A State of the Union Message for Elevators: ‘Of Canaries and Black Swans’

This market scares me — truly scares me. The last time I sounded a widespread caution like this was early fall 1995 — that should tell you something. Bull markets come and go. Bear markets come and can drag on for years. Explosive markets come far less often but leave their mark for decades. The bull market that began in 2006 is one of those explosive markets that will impact the grain industry for a long time to come. Grain elevators have never needed so much money just to operate, and they now face potentially record contract risk on the staggering volume of forward purchases from farmers. The Hedge-to-Arrive financial crunch of 1995/96 is a distant second compared to the risks facing the grain industry in 2008.

The good news is that record crops give you record handling volume, demand for storage, and the growth in exports as well as domestic markets provides numerous marketing outlets. Volatility brings risk, but it also creates opportunities. The challenge is to survive the risks.

Are the bull markets over?

The global surge in commodity prices has widespread causes. It’s fueled by the massive inflow of investment money into commodities as an asset class. Analysts and the media are talking about 10- to 20-year bull markets, with continued inflation, for example. The global surge is also fed by the rising standard of living in the Asian/India sector and the rising demand for protein and vegetable oils. It’s fueled by the steady draw-down of global inventories of all major food/feedstuffs, despite rising acreage. It’s increased by efforts of numerous countries to hold down food prices artificially, which in turn sustains demand. It’s fueled by the weak U.S. dollar that gives overseas countries greater buying power. All things — good or bad — eventually come to an end. That might be starting now but there’s no guarantee, and it just doesn’t have that ‘feel’ yet. What might be worse is if a significant retreat occurs, taking corn down a dollar or so, and soybeans down $2 for example — just enough to cause everyone to assume the storm is past. Then another and potentially even bigger rally could occur. It’s already happened this year in wheat.

Canary in the coal mine? 

The drought of 1988 threatened the ability of many grain firms to finance inventories and short hedges, but that bull market didn’t last long and mostly affected nearby futures. The bull market of 1995/96 caused July 96 corn futures soar to $5.00, but December 96 rarely exceeded $3.50. The HTA crisis of 95/96 was costly for our industry, but the largest losses were confined to a fairly small number of firms. This year is different and the grain industry could become the canary in the coal mine; an early warning system of broader concerns where hedging isn’t working the way the grain industry expects.

Hedging price risk using exchange-traded futures and options works for the grain industry because cash prices track reasonably closely with futures. Or they should. This parallel movement gives lenders confidence that losses (or gains) in futures will be nearly offset by an opposite movement in the price of the underlying collateral. It’s the main reason lenders will finance up to 100% of market moves against inventory hedges and up to 80% of market moves on hedges against forward contracts.

Convergence — In grains and oilseeds, there’s another important aspect to hedging: convergence. This is where cash and futures prices come reasonably close to each other in the futures delivery month in the delivery market. This gives hedgers confidence that sharply discounted basis levels will eventually rise as supplies tighten or as the futures delivery month nears. Since 2006, however, as grain and oilseed futures have climbed steadily, cash and futures prices are not tracking as closely. Convergence is not occurring as dependably in wheat and sometimes in soybeans.