Dear Friends, as you all know,
grains international trade market is based on so said futures contracts.
The term “contract” referred to
futures exchange trades can be a little off putting, but it is mainly used
since a futures investment has an expiration date and however is tying
a futures buyer and seller together on a commodities market to trade a
specified asset of standardized quantity and quality for a price agreed upon
today, while delivery and payment will be issued at a future date, as well
known as the delivery date. So we can still keep naming them as contracts.
The contracts are negotiated at a
futures exchange market, which acts as an intermediary between the two parties,
serving the different raw commodities or commodity groups.
Answering the question raised during
the Sochi Global Grain Forum (whether Russian Federation should acquire a
futures exchange market for grains), Mk&Partners underlines the importance
of the exchange market, since it brings together the opposite interests and
purpose of operators, costumers and investors.
I
n the case of grain commodities,
like corn and wheat, the commercial commodity producers as farmers, who plant,
harvest and sell their corn have an opposite interest and purpose from commercial
commodity consumers as for example cereal companies, bread manufacturers.
Upstream producers want to hedge
their crop against potential falling prices when harvest time comes, while
consumers want to lock in a good price today for future delivery of raw
commodities like corn, in the case of rising prices in the meantime.
It’s clear how futures exchange
markets are bringing futures speculators, hedgers and producers together.
The most controversial term, the
casus belli, in future markets is the price.
Once the delivery date arrives, the
amount exchanged is not the specified price on the contract, but the spot value.
Consequently it’s vital to elaborate tools for managing price and income risk
in the volatile price environment
Let’s make a practical example.
Producers want to protect themselves from possible future declining prices and
a potential loss at harvest time.
As you all know, the farmer has production
costs to be covered and therefore first of all they are willing to earn the cost
back and make a profit on the sold. But crops will be ready to harvest and sell
after several months.
All sorts of factors like weather
temperature, rain, drought, higher or lower yields from competing international
producers could influence the crops and the final price, in case he will be
able to sell it.
Consequently, on future exchange
market produces agrees to sell their products in the future markets to consumer
today, for a set specified price for delivery which will be placed several
months later.
The producers want to ensure they won’t
face a loss in case the overall market for crop produce a surplus, decreasing
commodity prices at harvest time.
On the other hand, if there’ll be a
shortage of production and high demand at harvest time, crops would be worth a
higher price in the future market.
In this case, the produces would
face a loss since there would have been a higher profit for crops, if had waited
for harvest to sell, but still came out to the good, locking in a good price to
cover costs and a profit by trading in the future markets 6 months ahead of
harvest time.
If there had been unexpected surplus
of production at harvest time, still producers acting on futures market would
be to the good, protecting themselves by locking in a pre-determined profit for
their corn when they agreed to sell crop months earlier at planting time.
On the other side, consumers act on
the futures exchange markets to ensure the lowest price they can for raw
commodity to avoid the possibility of crop shortage resulting in high demand with
the consequence of raising prices at harvest.
Noticeably, on commodities market
both parties are far more concerned with minimizing their future risk than
maximizing their profits.
Aware of the fact that reality isn’t
so simple as the foregoing examples and aware of all difficulties related with
cereals commodity market Mk&Partners would like to illustrate you the
following practical advises.
As stated before, the parties acting
on futures market have opposite interests and purposes.
Mors tua vita mea used to say the Romans,
so it’s mandatory not to consider your counterpart as your best friend (this is
the mistake almost all my client do at the very beginning, asking me not to be
too strict and rigorous writing the contract), but to be more realistic and be
aware that your contractual party is doing his own business and playing his
cards.
Operators tend to forget that the
contracts are legal instruments that obligate both parties to commitments and
obligations so try to follow the suggestions below before during your
negotiations:
1. Before you sign a contract, know
and understand all of its features and how they will affect your interests.
It shall be more than clear all the
aftermaths of the contracts on the reduction of market risk, where the
contractual terms and conditions could represent a risk for you, and what your
obligations really imply and mean;
2. So if you have any doubt don’t pretend
that you understood everything and don’t sign before you clarified and erased
all weaknesses with the assistance of an attorney.
3. Get informed on your counterpart,
especially about his financial and economic conditions and ability to perform
obligations.
4. Try to understand how the grain
price has been determined. As you have surely understood from above
explanation, the main risk of a future contracts comes from the price
volatility. If a formula is involved, be sure you understand how it works and
try to understand what your price would be with extreme market conditions.
5. Understand the implications if
your production falls short of the quantity you have contracted to deliver.
A production shortfall can have
implications for your net income and financial risk exposure, as well as for
meeting contract obligations. The contracting firm establishes a position in
the futures or options market to support your contract, and hence has financial
obligations that depend on timely fulfillment of your contractual obligations.
While some term and conditions of
grain sale or purchase contracts may vary, the following key elements, in all
their simplicity, should be present in all contracts:
1. The quality (grade) of grain delivered or to be delivered;
2. The date by which delivery is to be issued;
3. The location for delivery;
4. The price or formula to be used in determining the net price;
5. Price adjustments if you are unable to meet the specified grade;
6. The quantity being contracted;
7. Signatures of both parties and date of signing.
The price is a function of the
futures market and the cash market, so there is a futures component and a cash
component and the difference between the two is the basis.
Subtract the cash from the futures
price and you have the basis, which is likely a negative number, unless your
local processor, ethanol plant, or feed lot is in need of grain.
At that point it might be a positive
number. There are four independent dynamics which are identified as pushing and
pulling on the cash market to cause the basis to be where it is:
a)
Corn
and bean futures have declined. When the futures prices decline there is less
interest by producers in wanting to sell into a market in loss. Consequently,
when futures prices decline, cash prices typically rise because consumers need
to acquire the physical commodity;
b)
Ending
stocks got to be tight. With a small carryout end users know that bushels are
being rationed and it may be difficult to acquire needed stocks; Consequently,
cash prices will rise in an effort to acquire just enough stocks to satisfy the
immediate demand.
c)
Good
demand. Both processors and exporters are seeing increased demand so they are
also bidding up the cash price to obtain the physical commodity;
d)
Lack
of farmer selling. A basis contract can be used to market your grain by taking
advantage of the narrow basis, and then sometime later, locking in the futures
portion of the price. When that occurs you have a forward contract,
theoretically with a higher value due to the narrow basis.
The key to success is watching the
futures price and ensuring that the contract agreement is completed before the
futures price erodes further.
Therefore before to enter into a
future contract you shall consider the following risk elements:
1)
Market-volatility
risk with minimum price contracts; thus the risk that the net price on such
contracts will not change one-for-one with cash and futures prices as the price
level rises. The same kind of risk exists with maximum price contracts used for
feed purchases. The size of this risk varies with market volatility and the
length of time until contract delivery. It tends to be largest with volatile
markets and when the delivery date is several months away;
2)
Tax
risk, which includes the risk of whether futures or options-based losses in
contracts will be ordinary business expenses or capital losses, as well as
other tax issues. Provision is made to carry capital losses forward to later
years. For corporations, no capital loss is deductible unless matched by
capital gains. Elevator contracts typically do not separate these price
components, but tax issues can still be critical;
3)
Counter
party risk. The risk that the buyer will be unable to perform part or all of
his or her contractual obligations or will be unable to pay for your grain.
This risk is especially important for credit-sale contracts, in which the title
of grain has been transferred to the buyer but payment has not yet been made.
This risk also may be a consideration with other types of contracts;
4)
Control
risk —the risk that contracts will get out of control. Some contracts require
several stages of decision-making beyond the initial contract signature. With
these contracts, there is risk that market action will move your net return to
an unacceptable level before you realize what is happening and can take
corrective action.
From all aforesaid, it’s evident
that grain contracts are important tools for managing price and income risk in the
volatile price environment.
Successful use requires a complete
understanding of how various contracts work, the kinds of risk they are
designed to control, and the areas of risk that remain after the contract is
signed.
In conclusion, we hope that our
practical suggestions will lead you on the right route in your cereals trades.
But do not forget to get professional assistance if necessary.
