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

One misconception among many elevators is that there is a floor to the basis. But sellers cannot just sell futures and bring trucks or trains of grain to Illinois and deliver them at the futures price (perfect convergence). That leaves cash to seek its own level, which could be far below futures. Can we say with confidence that if some unknown event triggers $20 soybeans, cash prices will go along cent for cent?

When cash and futures don’t track well, and futures and cash don’t converge properly, hedging effectiveness is reduced. It doesn’t mean elevators won’t or can’t make money from basis change, it just means the changes may be less predictable and more a result of random events.

Overall risk to grain hedgers rises when there’s record financing demand, record prices, no floor to the basis and unprecedented demand from producers who want to forward-sell production as far out as 2010. If elevators should be unable to secure financing, and risks become too great, dramatic changes could result: consolidation for example.

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Beware the black swan

Nassim Taleb authored a book in 2007 entitled “The Black Swan – The Impact of the Highly Improbable” that should be required reading for the grain industry. Taleb’s book leads off with “Before the discovery of Australia, people in the Old World were convinced that all swans were white...” But the fact that people hadn’t seen a black swan didn’t mean such swans didn’t exist. He then takes that logic and generalizes it to describe “Black Swans” as events with three main characteristics:

• it’s unexpected, largely unpredictable and inherently rare;
• it has a dramatic impact;
• we create explanations for it after the fact.

September 11, 2001 is a classic Black Swan. The Christmas Day tsunami was a Black Swan. The subprime-mortgage catastrophe is a Black Swan (although some would say that it was predictable). Could the next Black Swan involve the economic sector?

My fear is the grain industry is more vulnerable than ever to a Black Swan — or even a gray one. It could be something that sends prices soaring, or one that cuts markets off at the knees. Consider for a moment the impact on agricultural futures, cash prices, and global trade if any of the following dramatic events occur:

• crop failures or shortages in more than one major producing country;
• a deep, global recession that causes demand to plummet;
• a catastrophic geopolitical event, such as a nuclear event between India and Pakistan, a political overthrow in China or Saudi Arabian oil complexes are blown up and oil soars to $200;
• a meltdown in the global financial sector that causes credit to essentially dry up for all but the highest-rated borrowers.

Take heed 

Your primary business responsibility is to survive. Profits and customer satisfaction come next. Think about the impact of dramatically higher prices on your business or of a sharp retreat. As an owner or manager, do what you need to in dramatic markets — even if it’s unprecedented and potentially unpopular.

• Assess your real cost of handling grain at record prices. (what’s the shrink on $13 beans?)
• Set margins and service fees based on real costs.
• Stay hedged — holding a sizable long price risk position carries its own risks. 
• Monitor all open contracts regularly for purchases and sales. What if that locally-owned ethanol plant fails before this fall, or what if corn futures fall sharply and the ethanol plant tries to walk away from $5 corn purchases? What if that big farm customer with all those 2009 sales to you dies next year and his widow sells the farm?
• Consider caps on forward contract price risk That could include aggregate by crop year, by customer, or by some other measure. 
• Set caps on basis positions (long or short)?
• Assess and limit the types of strategies you offer beyond the current crop year. Some firms won’t offer HTAs, while others won’t buy fixed-price grain, for example.
• Charge fees on forward contracts. It defrays part of your interest cost and shows more commitment by the seller for performance.
• Line up financing and alternative sources of working capital that will allow your business to handle ever higher futures prices.

I hope dramatically higher prices don’t happen; $13 soybeans, $5.50 corn and $10 wheat are enough of a challenge. But you never know what lies ahead.