Some valuable practical detail in BTL comments after that last post - very much what I had in mind when writing "very real practical complexities around our simplified account above - which might have made for a genuinely interesting & informative Countryside piece." Let's take a look at the issues they raised, & some more that I'm chucking in for good measure.
1. The ability to hedge, even in principle. (A) Scale. Jim has suggested the threshold for being able to get into grain futures is 10,000 acres. There will always be a lower limit (although with spread betting and ETF, that's been getting lower and lower) and certainly I have no better data. And why shouldn't there be a minimum size / critical mass for any particular viable line of business? We scorn the pitifully small energy suppliers (well, I do) for their lack of capitalisation, and wonder WTF they got a supply licence from Ofgem in the first place. Why shouldn't some industries be for the competent Big Boys? Nobody has a God-given right to set up a "craft" blast furnace just because they fancy.
1(B). Credit. - maybe thought of as an aspect of 1(A), but it's a distinct issue. It's always the case that a non-creditworthy counterparty (however large) can't get an OTC forward contract. That's because payment may become due either way, & maybe they ain't good for the potential monies due. Of course, if you're trading on an exchange (futures), you'll need to put up collateral and pay ongoing margin (if your position is moving out of the money) to minimise the credit risk. That again may exclude some players if they can't put up the table money. Again - so what?
2. Weather. As raised by a couple of you. Yep, this is one of the 'operational risks' that actually has little directly to do with hedging the financial exposures involved (though see 3. below on volume & Basis). Weather risk will impact on farmers irrespective of market risk - it can impact adversely on timing, quantity and quality. There was a time, in the late '90s / early '00s, when lots of people believed a big market was going to develop that would offer 'weather derivatives', there seemingly being a vast potential range of applications for such products. It never really took off (for reasons we might discuss in another post), despite many big players putting in a lot of time, money, people & effort go get it going. So: as was mentioned BTL, insurance always was, and remains, the first recourse.
Insurance, BTW, should always be anyone's fallback if they can't get a satisfactory hedge - and not just for weather, and not just for farmers . No credit issues, except that naturally you need to be able to afford the premium upfront. I say 'no issues' but of course as the client, you always have concerns over the creditworthiness of the insurance provider. it's a heavily regulated sector, for that reason.
3. Volume. (Also mentioned BTL.) Being subject to several unknowns - weather being perhaps the biggest - how does the farmer know exactly how much by volume to be trying to hedge? This volumetric uncertainty is an intrinsic feature of some sectors, while virtually unknown in others. The answer, as far as it goes, is easy: pick a sensible, maybe conservative estimate, and hedge that. You're then exposed on the balance, be that long or short. Coupled with weather insurance, it's the best you can do.
4. 'Basis Risk' generally. In markets where volumetric risk is small (& hence not requiring a whole risk-management discipline of its own), it would be viewed as a subset of the more general category of 'Basis Risk' - where there's an element of exposure remaining even when you've hedged the best that anyone can. It can arise from a heap of different factors impacting the 'basis' of your hedge vs the basis of your own situation, e.g.:
- the forward / futures contracts are only traded in lot sizes that don't allow you to create a perfect volume match;
- the settlement of the traded forward / futures is at a location and/or date that doesn't perfectly match your own locational / timing situation;
- the settlement is for a quality or grade of product that doesn't perfectly match that of your own product (e.g. a very special grade of oil for which there is no specific forward contract).
That last point - quality - was indeed specifically raised in the Countryfile prog - about the only interesting thing that was aired. They said that weather could affect what type of grain the crop would turn into, in terms of how it would be viewed - and priced - in the market. I hadn't known that, but it makes perfect sense.
* * * * *
To my mind the Countryfile team should have been at least mentioning some of the above, just as they very fairly (and in an easily-understood manner) alluded to the Basis risk of the quality uncertainty. It's the job of TV to make these things accessible, and the whole of it is no more difficult than the quality point.
Finally, though, we get to Sobers' really interesting - and quite technical - comment that, courtesy of outrageous hanky-panky on the part of the hedge-providers, for the farmer to enter a forward / futures contract they are in practice writing a naked option. If that terminology doesn't mean anything to you, well (a) I think Sobers explained the essence of the problem well enough, in lay terms; and (b) writing a naked option is about the most dangerous thing you can do in financial trading.
As many of you will know, agriculture isn't my sector. I've already noted that small players needn't expect to find things just as they'd like them in any sector, so maybe this is really just another manifestation of 'too small'. That said, to me it's a pretty shocking matter when, within an industry where quality matters so much, there aren't objective standards and assays that can be relied upon for both parties. The whole of trade finance depends on it. WTF should agriculture be different to energy, or metals, or pharma? Yes, fraud happens in any industry, but what Sobers reports is daylight robbery & very depressing. Is it really a problem for bigger farmers? In principle there would, IMHO, be a huge opportunity for large, honest players to step into this situation charging a very modest premium for a proper service.
ND
12 comments:
Actually, I think people do have a right to set up a craft blast furnace jn their back garden. I know someone who has.
The difference is he does not expect to be able to buy the gas on a forward basis.
Touché !
" That said, to me it's a pretty shocking matter when, within an industry where quality matters so much, there aren't objective standards and assays that can be relied upon for both parties. "
The problem is that you have a system that is fundamentally open to fraud by either party, producer or consumer. As its set up now it favours the consumer. When grain is delivered from farm to mill its sampled at the mill intake point. If that sample fails the spec requirements the producer gets a phone call - what do you want to do with this failed load? We will take it at a discount, or you can it delivered back to the farm (at your cost) or you can send it to another location of your choice (again at your cost). The farmer has to weigh up the cost of bringing it home, or finding another local-ish buyer to send it to, vs taking the hit on the price. Usually he takes the price hit, unless he's convinced the mill is taking the p*ss in which case he may demand its sent home. Sometimes he'll find its been tipped anyway, because the mill know they can mix some underspec grain with all the other, which will be over spec, and thus the whole will be OK. They just want to knock the price down. And all this is entirely within the control of the mill - they sample the intake, they do the tests. If they want to find a problem, they can. There is no mechanism to detect sharp practice. The mill sample should be split into 2 and half retained so the farmer can demand an independent test, but again, if the mill do this, there's still no control over what happens to that sample remainder, it could be tampered with, its never under independent control. And getting a independent test will take days, while you have a lorry full of grain that needs to be unloaded somewhere, sharpish. It can't sit around for days waiting for a test to come back.
So you have a system whereby the consumer can determine if they really want to buy the product or not, regardless of any contract they've signed, and have multiple avenues to take if they want to indulge in sharp practice. As I've said there are documented cases of farmers getting phone calls from mills saying 'Your grain failed to meet moisture spec (or some such), we want to know £X/tonne off the contracted price' only for the farmer to reply 'That's funny, the lorry is still here in my yard, as its broken down.....'
On the other hand you could say that all buyers of grain have to sample the product in store on the farm and then have to accept whatever gets delivered to them. Which is as open to sharp practice by the farmer as the current system is to fraud by mills. All manner of cr*p could be loaded with the sampled grain (and knowing some farmers, would be).
So I don't know what the solution is. Its a system that can only work on 100% trust, and given human nature if either side have a chance to shaft the other side, they will.
@ Sobers.
Is the testing so expensive that the farmer, or a co-operative of farmers, couldn't test before delivery?
"Is the testing so expensive that the farmer, or a co-operative of farmers, couldn't test before delivery?"
Testing isn't expensive, but its no good testing in the store, because the end user can't be sure what will get loaded into the lorry on the farm, and then be delivered to their premises. The farmer loads the grain, and the haulier has nothing to do with the grain purchaser, he's just a haulage contractor. He doesn't know what the buyer and seller have contracted, or whether what the farmer is loading is the right stuff. So it would be trivially simple for the farmer to get the buyer to sample heap A of grain, but then send lorry loads off heap B (of lower quality) from the same store. Or mix in bits of heap B with some from heap A.
So the buyers rightly want each individual lorry load sampled at intake, to protect themselves from sharp practice on the farm. But thereby giving themselves the ability to manipulate things in their favour instead......
Another issue, certainly in my neck of the woods - availability of contractors/machinery. Fields harvested by huge and expensive caterpillar-tracked machines, the old combine harvester mostly gone now.
Trouble is, everyone in a given area wants them at the same time, even with 24/7 operation round our way not everyone will get what they want when they want.
New tenant farming our local fields is even worse than the last guy - ploughs up bridle paths, doesn't leave any headland even when there's a path there, doesn't maintain bridges/stiles like the old brigade did, and IMHO left harvesting both rape and wheat about a month too late. Rape was ridiculous, walked through the overgrown/tangled paths and seeds just poured onto the ground and into my shoes. Wheat went from perfect to dark and unappetising.
I don't follow your answer, Sobers. Of course the buyer will want to do his own tests. I'm asking why the seller doesn't do his own so he has some evidence with which to argue. The idea that both sides of a trade do tests is commonplace elsewhere in the commercial world.
It sounds, I'm afraid, like the usual bleating from farmers that the whole world is against them and therefore they deserve subsidies. Poor babies.
In days of your I used to test tar for moisture. If I remember right we took two samples as lorry loaded The buyer took two samples . We each tested one sample and if there was a dispute the second samples would be tested.
I would think moisture tests should be easy and quick to do on grain.
"I'm asking why the seller doesn't do his own so he has some evidence with which to argue."
You can test the heap in the farm store as much as you like, but if the sample taken from the lorry at the mill intake doesn't meet spec then you don't have a leg to stand on. And its all done with a ticking clock. If a lorry load gets rejected you have minutes to decide what to do, with a lorry maybe a hundred miles away or more. You can't just go and see whats going on for yourself, you have to take the mill's word for everything. And hauliers don't want to sit around with full lorries waiting for decisions. Their time is money, they want to be tipped and gone to the next job.
Is there a real problem here? Are farmers going out of business, are the supermarkets devoid of bread?
As said, fiddling is possible and the smaller producer has no real clout. But is government likely to be any help - probably not. As discussed the mills have the whip hand but so does any major buyer in a market with limited competition.
There could be a problem but in practice the system seems to work and any feasible interventions seem likely to be more trouble/cost than they are worth.
@Sobers IMO this sounds like the hauliers are losing out on an opportunity, aren't they perfectly placed to be arbiters here and provide a neutral testing service?
They'd have to go prod the government to bully the mill owners to agree, but if they're taking advantage of this, there are probably quite a few other things they'd prefer the government not to take note of. Always painful to lose a good wheeze, but less painful than having many more of them dragged into the light.
CH - yup, see last sentence of post.
(The combined wit of C@W should step in and make a fortune here ...)
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