Price Risk Perspective in the Grain Supply Chain
This article is the first in a series entitled ‘Grain Price Risk Management.’ Please visit HedgeStar University for other articles in this series.
Organizations that produce or consume grains such as corn, soybeans and wheat are exposed to commodity price risk. Commodity price risk reflects an organization’s exposure to adverse changes in market prices. Much like interest rates that fluctuate with things like geopolitical decisions and monetary policy, grain prices can change based on anything from weather patterns to consumer behavior. Put simply, markets are unpredictable and commodity prices exemplify that fact.
If we could use a crystal ball to see the future, we would have no price risk and all outcomes would be expected. But we can’t see the future and prices continue to surprise us and present inconvenient hurdles as we stumble and trip toward our business goals. It is for this reason that financial risk management has become so popular (major corporate bankruptcies and economic turmoil notwithstanding) over the years and more specifically, why interest in hedging one’s risk exposures has increased.
Thinking about grains, consider three different roles throughout the grain supply chain: a) producers, b) suppliers/traders and c) consumers. Some organizations operate in one of the roles while others do all three. No matter the role, an organization will always try to maximize its own utility. This means that every organization is either trying to buy at the lowest price, sell at the highest price and/or generate the biggest margin possible. As a result, each organization has a different perspective on grain price risk and therefore, a different perspective on hedging.
Take producers, for example, which primarily include farmers. These folks sell grain at the highest possible price to garner a reasonable margin relative to production costs. Farmers often measure production costs per acre, considering factors such as taxes, storage, distribution, local supply/demand and other demographic inputs to determine what a reasonable grain price looks like. Farmers desire flexibility for grain pricing while maintaining margins in excess of those production costs. The objective is straight forward but not easy to achieve.
To our previous point, markets are unpredictable, and this can make the budgeting process difficult if producers (or any grain sellers for that matter) are always selling grain in the spot market . This is especially challenging for farmers that lease the land they cultivate. As you might imagine, landowners have far greater flexibility and tolerance for price volatility than land leasers. For these reasons, producers like to hedge using contracts such as ‘hedge-to-arrive’ (HTAs), averaging and basis. HTAs, for example, allow farmers to lock-in the futures reference price with the consumer and then establish the basis component of the total purchase price at a later date. All of the aforementioned contract types grant farmers the latitude they desire with price risk reduction and improved price certainty as well.
But what if grain prices are at historic lows, and the only conceivable direction they could go is up over the coming year? Does the producer agree to provide fixed-price purchase agreements to its customers and if so, how far out? If prices then increase, the opportunity for the producer to participate in improved market prices is foregone. For the producer, the desire to benefit from future price increases is undeniable and must be appropriately considered alongside its needs to maintain and achieve sustainable profit margins.
Moving now to Consumers. Consumers can be many different organizations such as protein or dairy suppliers, food and beverage manufacturers, bioscience companies and even vertically integrated wholesale/retail corporations. Any organization that uses grain as an input to cost of sales is a consumer. These organizations need to purchase grain in large quantities and at the lowest price possible in an effort to improve their raw material input costs.
Desiring price certainty and price risk mitigation, consumers hedge by locking-in prices for physical delivery of grains. Consumers are looking to hedge price risk as far out into the future as possible. But what if grain prices are at historic highs, and the only conceivable direction they could go is down over the coming year? If prices decrease, the opportunity for the producer to participate in improved market prices is foregone. For the consumer (opposite of the producer), the desire to benefit from future price decreases is undeniable. Yet, similar to the producer, this must be appropriately considered alongside its needs to maintain and achieve sustainable profit margins.
This brings us to suppliers and traders. These may include cooperatives, farmer-owned grain elevators, commodity brokerage companies and market makers with global reach. These organizations provide the grains market with liquidity, which means helping facilitate transactions between producers and consumers in a timely and orderly manner. They may stand in the middle and help deliver the physical grain from producer to consumer or serve as counterparty to hedging transactions to help their producer and consumer clients mitigate their own price risk. Often, these organizations are trying to maintain an optimal margin between physical grain sold and physical grain purchased, and vice-versa.
Suppliers/Traders are basis-risk sensitive. Trading basis – the grain price component tied to physical handling, storage, and distribution – is a meaningful profit source for Suppliers/Trader, which means consumers may have difficulty negotiating basis in their favor with a Supplier/Trader. Suppliers/traders also attempt to be market neutral and avoid having significant price risk exposure in one direction or another. They care about grain price volatility for the same reasons producers and consumers care about it. While consumers and producers are typically biased toward price movements in a single direction, suppliers/traders worry about price movements in all directions. Said another way, significant grain price volatility, or grain prices that move sharply in either direction many times in a given period, make it difficult for suppliers/traders to effectively mitigate their price risk.
As you can imagine, the sheer volume of grain being traded makes it a constant challenge for internal risk managers to monitor and manage the residual price risk facing the organization. For suppliers/traders, locking in a profit margin is often the most desirable outcome while accepting some minimum price risk level for the purpose of serving both producers and consumers.
As mentioned before, producers, consumers and suppliers/traders are always trying to maximize their own utility. Everyone wants to reduce price risk, but they also want to optimize margin, participate in beneficial price movements and remain competitive in the marketplace. And like most businesses, uncertainty is an ever-present issue. Ultimately, market participants want to know quickly and to what extent revenues will be greater than expenses, or cash receipts greater than cash payments, or not. Most organizations handle this using a combination of two things: 1) identifying a hedge ratio that changes with the market and is consistent with the organization’s risk appetite, and 2) utilizing an optimal mix of hedging instruments that addresses the risk management objective of the organization.
Our articles on Using a Hedge Ratio and Instruments for Hedging Grain Prices will provide more information about finding the best ways to use hedging instruments and derivatives. Please also stay tuned for articles on Understanding Grain Price Risk Exposure, Considerations for Grain Hedge Accounting and Monitoring Grain Hedges.