THE USE OF DERIVATIVES IN A NEW ERA FOR AGRICULTURE
Commissioner Joseph B. Dial
Commodity Futures Trading Commission
1997 Agricultural Outlook Forum
Sponsored by the United States Department of Agriculture
February 24, 1997
To the best of my knowledge, this is the first time a Commissioner of the Commodity Futures Trading Commission (CFTC) has been a speaker at USDA's annual Agricultural Outlook Forum. I am honored to have the opportunity to participate in such a prestigious event.
In view of the fact that most people know little or nothing about the CFTC, I think it might be useful to give you a brief description of who we are and what we do. The CFTC was created by Congress in 1974 to serve as the independent federal regulator of all U.S. futures exchanges. Contrary to what some people think, and with all due respect, we are not a part of USDA. We presently regulate 11 exchanges that trade, on average, approximately two million futures contracts daily. The value of the underlying assets, upon which the futures are traded, oftentimes is in the trillions of dollars. We also have the responsibility to supervise the 64,000 persons and firms that make up the futures industry. Finally, the Commission maintains daily surveillance over the trading of some 200 different futures contracts. Additional information about the CFTC can be found on the Internet. Our website address is http://www.cftc.gov.
It may be of particular interest to this forum's audience to know that for 13 years the CFTC has worked closely with its Agricultural Advisory Committee (AAC). This group meets formally twice each year and deliberates the issues that affect agricultural futures markets and our regulation of those markets.
The AAC has 25 members, designated by organizations representing every major segment of the agricultural community in this country. As chairman of the committee, my office is in daily contact with one or more of the organizations that make up the AAC. In order to give you an idea of the types of important substantive work the AAC has been involved in, I would point to three relatively recent landmark events: the 1991 "Kalo A. Hineman Delivery Issues Symposium," the 1994 "Summit on Risk Management in American Agriculture," and the 1995 "Round Table Discussion on Agricultural Trade Options." If anyone would like more information about the CFTC Agricultural Advisory Committee, you can contact me by e-mail, my address is firstname.lastname@example.org.
My topic today is, "The Use of Derivatives in a New Era for Agriculture." I recognize the term derivatives is not a household word, so a simple explanation is in order. Derivatives involve the trading of rights or obligations based on an underlying product, without necessarily directly transferring that underlying product. The derivative instruments you are probably most familiar with are exchange-traded futures and options. Other derivatives are negotiated between counterparties in the over-the-counter (OTC) market, sometimes with the help of an intermediary. OTC derivatives come in a variety of forms, including swaps, hybrid instruments, energy forward contracts, and trade options.
A New Era for Agriculture
Having explained derivatives, let me do the same for what I mean by the phrase, "a new era for agriculture." On a beautiful, cherry blossom spring day in early April 1996, the Federal Agricultural Improvement and Reform (FAIR) Act became law in the U.S. I think this legislation will have the same affect on public agricultural policy around the world that the collapse of the Berlin wall had on global public economic policy. Just as the fall of Communism encouraged both developed and developing nations to move toward a free market philosophy, so too has the fall of price supports and production controls pushed producers in many lands to make the transition to farming for the market and not the government. We have not seen U.S. agriculture rely this much on the market for almost 70 years. In my mind, this paradigm shift in the government's farm policy has created a new era for agriculture.
I believe the success of this grand experiment depends primarily, although not exclusively, on a producer's ability to develop a written marketing program that includes the prudent use of derivative instruments. In order to master this particular task, farmers will have to become business specialists in production agriculture. The reward for improving their business management skills and enhancing their computer literacy through continuing education will be the creation of their own financial safety net. This will occur as growers learn how to secure guaranteed revenue by transferring production and price risks to other parties.
What is encouraging about this process is that it is occurring as we speak. In just ten months there has been a phenomenal change in the agricultural community's attitude toward risk management. Witness the recent public declaration by 17 agricultural organizations of their belief in the economic importance of risk management. This took place on October 7, 1996 at the 22nd meeting of the CFTC Agricultural Advisory Committee. This attitudinal adjustment was a giant leap forward in the development of 21st century business models for American agriculture.
The Use of Derivatives in a New Era for Agriculture
In this final segment of my presentation I will talk about derivatives and their use in different business models in a new era for agriculture. But first, because of a general misunderstanding concerning derivatives, I think it is important to repeat a point of view recently expressed by Jerry L. Jordan, president of the Federal Reserve Bank of Cleveland. "Derivatives," he said, "don't add to the risks inherent in a modern financial system. They do, however, allow risk to be borne more efficiently."
As you are aware, the current business models for poultry, hogs and cattle have allowed those industries to operate for decades without government production controls or direct price supports. As a result, these industries have been dynamic in responding to competition in the market place. Among these three, poultry is perhaps the best example of using a vertically integrated business model to improve an industry's overall efficiency and post impressive gains in market share. In just two decades, from 1975 to 1995, the poultry industry increased its market share by 17 points, from 24 percent to 41 percent of the market for meats. Although there are exchange-traded derivatives for poultry, pork and beef listed on the Chicago Mercantile Exchange, the futures contract for broilers is the only one not being traded, and thus classified as dormant.
The success of the poultry business model has not escaped the attention of those interested in the pork industry. For several years now a number of mega-size hog operations have copied most of the practices used by the integrated broiler business. However, Land O'Lakes, Inc. a Minneapolis, Minnesota-based cooperative recently announced its "aligned pork production system." According to Dan Glienke, Director of Pork Business Development for Land O'Lakes' Midwest Feed Division, this system will provide resources and technical skills for farmers committed to competing with the big integrated operations, while allowing them to maintain their independence. This approach also permits the grain farmer to diversify his/her operations. The Coop offers producers a "cost-plus" marketing program, which lenders prefer because it reduces their risk.
Speaking of transferring price risk in the pork business, there are several exchange-traded derivatives in use. The Chicago Mercantile Exchange offers futures and options on the cash settled Lean Hog and on the physical delivery Pork Bellies contract. These contracts have respectable volume and liquidity, plus they provide a useful price discovery mechanism. As the pork industry changes in a new era for agriculture, will the Lean Hog and Pork Bellies contracts experience the same fate as broiler futures? They might if Mr. Gary L. Benjamin, economist and vice president of the Federal Reserve Bank of Chicago, is correct. Recently Mr. Benjamin wrote, "The hog producing-processing model that has evolved with the industrialization process in recent years suggests that all pork production for the U.S. could be supplied by 12 packing plants handling the output of some 50 megaproducers."
While poultry and pork are gaining market share because of their business-first approach to delivering what the consumer wants, cattlemen still have some room for improvement. Not the least of beef's challenges is how to herd over 900,000 fiercely independent cow-calf producers toward changing their production and marketing practices. To move ranchers from their traditional practice of raising a generic commodity will require economic incentives that are the exception rather than the rule in today's cattle industry. Yet the trend toward offering the consumer a lean, tender, consistently tasteful, easy-to-prepare cut of beef is picking up steam.
Although there are a number of quality controlled beef programs, one that comes to mind is Ukrop's Supermarkets in Richmond, Virginia. Since 1992, Ukrop's has offered its own private brand of beef. Drawing on the superior genetics in some 20,000 head of cattle enrolled in Ukrop's program, the PM Beef Group of Ashland, Virginia, supervises every facet of the operation -- from the rancher's gate to the consumer's plate. The result -- Ukrop's shoppers get a money-back guarantee on all its beef. The few complaints Ukrop's does get are traced back to the animal the cut came from. The cause of the complaint is identified and corrected. In other words, the consumers' preferences drive every phase of this particular beef operation.
The derivatives used in the cattle business are the 32-year-old physical delivery Live Cattle contract and the cash-settled Feeder Cattle contract. Futures and options on both of these are traded on the Chicago Mercantile Exchange (CME). For at least the past 12 years, the CME and the cattle industry have been engaged in an ongoing lively debate over periodic changes to the delivery terms and speculative position limits for these two contracts. Other beef-related contracts currently being developed by the CME include 90 percent and 50 percent Boneless Beef futures.
Now let me shift gears and talk about derivatives in a new era for agriculture. An era that may see up to 50 percent of feed grains genetically engineered with special characteristics designed to meet the demands of "value-added" markets. Before giving some possible scenarios concerning how the business risks inherent in niche and generic crops might be managed, I would make this observation.
In my mind there are two different methodologies farmers can use to manage their business risks. The one has been in use for some time and focuses on predicting the weather and trying to guess the direction of agricultural commodity prices. The purpose of this exercise is price enhancement and derivatives are the primary instrument used. There is a well developed industry that provides information, advice, and the services necessary for farmers to try to enhance the prices they receive for the commodities they raise. The second risk management methodology is one I like to describe as the "safety net" approach. Its development has accelerated at a rapid pace since the passage of the FAIR Act in 1996.
The USDA and the private sector are actively engaged in developing "safety net" risk management tools. Generally speaking, these tools fall into two somewhat different categories of contracts. The first, and at present the most widely used, is called revenue insurance. This terminology denotes the fact the contract is written by an insurance company. Among the examples that have been covered here today are Crop Revenue Coverage (CRC) and Income Protection (IP).
The second category is one I call revenue assurance. It is not written by an insurance company, it is evolving as we speak, and it will probably be used primarily by agribusiness companies. In any event, both revenue insurance and revenue assurance seek to transfer the production and price risks inherent in farming away from the producer in order to guarantee revenue for his/her operation.
As I mentioned a moment ago, you have already heard an explanation of revenue insurance-type "safety net" contracts, so, I won't duplicate that effort. However, I am going to talk about a concept that is on the drawing board and has the potential to work advantageously for revenue insurance and revenue assurance contracts alike. One way to develop this concept would be to offer it as an exchange-traded futures and options contract. This contract would, for example, settle on the product of CBOT December corn and Iowa Area Yield futures contracts. According to Dr. Dermot Hayes of Iowa State University at Ames, " the expected value of the product of price and yield is equal to the product of the expected values, plus the covariance." The covariance in this instance is a measurement of the tendancy of values to move or not to move together. The contract would trade this covariance, and as Dr. Hayes explained, "option premiums on a revenue product would be much less expensive than the sum of option premiums on separate price and yield contracts." As a result, this type of derivative contract could possibly reduce the cost of reinsurance for crop insurance companies. It could also afford agribusiness organizations an economical way to lay off the risks they take on when they enter into a revenue assurance contract with a farmer.
With regard to the revenue assurance contract between the producer and agribusiness company, it would work as follows. The company wants to maintain or initiate a long-term business relationship with the grower. Furthermore, the company wants to supply the seed, fertilizer, chemicals, fuel and financing to the farmer -- and manage his/her production and price risks by guaranteeing revenue per acre. There are a number of reasons why the company wants to provide this safety net for the producer, but the company must be able to transfer the risks it takes on in the process. A revenue futures contract like the hypothetical one I described earlier would facilitate the necessary risk transfer.
The final class of derivatives I will cover is "trade options." A "trade option," in its simplest form, is a contractual agreement between two parties that provides for the payment of a premium in order to secure the right, but not the obligation, to make or take delivery of the commodity described in the contract. Trade options have been used for decades by producers, processors and others involved in metals, energy, and financial products businesses, but they are currently subject to a regulatory ban for agricultural commodities. Nevertheless, let me illustrate how an agricultural trade option might work if the prohibition was lifted.
For example, a farmer who entered into a trade option contract with an elevator would pay a premium to the elevator for the right, but not the obligation, to deliver a certain quantity of grain within a specified time frame at a price the counterparties had agreed upon when they signed the contract. If the local cash price on the delivery date is higher than the contractual price, the farmer could abandon the option and sell his/her commodity to the highest bidder. There is a strong likelihood the elevator would cover the risk it incurred in granting the option with an offsetting position in an exchange-traded option covering the same commodity.
What is the advantage to the farmer? The contract itself fixes a price that may allow the farmer to lock in a profit -- in effect, a price floor -- lets the producer retain the opportunity to make more money if the price is higher at harvest. In a worse case scenario, the option at least limits the potential for loss to an amount the producer has decided he/she can afford to self-insure. However, once again, the grower can walk-away from the unattractive contract price and sell in the cash market if prices are higher at harvest time.
Another possible use of the agricultural trade option concept would be in the case of "value added" feed grains -- where there is no matching exchange-traded derivative available. For example, a processor enters a trade option contract with a group of farmers like the Kearney (Nebraska) Area Ag Producers Alliance. The counterparties agree on the fob price, the quantity, and the time frame for delivery of a high oil, high protein corn. The processor has specified the delivery dates and quantities to coordinate with all its other purchases in order to achieve a "just in time" delivery system. This delivery arrangement is predicated in part on the processor's need to maximize operational efficiencies, including availability and attractive pricing of rail, barge, truck or ocean freight. Among the other advantages offered by "just in time" delivery are opportunities to adjust to unexpected weather conditions, to achieve some flexibility in matching production to sales, or to take advantage of a better cash or other contracted price at a particular time. Obviously, for the processor there are economic benefits to achieving these results, but it might require changing the quantity the Producers Alliance has agreed to deliver on certain dates. So the processor wants the right, but not the obligation, to take delivery on the set days of a lesser or greater quantity than called for in the contract. The counterparties do know exactly what the lesser and the greater amounts are, because those quantities were specified in the option clause of the original deal. The processor can exercise this right with only 72 hours advance notice prior to the delivery dates spelled out in the contract. However, the number of times the processor can exercise this option within a given time frame is limited by the contract. For these options the processor is willing to pay a premium to the Alliance. If this sounds futuristic, it may be for agriculture, but it is similar to a trade option presently being used daily in the natural gas business. My time is about up, which means you have been saved from any further examples of derivative contracts.
In conclusion, let me say I am convinced that in order for producers, processors, merchandisers and exporters to be profitable in this new era for agriculture, they must have the freedom to develop innovative ways to use both exchange-traded and over-the-counter derivatives to manage their business risks. Unfortunately, as I noted earlier, the CFTC currently has a ban against agricultural trade options, like the last two examples I have just given. However, the Commission plans to take another look at the ban in he near future and it is my fervent hope that sooner, rather than later, the Commission will consider lifting that ban, with or without restrictions.