Mr. Grieder said.
But Mr. Grieder’s days on the farm in Carlock, Ill., are getting even longer. He now has to keep a closer eye on the derivatives markets in Chicago, trying to hedge his risks so that he knows how much he will be paid in the future for crops he is planting now. And the financial tools he uses to make such bets are getting more expensive and less reliable.
In what little free time he has, Mr. Grieder attends Illinois Farm Bureau meetings to join other frustrated farmers who are lobbying officials in Chicago and Washington to fix a system that was designed half a century ago to reduce uncertainty for food producers but is now increasing it.
Mr. Grieder, 49, is shy about complaining amid so much prosperity. Prices for his crops are soaring on the updraft of growing worldwide demand, and a weak dollar is making the crops more competitive in global markets.
But today’s crop prices are not just much higher, they also are much more volatile. For example, a widely used measure of volatility showed that traders in March expected wheat prices to swing up or down by more than 72 percent in the coming year, three times the average volatility for that month and the highest level since at least 1980. The price swing expected in March for soy beans was three times its monthly average, and the expected volatility in corn prices was twice its monthly average.
Those wild swings in expected prices are damaging the mechanisms — like futures contracts and options — that in the past have cushioned the jolts of farming, turning already-busy farmers into reluctant day traders and part-time lobbyists.
One measure of the farming industry’s frustration is the overflow crowd expected at a public forum on Tuesday at the Commodity Futures Trading Commission in Washington. Interest is so high that the commission, for the first time ever, will provide a Webcast of the forum, which it says is being held to gather information about whether crucial markets for hedging the price of crops “are properly performing their risk management and price discovery roles.” The Webcast link is available on the commission’s Web site, www.cftc.gov.
The additional costs that stem from volatility in grain prices — higher crop insurance premiums, for example — are not just a problem for farmers. “Eventually, those costs are going to come out of the pockets of the American consumer,” said William P. Jackson, general manager of AGRIServices, a grain-elevator complex on the Missouri River.
Prices of broad commodity indexes have climbed as much as 40 percent in the last year and grain prices have gained even more — about 65 percent for corn, 91 percent for soybeans and more than 100 percent for some types of wheat. This price boom has attracted a torrent of new investment from Wall Street, estimated to be as much as $300 billion.
Whether new investors are causing the market’s problems or keeping them from getting worse is in dispute. But there is no question that the grain markets are now experiencing levels of volatility that are running well above the average levels over the last quarter-century.
Mr. Grieder’s crop insurance premiums rise with the volatility. So does the cost of trading in options, which is the financial tool he has used to hedge against falling prices. Some grain elevators are coping with the volatility and hedging problems by refusing to buy crops in advance, foreclosing the most common way farmers lock in prices.
“The system is really beginning to break down,” Mr. Grieder said. “When you see elevators start pulling their bids for your crop, that tells me we’ve got a real problem.”
Until recently, that system had worked well for generations. Since 1959, grain producers have been able to hedge the price of their wheat, corn and soybean crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date.
More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures.
These tools have long provided a way to lock in the price of a crop as it is planted, eliminating the risk that prices will drop before it is harvested. With these hedging tools, grain elevators could afford to buy crops from farmers in advance, sometimes a year or more before the harvest.
But that was yesterday. It simply is not working that way today.
Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.
When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market. Such anomalies create uncertainty about which price accurately reflects supply and demand — a critical issue, since the C.B.O.T. futures price is the benchmark for grain prices around the world.
“I can’t honestly sit here and tell you who is determining the price of grain,” said Christopher Hausman, a farmer in Pesotum, Ill. “I’ve lost confidence in the Chicago Board of Trade.”
David D. Lehman, director of commodity research and product development for the C.B.O.T.’s owner, the CME Group, said: “We know that the current global environment is creating challenges for many of the traditional users of our markets, and we are very concerned. But there are a lot of things that are changing and there is no silver bullet, in terms of a solution.”
Many farmers and people in related businesses blame the tidal wave of investment pouring in from hedge funds, pension funds and index funds for the faulty futures contracts and rising volatility. But those institutional investors’ money actually adds liquidity to the market, which in theory should reduce price volatility, Mr. Lehman noted.
In any case, at current levels of volatility, options trading becomes riskier, and therefore more expensive — too expensive for many farmers like Mr. Grieder, who now has to hedge with the recently less reliable futures contracts.
That exposes him to the risk of having to put up more cash — to maintain his price protection — whenever a weather threat, shipping disruption or a fresh surge of money from Wall Street suddenly pushes up grain prices.
“If you’ve got 50,000 bushels hedged and the market moves up 20 cents, that would be a $10,000 day,” he said. “If you only had $10,000 in your margin account, you’d have to sit down and write a check. You can see $10,000 disappear overnight.”
On an unusual day, he said, he might get four phone calls a day from his broker seeking additional margin. “But usually, the margin calls come in the mail, in a little blue envelope,” he said. “You don’t have to open it to know what it is.”
When it arrives, he sometimes has to rely on his bank to advance him the margin he needs to keep those hedges in place — a worrisome requirement even for a successful farmer in an economy already struggling with a credit squeeze.
“The nightmare scenario is when you have to make margin and you’re looking out your back door and seeing, maybe, a crop problem,” he said. “Everybody has a story about a guy they know getting blown out of his hedge” by unmet margin calls.
Farmers used to leave the market-watching to traders who work for big grain elevator companies. But with some of those companies now refusing to buy crops in advance because hedging has become so expensive and uncertain, farmers have to follow and trade in those markets themselves.
“This is something the farmer didn’t have to worry about before,” said Curt Kimmel, a commodity broker at Bates Commodities, the advisory service Mr. Grieder uses. “It’s a cruel and unforgiving market.”
John Fletcher, a grain elevator operator in Marshall, Mo., started pressing the C.B.O.T. to address the flaws of futures contracts almost two years ago — even before his futures hedge on a million bushels of soybeans failed to fully protect him last September, hitting him with a cash loss of $940,000.
Mr. Fletcher does not blame the big institutional investors stampeding into the market. “But they have contributed to the problem by making these markets so much larger — so large that they have outgrown their delivery system,” he said. “And that has detached the futures market from the cash market.”
Frustrated over the flawed futures contract, Mr. Fletcher is voting with his feet. Last year, he entered into a contract with A.I.G. Financial Products, a leading sponsor of commodity index funds, which allows him and the index fund to hedge their risks without using the C.B.O.T.
Instead of using futures or options, A.I.G. simply buys the commodity directly from Mr. Fletcher, who stores it for a fee and buys it back six months later. His storage fee is lower than the one built into the C.B.O.T. contract, so A.I.G. pays less for its stake in the market. And he has a hedge he can rely on.
“I did a deal with them for corn a year ago, and this year I’m doing a deal on soybeans,” he said.
But private deals like these do not provide pricing data to other farmers and to the rest of the food industry, which 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.”
Robert E. Young II, chief economist for the American Farm Bureau Federation, has held meetings on this topic around the Farm Belt over the last month and has gotten an earful from distressed food producers and elevator owners, he said.
“I tell people, ‘You are not going to market the 2009 crop the way you marketed the 2007 crop. You may never market grain that way again.’ ”