As a little girl I had a small cloth clown that I carried everywhere. He was soft and familiar and infinitely comforting during the numerous trials of my childhood. But Clownie became grubby and beat up, and lost much of his stuffing despite my mother's secret attempts to patch him for me. I still loved him, but one day I recognized that it was time to keep my old friend in my room and carry something else with me.
Managing merchandising risks this year reminds me of my beloved clown. The old familiar ways and strategies are reassuring, and it's a little frightening to recognize they may not be up to the demands of these markets. It can be unsettling that it could be smart — even necessary — to bring some new tools and strategies into the mix to complement the old ways.
Most merchandisers and managers are conventional hedgers ("CH"), using strategies that reflect principles you learn in Basic Merchandising:
- Hedging means equal and opposite positions in cash and futures.
- Keep short hedges in the futures month most closely corresponding to the cash transaction.
- Roll short futures forward when a futures spread nears "full carry."
- Basis tends to be fairly repetitive and reasonably predictable. It tends to be weakest at harvest and typically firms when farm selling declines. Buy grain at harvest, roll short hedges forward and liquidate inventory through the year to earn the carry.
- Go short the basis and ship Delayed Price ownership when basis and futures are inverted.
- Futures prices provide signals for basis and spread expectations: High prices typically reflect tight supplies where spreads are narrow and basis is high.
Real world merchandising is much more complex than that, of course, but most managers would still consider themselves conventional hedgers. Nowadays futures and basis don't always react the way we expect. The bull markets of 2007 and 2008 reflect global agricultural supply and demand, fueled by the explosive growth of investment capital buying commodity futures. Despite record-high futures, spreads repeatedly move close to Full-Carry and basis is setting record lows in some markets for wheat and soybeans. At the same time, a smaller market such as Minneapolis wheat soared to inconceivable levels and affected basis and spreads in other commodities.
Conventional strategies and tools by themselves don't seem up to the task of adequately managing this year's risks. But putting "conventional hedging" on the shelf the way I retired my old stuffed clown is too drastic. CH will remain the right tool for most merchandisers in most crop years.
Venture outside your comfort zone this year and at least check out other strategies. First, define the different issues, factors and risks your business faces in these unconventional markets:
Cash and futures prices are not tracking as conventional markets would anticipate. That adds risk.
Investment capital in commodities doesn't respond to supply/demand signals. It provides steady new buying that can leave cash prices lagging. Expect this sector to continue to grow.
There is no limit to how high the basis can go when supplies are tight. Harsh lesson #2: there is no economic floor to the basis. And harsh lesson #3: Short hedgers cannot take their inventory to the delivery market to fulfill short futures (at zero basis). The good news is that extreme basis volatility also creates opportunities.
Financial requirements to buy grain and maintain short hedges in bull markets can exceed past requirements by many multiples. Underfinanced firms can find themselves forced into bad cash contracts when futures soar.
Counter-party credit and contract exposure with your buyers and sellers is much higher these days.
Redefine "good" basis: Selling "cheap" basis is fine as long as you're buying it even cheaper. Looking at past sales and objectives can be an expensive mistake in extreme markets.