Hedge-to-Arrive Grain Contracts and Regulatory Compliance
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Live Cattle Marketing Committee
NCBA 1996 Summer Conference
August 2, 1996
I would like to preface my remarks about hedge-to-arrive (HTA) contracts with a little bit of background to put the HTA issue in perspective. I will then review three basic areas: (1) the mechanics of HTA contracts, using a hypothetical example based on actual cash and futures prices of corn; (2) CFTC actions involving HTA contracts; and (3) market surveillance concerns relating to HTA contracts.
Background on HTA Contracts
The restructuring of federal agricultural programs is giving producers of basic agricultural commodities tremendous new opportunities -- the chance to farm for the market and not the government. At the same time, however, the process exposes these farmers to a new era of reduced monetary support from U.S.D.A.
In order to adjust to this change in farm policy, producers will need to construct their own financial safety net through the prudent use of risk-reducing strategies, including exchange-traded futures and options or a variety of innovative hybrid cash contracts. The key word in this formula is prudence. Where farmers and elevators use these marketing tools imprudently, -- where they do not fully understand the potential consequences of a given strategy -- or where they choose to disregard a worst case scenario that "just couldn't happen," in trying to squeeze out a few extra dollars of profit -- they may be creating risk instead of controlling it. Such appears to be the case with some HTA contracts.
Mechanics of 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.
CFTC Actions Involving HTA Contracts
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. In certain cases, unfortunately, the court that does the deciding will probably be the bankruptcy court.
Looking to the enforcement aspects of the HTA issue, Acting CFTC Chairman, John Tull, made the following statement on HTAs in testimony before the House Agriculture Committee on July 24:
... the Commission is aggressively investigating several situations involving hedge-to-arrive contracts. Our Divisions of Economic Analysis and Enforcement have been looking into the HTA situation. Among the issues that they are evaluating are: (1) whether some of these contracts may be illegal off- exchange futures or agricultural trade options; (2) whether certain participants are required to be registered [with the CFTC]; and (3) whether some participants may have committed fraud in the marketing or sales of HTA contracts. The Commission will take appropriate action to address any violations of the law that it may uncover, and it is pursuing its inquiries with resolve, dispatch, and care. Any illegal conduct will not be tolerated.
Market Surveillance Concerns
The Commission is also vitally concerned with the potential impact of the HTA situation on the futures markets we regulate. I would like to close with a review of the 1996 CBOT corn futures contract expirations.
The old-crop corn futures expirations have occurred in the economic context of: (1) projections for critically low U.S. corn and feed grain supplies; (2) very strong export and domestic demand; and (3) concerns for the size and quality of next year's crop, due to adverse weather conditions. Another complicating factor is the diminished delivery capacity on the CBOT futures market resulting from the closing of several warehouses in Chicago last fall. In case things were not interesting enough already for the CFTC and CBOT surveillance staffs, the July corn future was used by grain merchants to hedge a substantial number of HTA contracts that producers probably would not be able to deliver grain against before this fall's harvest, if then.
Cash and futures prices for corn rose to all-time record-high levels this spring and summer in response to these fundamental supply and demand factors. The phenomenal increase in prices, and the huge price inversions that developed in the July/September and July/December futures spreads, made it very costly for short hedgers, such as elevators, to roll hedges forward. This was the hedging dilemma faced by those merchants who had entered into HTA contracts with producers who could not deliver the grain this crop year.
Despite all these complications, we believe the July corn future expired in a very orderly manner on July 22. Large short positions associated with HTA exposures appear to have been liquidated early. Our staff paid particularly close attention to traders involved with those contracts, from the time we conducted a series of telephone interviews in May to identify those accounts until the July future expired. We do not think the liquidation of HTAs played much of a role in the expiration overall. During June and July, futures prices were reacting primarily to two market factors: (1) strong domestic and export demand; and (2) growing conditions in the corn belt -- first to a long dry period and then to significant rainfall.
Large traders carrying long and short positions into the final weeks of trading were monitored closely by CFTC and CBOT surveillance staff to ensure that they would not contribute to a disorderly expiration. In that regard, the lessons learned from the price spike on the last day of trading on the March 1996 wheat future were well remembered by all.
It is still early to make any predictions regarding the September corn future, but at this stage everything looks good. Total open interest in that future is below last year's level for comparable dates and there are no unusual position concentrations. While there is still a large price inverse between the September and December corn futures, it is much less than the July-December inverse. Needless to say, our close surveillance continues.
Let me leave you with the following thoughts:
The lessons learned from the use of HTA's with the strategy of rolling reference prices from old-crop to new-crop months are as old as time itself. These same lessons have application in the cattle business too. Number one, past performance is no guarantee of future success. Number two, if something sounds too good to be true, then it probably is. Number three, waiting to sell at the top of the market means you won't.
Most feedlots and many, many cattlemen have found the secret to success in the beef business to be determined by the ability to combine their innate talent as cowmen with modern day business practices and the use of sound technological advances. Input suppliers and academic institutions are to be commended for their role in making this possible. Yet, those of you in this room and others like you that are progressive producers cannot single handily overcome the loss in market share your industry is experiencing today. What it will take is a paradigm shift in attitudes and practices by your industry. The change in attitude will move cattlemen away from looking for a scapegoat to blame for low prices. The change in practices will occur with the advent of integrated contractual arrangements that will form a seamless web of consistent quality from the cowman to the consumer.
Education and product innovation are the keys to making all of this happen. I am confident you will succeed and in the 21st century move the beef business from its commodity status to a quality controlled food item designed to meet your customer's needs.