Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Commodity Club of Washington
July 23, 1996
I've been attending these periodic Commodity Club luncheons ever since I came to Washington to join the CFTC in 1991. From the outset, I have been impressed with the Commodity Club as an efficient and effective forum for discussing agricultural issues of current interest. Therefore, it is not surprising that these luncheons attract some of the most knowledgeable and active figures in the agricultural arena -- from Congressional and agency staff members, to lobbyists and trade association representatives, to foreign attaches and journalists. Collectively, this group has a tremendous impact on U.S. and, in turn, world agricultural policy. I am honored to have been invited to address such a distinguished audience.
Many of you in this room spent countless hours working on the Federal Agricultural Improvement and Reform (FAIR) Act. As a result of those efforts, the FAIR Act has become a harbinger of a new era in U.S. agriculture. I would note in passing that it also set a new legislative standard for creative acronyms.
Today, my remarks will focus on agricultural risk management, and the CFTC's involvement in that area, in three related contexts: (1) the Commission's oversight and educational responsibilities concerning agricultural markets; (2) hedge-to-arrive contracts -- a strategy that for some users turned out to be risk assumption in the guise of risk management; and (3) some forecasting about how the new era in agriculture will require a combination of farming and business skills little used today, but absolutely necessary in the 21st century.
The CFTC's Oversight and Educational Responsibilities
The CFTC opened its doors in April 1975. In fiscal 1976, the first year for which we have complete statistics, total volume of futures trading was 33 million contracts, with agricultural trades accounting for 76 percent of that volume. For fiscal 1995, futures and options volume was some 505 million contracts, but agricultural commodities accounted for only 33 percent of the total.
Despite the fact that market composition has changed, with futures on financial instruments now comprising the majority of trading, agriculture remains a central concern of the CFTC. For example, because physical delivery contracts are more susceptible to delivery problems than financial contracts, which are usually cash-settled, we devote a disproportionate share of our surveillance resources to monitoring agricultural futures and options trading. The Commission also maintains excellent lines of communications with USDA, including frequent attendance by USDA staff members at our regular Friday market surveillance meetings.
The Commission maintains close ties with the agricultural community as well -- among other things, through its Agricultural Advisory Committee. This Committee, which includes representatives of 24 agricultural, agri-business and agri-banking organizations, has been active since it was founded in 1983 by my predecessor, Commissioner Kalo Hineman. The Committee meets twice a year. As its current Chairman, I would like to invite you to attend our next meeting in October.
Agriculture also figures prominently in the CFTC's educational responsibilities. The Commodity Exchange Act includes an educational charge in Section 18(a)(2), directing the CFTC to:
establish and maintain, as part of its ongoing operations, research and information programs to assist in the development of educational and other informational materials regarding futures trading for dissemination and use among producers, market users and the general public.
In addition to the activities of the Ag Advisory Committee, and various other programs and publications, one recent prominent example of CFTC educational efforts is the November 1994 "Summit on Risk Management in American Agriculture," cosponsored by the Commission and the Farm Foundation.
Apparently, Congress still considers the CFTC's educational role to be an important one. Section 192 of the FAIR Act, entitled Risk Management Education, provides in relevant part that:
In consultation with the Commodity Futures Trading Commission, the Secretary [of Agriculture] shall provide such education in management of the financial risks inherent in the production and marketing of agricultural commodities as the Secretary considers appropriate.
Hedge-to-Arrive (HTA) Contracts
As an example of the need for risk management education, and the importance of prudent risk management, I would point to the ongoing controversy surrounding hedge-to- arrive (HTA) contracts. HTAs represent a relatively recent type of contracting practice whereby elevators have offered farmers the ability to "fix" in advance a price for their grain, referenced to a specific futures delivery month, while leaving the basis open to be set at a later time. Many of these contracts allow farmers to "roll" the reference price from one futures month to another. Under current market conditions, some variations of these contracts have proved imprudent to the point of bringing serious financial distress to some producers and elevators during a time of rising grain prices.
On the surface, this seems impossible -- farmers losing money when corn is over $5.00 a bushel? How can it be? Let me walk you through a hypothetical example that explains what could happen to a farmer and an elevator utilizing HTA contracts that allowed the producer to roll the exchange-traded futures price of corn from old-crop to new-crop futures months.
Please note that the prices used in this example are the actual prices for No. 2 yellow corn futures on the Chicago Board of Trade for the days mentioned. The overall amount of money made or lost would depend on the specific times when a producer originally priced the contract and when the rolls took place. The example does not reflect certain other items that would affect the gain or loss column, including: (1) the fees an elevator would typically charge each time the futures price is rolled; and (2) the local basis, which is assumed in the example, for simplicity's sake, to be negligible. A step-by-step description of the hypothetical HTA goes like this.
In the late spring or early summer of 1995, a farmer enters into the subject HTA contract with his local elevator. He forward contracts a quantity of corn based on a December 1995 futures price of $2.80 per bushel. By harvest time in November, the cash price of corn has risen to $3.30 per bushel. At that point, the farmer has several choices. He can set the basis and deliver the corn for $2.80 per bushel, thus completing the HTA contract. He can hold the corn and roll the futures position to another month. Or he can sell the corn on the cash market for $3.30 per bushel and roll the futures position.
In our hypothetical, the farmer decides to sell at $3.30 in the cash market, put that money in the bank, and roll the HTA obligation to a July 1996 futures position. To complete the roll, the elevator offsets the $2.80 short position in Dec corn on the last day of November at $3.30 3/4 -- creating a loss of 50 3/4 cents per bushel -- and reestablishes a short position in July '96 corn at $3.34. With the loss factored in, the HTA price is now $2.83 1/4 per bushel.
As the days, weeks and months pass in 1996, the producer watches the cash and futures prices of corn continue to go up. With his 1995 corn already sold, and July approaching, the farmer has two choices -- buy enough corn in the cash market to deliver in fulfillment of his HTA with the elevator, or roll the futures position again. Buying the cash corn at current prices has immediate -- and very unpleasant -- financial consequences. Rolling to a distant futures month puts off final settlement with the elevator and holds out hope that the market might turn in the producer's favor.
Therefore, on the last day of June, the farmer decides to roll the HTA obligation to a December '96 futures position. This involves the elevator offsetting the July '96 short position, originally established at $3.34 per bushel, with an equal and opposite long position at the current July '96 futures price of $5.16 1/4 per bushel. This creates a further loss on the futures position of $1.82 1/4 per bushel. The elevator then reestablishes the short position in December '96 corn futures at $3.61 1/4 -- a substantial discount from the July future reflecting an unusually wide old-crop/new-crop spread. Deducting the $1.82 1/4 loss from the Dec '96 price results in an HTA price for the farmer of $1.79 per bushel.
These transactions affected the elevator in the following way. Upon entering the HTAs, the elevator committed itself to maintaining the short futures positions upon which the farmers' futures reference prices were based. This involved meeting margin calls on those short positions in a rising market. Because of the unprecedented rise in grain prices, especially corn, many elevators found themselves extended beyond their financial limits as they struggled to meet continuing margin calls. Bear in mind that in our hypothetical, for example, the farmer is not committed to deliver corn to the elevator until November of 1996. Thus, the elevator doesn't have physical corn to pledge as collateral against its line of credit. The liability side of its ledger is increasing dramatically, while the asset side is not. How long this can go on before the elevator goes under depends on the willingness of its lender.
It remains to be seen how the HTA situation will work itself out. The Commission has encouraged farmers and elevators to try to resolve their differences among themselves. Our efforts have included a May 15 staff Policy Statement and Statement of Guidance designed to: (1) remove any perceived legal impediments to financial work-out agreements among the parties; and (2) describe what our staff considers to be a regulatory safe harbor for HTAs that allow rolling only within the same crop year. Considering the amounts of money at stake, however, and the desperate financial straits of some parties on both sides of the issue, it is likely that some of the disputes between farmers and elevators will ultimately be decided in the courts.
Looking to the enforcement aspects of the HTA issue, Acting CFTC Chairman, John Tull, stated in June 5 testimony before the Senate Agriculture Committee, that the Commission is:
... aggressively investigating several situations involving hedge-to-arrive contracts. Among the issues we are evaluating thoroughly are whether some of these contracts may be illegal off-exchange futures or agricultural trade options; whether certain participants are required to be registered [with the CFTC]; and whether some participants may have committed fraud in the marketing of [HTA] contracts ...
Acting Chairman Tull testifies tomorrow on this same topic before the House Agriculture Committee and I'm sure many of you will be in the audience.
Farming and Business Skills for the 21st Century
In the final portion of my remarks, I would like to refer back to a statement I made at the outset -- that the FAIR Act is a harbinger of a new era in U.S. agriculture. This was no mere rhetorical statement. We truly have reached a watershed in domestic and international agricultural policy.
There are several forces at work in creating this new era. First and foremost is the changed attitude of governments around the world concerning agriculture. For example, in the recent past, many governments assumed a significant portion of the yield and price risk present in farming. Today, policy makers are gradually moving toward programs that pass this responsibility on to producers. With the government safety net being phased out, producers will be farming for the market and not for the government.
Another factor moving agriculture into a new era is the public policy decision to phase out international tariff and non-tariff trade barriers. Among other things, pacts like the GATT and NAFTA agreements will allow the prices of farm commodities in the global marketplace to be driven more by supply and demand, and less by government intervention. Inevitably then, in the future there will be times when the prices of basic food and feed products will be as volatile as corn prices have been in 1996 and cotton prices were in 1995.
In such an environment, producers will have to learn how to prudently manage the risks inherent in their business. The new era in agriculture will require them to develop and implement a plan designed to generate a secure level of revenue for their operations. This will call for an attitudinal adjustment by many farmers who in the past have experienced an emotional roller coaster as they tried to outguess the market.
What will the farmer of the new era have to do to secure revenue and be profitable, rather than chase price and put his or her financial security at risk? First, he must change his attitude toward change. One cannot hope to stay competitive in the global marketplace by embracing the status quo. In the 21st century, it will not be enough to be a top producer of food or fiber. The times will require farmers to become business specialists in production agriculture. They will achieve this status by pursuing continuing education programs throughout their careers -- training that will give them needed proficiency in a whole range of skills, from computerizing their farm operations and surfing the Internet, to precision tillage and biotechnology, to adopting the latest financial and business management practices.
Using these skills to operate their business of production agriculture will open the door to a great comparative advantage available in the U.S. -- namely the ability to prudently manage yield and price risks through the use of revenue insurance, revenue assurance, or becoming part of an integrated commodity production and processing arrangement.
In closing, I respectfully submit that the lion's share of the world's top agricultural producers are found in this country. This reality can be attributed to several factors. Among them are the ongoing improvements in production techniques resulting from U.S. research and development efforts. Another is the innate talent America's farmers have for tilling the soil. Throw in our rich midwestern farmland and, when the weather cooperates, the result is bin- busting harvests.
Now and in the future we should not worry so much about America's ability to produce a bountiful crop. We can do that. The challenge we face is to provide our farmers the educational opportunities that will allow them to raise their business acumen and achieve profitability on their own.
To the credit of many shareholders in American agriculture, this educational process is already in motion. The FAIR Act includes an educational mandate; USDA's Economic Research Service has a prototype for a program called "Managing Change in Agriculture;" the American Farm Bureau is planning a risk management conference for this fall; the National Grain and Feed Association recently published a white paper and held a series of seminars on grain contracting and best management practices; and numerous state and national general farm and commodity organizations are developing their own risk management training programs.
If we can keep the educational train on the tracks, it will carry America's farmers to future profitability even without a government safety net and in the face of tough global competition.