"The Role of Derivatives"
"Managing Agricultural Business Risks in a New Era"
Commissioner Joseph B. Dial
Commodity Futures Trading Commission
FORUM ON RISK MANAGEMENT
AND COMMODITY FUTURES MARKETS IN JAPAN
April 14, 1997
I would like to thank the Tokyo Grain Exchange, the Tokyo Commodity Exchange, the Futures Industry Association of Japan, the Japan Federation of Commodity Exchanges, Inc., the Commodity Futures Association of Japan and the Tokyo Grain Market Research, Inc. for inviting me to participate in this Forum on Risk Management and Commodity Futures Markets in Japan. It is indeed a signal honor for me to present a keynote lecture today to the distinguished representatives of these influential organizations as well as all the other eminent persons attending this Forum.
I have the greatest respect and admiration for the state-of-the- art posture of Japan's agricultural and commodity futures industries. Therefore, you may already have in place some of the public policies and business practices I will describe in my presentation. Nonetheless, it is my fervent hope you will be able to use some small part of this lecture in a way that will be beneficial to you.
The title of my presentation is "The Role of Derivatives -- Managing Agricultural Business Risks in a New Era." My comments and observations are based on 35 years of experience in farming, ranching, agribusiness, banking and international trade, as well as nearly six years as a Commissioner of the Commodity Futures Trading Commission. Upon reflection, it seemed appropriate to divide this lecture into three parts. First, how changes in public policy have ushered in a new era for agriculture. Second, the use of derivatives in today's agricultural business models. And third, derivatives and the industrialization of agriculture in the 21st century.
Changes in Public Policy Usher in 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 US. I think this legislation will have the same effect 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 agriculture rely this much on the market for almost 70 years.
A similar change in farm policy, from one of government control to a new market-based freedom to farm, is underway in other countries too. Three and one-half years ago I was invited by officials of the United Nations Conference on Trade and Development (UNCTAD) to serve on their Group of Experts. This advisory panel to the Committee on Commodities met in Geneva, Switzerland for three days. We were asked to prepare a road map to the future that governments could use to facilitate farmers' use of private sector tools to manage their risks. Even back in 1993 there was an awareness that deficit reduction was a must, and that governments around the world would need to gradually move producers toward relying more and more on the market.
There are many specific examples of this process in action. Brazil is transitioning toward a reduction in farm subsidies and the members of the European Union have initiated some minor adjustments to their Common Agricultural Policy (CAP). This window dressing of the CAP was discussed in part during a conference I chaired in London in October of 1996 on Risk Management in European Agriculture.
Some of the other countries that are making major changes to their governments' farm policies, include New Zealand, Australia, Mexico, and Uganda. I believe these paradigm shifts in public farm policy, combined with the profound changes in global agricultural trade brought about by the GATT and NAFTA agreements, have ushered in a new era for agriculture.
In my opinion, 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 the US, for example, over just the past year 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 Today's Agricultural Business Models
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 swap agreements, hybrid instruments, energy forward contracts, and trade options.
The interesting thing about derivatives is that few people have a clear understanding of exactly what these instruments can and cannot do. One of the best explanations I have read comes from Jerry L. Jordan, president of the Federal Reserve Bank of Cleveland, Ohio. "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."
In the US, continual changes in the 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 marketplace. Among the 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 US 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 US pork industry. For several years now a number of mega-sized 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 two exchange-traded
derivatives being used in the US. The Chicago Mercantile Exchange offers futures and options on the cash settled Lean Hog contract 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 mega- producers."
While US poultry and pork are gaining market share because of their business-first approach to delivering what the consumer wants, US 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 US ranchers away 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 in the US, 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 all the way back to the animal the cut came from and 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 US 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.
The other agricultural business model I will cover is the one that applies to row crops in general. However, my example will single out the specific model used in food and feed grains in the US The commodities I am referring to are corn, soybeans and wheat.
Although there are other variations on the business model for the products I have just mentioned, allow me to give you a simplistic description of today's practice. The farmer produces the crop and sells it to an elevator or a processor. The first handler of the commodity then sells it in bulk or some state of being processed whereupon it is eventually sold on either the domestic or international markets.
Now let's look at how derivatives are used in this chain of events. There is anecdotal evidence that, before 1996, only about ten percent of the two million farmers in the US used exchange-traded futures and/or options to hedge the price risks of the commodities they raised. With the passage of the FAIR Act in April of 1996, producers realized they needed to pay more attention to managing their price risks. One indication of farmers' new found interest in using exchange-traded options is the overall 68 percent increase in the volume of agricultural options traded on the Chicago Board of Trade (CBOT) in 1996 as compared to 1995, including a 74.5 percent increase in options on corn futures.
There is reason to believe that, for a number of years before 1996, an additional 20 to 30 percent of US growers would market their commodities each year by entering into a forward contract with their local elevator or nearby processor. In most instances, these agribusiness firms would take a short futures position to cover the price risk they assumed upon signing the forward contract. When the farmer delivered the commodity, usually at harvest, the company would offset its short futures position.
Upon loosely extrapolating the percentages I just used, you can reasonably assume that 50 percent or more of all American producers, at least prior to 1996, took the prevailing cash market price at harvest time. They had no marketing plan nor did they use futures/options to shift the price risks on what they were growing.
I am convinced this behavior was predicated on at least two factors. First, since 1933, the US government had been doing most of the marketing and risk management for farmers. So why should they do it? Second, there was and still is a general misunderstanding in the producer community of what the economic function of futures/options is. As a result of this misunderstanding, many farmers have viewed all trading on futures exchanges with considerable skepticism and in some cases have had little or no confidence in the integrity of the price discovery process.
On the other hand, a relatively high percentage of grain handlers and processors rely upon futures/options to manage the price risks of the commodities they deal in. They also depend on the prices discovered on the futures exchanges for price-basing.
So there you have a thumbnail sketch of the use of derivatives in today's US agricultural business models -- as it applies to the food and feed grains sector as well as the major poultry and livestock enterprises. I have not addressed the production, processing and use of derivatives for oats and barely, vegetables, fruits, nuts, wool, mohair or dairy because there isn't enough time. However, I would mention that there are US exchange-traded futures contracts for oats and barley, cotton, frozen concentrated orange juice, potatoes, cheddar cheese, non- fat dry milk and fluid milk.
Now that you have in mind where we are today in using derivatives in U.S. agriculture, let me move on to the final part of my lecture -- derivatives and the industrialization of agriculture in the 21st century.
Derivatives and the Industrialization of Agriculture in the 21st Century
I believe the successful industrialization of agriculture in the 21st century will revolve around two things. First, the efficient and economical transfer of production and price risks, and second, delivery of exactly what consumers want. Derivatives will play a major role in accomplishing the first goal. They will be the building blocks for the development of a new generation of "secured revenue" type risk shifting contracts. Please keep in mind that I am talking about this evolutionary process taking place in a new era for agriculture that began in earnest in 1996.
Let me explain what I mean by the term "secured revenue." Simply stated it describes a commercial contract between a farmer and a counterparty that will protect the producer from much of the financial consequences of adverse weather or low commodity prices, or both. Without this protection the economic viability of many of those who till the soil will be tenuous at best. As a result, the first time the weather or markets causes farmers to come under considerable financial stress, there will be tremendous political pressure for the government to reassert its role in agriculture once again. If that occurs, it will slow the drive toward improving economic efficiency in the production and processing phases of agriculture. That means consumers will have to pay more for their food than they would if farmers have "secured revenue" protection.
The first of a new generation of "secured revenue" type risk shifting contracts is not a derivative, rather it is a crop insurance policy available in the US under the name of Crop Revenue Coverage (CRC). Basically, what CRC does is to guarantee the farmer revenue from his/her crops if any combination of poor yields due to adverse weather or low prices occurs. This policy is offered by firms that handle crop insurance. The demand for it in two states during a 1996 pilot program was so great, that it is now available in 13 states.
I think there are several reasons why producers use CRC. First, farmers realize they need to establish their own financial safety net because the FAIR Act called for government subsidies to be phased out. Second, producers have a better understanding of how insurance works and are more comfortable with it than they are with futures/options. Third, agricultural lenders are more likely to make an operating loan if the grower assigns to the bank any indemnity payments that might be received under the crop insurance policy.
Also, consider this, with CRC providing a financial safety net, a farmer can become more independent in choosing a banker, input supplier and prospective buyer for his/her crops. Furthermore, CRC may be part of the reason why we are seeing a trend developing in the US whereby farmers are joining together in geographic area business alliances in order to sell directly to a value-added processor. The producers will guarantee quality and ship identity-preserved grains in unit-train quantities, with delivery dates and quantities coordinated with a processor's "just in time" delivery schedule. If the commodity is exported to a foreign firm, the producers may use a futures contract to hedge their currency exposure. The agreements may well be long- term with flexible pricing.
What I have just described is a precursor to a restructuring of agriculture in a new era. As a result, in the future, elevators and processors may find themselves in an even more competitive environment than they face today. A number of agribusiness companies recognized this some time ago. And they are gearing up to be among the first to implement pilot programs to test the feasibility of providing farmers with a unique package of goods and services. For example, the ABC Company will enter into a fixed-price contract with the farmer to provide seed, fertilizer, chemicals, and fuel.
This approach, in and of itself, is not revolutionary. However, what will make this merchandising technique different is a minimum dollar guarantee of revenue per acre to be paid to the producer by the Company. This payment will be made even if adverse weather and/or low prices preclude the farmer from delivering value (yield x price) equal to the guaranteed revenue dollar amount. Another attractive feature is that, if the price is higher at harvest than the original reference price, and the farmer delivers more than the contract calls for, then he/she is paid more than the minimum guarantee per acre. In return for these goods and services, the grower must agree to use the company-provided inputs according to certain specifications and to maintain the identity-preserved status of the commodity. In order to round out their full service package, the ABC Company would finance the producer's operating expenses.
Obviously, the linchpin to the success of such a package is the transfer of the farmer's production and price risks. One way the Company could do this is to give discounts on the inputs it supplies in an amount equal to the premium the farmer would pay for CRC coverage. In return, the producer would assign the CRC indemnity payments to the Company as collateral against the operating loan he/she had received. That's a possibility, but it's not exactly what agribusiness companies are looking for. What they need is an exchange-traded or over-the-counter derivatives contract that would efficiently and economically transfer the revenue risk they are assuming.
One concept that has the potential to meet this need is a futures contract designed to settle on the product of the CBOT December Corn and Iowa Area Yield Corn 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 tendency 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." Furthermore, speculators in the covariance futures would lay off their risks in the CBOT Area Yield and commodity price futures markets. As a result, this type of derivative contract may well offer agribusiness organizations an economical way to lay off the risks they take on when they enter into a "secured revenue" contract with a farmer.
Almost everyday, I have the good fortune to be able to talk to a large network of key decision makers in the public and private sectors of agriculture -- domestically and internationally. Therefore, I have no doubts about the private sector's ability to develop "secured revenue" type commercial contracts. The competitive forces of the market place are at work to drive their development and the financial reward will be great for those who are among the first to offer them.
I believe the combination of a new era for agriculture, tremendous advances in technology, and a sizable segment of the world's population experiencing an increase in its disposable income, will accelerate the pace of change in agriculture unlike any developments we have ever seen before. Those countries that give their producers the freedom to farm for the market and not the government, will improve the economic efficiency of their agricultural sector. This, in turn, will benefit consumers. In order to reap the rewards of this change in public policy, farmers will need to become involved in a continuing education program. This will empower them to use appropriate private sector tools to transfer their yield and price risk.
The new era for agriculture I have described, opens up a new world of change and challenge for everyone involved in the production and processing of food. It also provides unique opportunities for those who offer exchange-traded and over-the- counter derivatives. Producers and processors who would take advantage of those opportunities will need to be open to new approaches, and unafraid of doing things that haven't been done before.