September 15, 2008

Agricultural Commodity Price Increases: Spurring a New Farm Crisis?

Introduction

The past year has seen dramatic fluctuations in agricultural commodity markets. These market fluctuations have been the focus of much attention within the industry, in the media, and in government. However, the impact of higher commodity prices on certain segments of the agricultural sector and the legal issues that flow from such market conditions, including the allocation of risk, have gone largely unnoticed.

Had commodity prices remained at the high levels of June and July, an industry-wide crisis may have resulted. But while market prices ebbed in late summer (which itself created issues for certain industry participants), they remain at historically high levels, and the future remains uncertain. High commodity prices and market volatility have adversely affected numerous industry participants. Determining which participants will ultimately bear the risks may be the work of lawyers, arbitrators, judges and juries for several years to come.

Impact on Producers

Given record-breaking commodity prices, Americans might reasonably assume farmers are prospering. In fact, many are. Others, though—both crop farmers and livestock producers—are facing financial peril.

To understand why, it's necessary to understand how many farmers market their crops. Like most businesspeople, they plan ahead. Thus, in the summer of 2007, when grain farmers saw futures prices for the 2007 crop, including the July 2008 futures contracts for corn and soybeans, trading at what were then considered high prices ($4.00 per bushel for corn and $9.00 for soybeans), many chose to "forward contract" their 2007 crop to grain buyers—to sell before it was harvested, for a fixed price, and for delivery at a specified time in the future.

Under a standard forward contract, a grain farmer agrees to deliver a certain number of bushels months, or even years, later. In return, he is guaranteed a price tied to the applicable futures reference price, minus the basis (the difference between the futures price and the local cash price).

Assume, for example, that in September 2007, Mr. Maize, a grain farmer, saw July 2008 corn futures trading at $4.00 per bushel. He called his local grain elevator (Buyer), and with a basis of $0.25 (to account for local market variation), contracted to sell 50,000 bushels of corn at $3.75 per bushel for delivery in July 2008. When delivery time arrived, though, corn prices had risen, and Maize had to deliver a crop worth more than $7.00 per bushel while accepting payment of $3.75 per bushel—a lost profit opportunity of $3.25 per bushel.

For some farmers, however, more than a missed opportunity is at stake. Since 2007, their costs have increased considerably, including rent (which has risen on pace with record land prices), diesel fuel and fertilizer. For the most part, though, those higher costs did not affect the 2007 crop, so Maize may have enjoyed a profit, even at $3.75 per bushel.

Vary the hypothetical, however, and the outcome changes dramatically.

Assume that in September 2007, instead of selling 50,000 bushels for July 2008 delivery, Maize sold 50,000 bushels of his 2008 crop for November 2008 delivery, also at $3.75 per bushel. But in 2008, Maize has to pay higher rent; he may even have lost some production acres because of rent increases. Meanwhile, the spring was very wet, and Maize only planted 90 percent of his remaining acres to corn. He lost another 10 percent to flooding. Fertilizer and fuel costs were also dramatically higher.

Come November 2008, the spot (cash) market is trading at $6.00, and Maize delivers his entire crop—just 40,000 bushels—to Buyer, who invoices Maize $2.25 per bushel on the undelivered 10,000 bushels. Maize may have lost a considerable sum, and remains indebted to Buyer.

Livestock producers, who are but one step removed from this process, are experiencing similar tectonic shifts due to higher feed costs. Put simply, many are paying more to feed and house animals than the animals are worth when ready for harvest.

Impact on Buyers

Buyers of grain, including grain dealers, feed companies and processors, may also be negatively affected by higher grain prices, albeit in a complicated fashion. Such buyers hedge against the risk of fluctuating prices by entering into futures contracts in association with forward contracts to purchase grain from producers.

Look again at Mr. Maize, who in September 2007 agreed to sell 50,000 bushels of corn, via a forward contract, to Buyer for $3.75 per bushel, with delivery by July 2008. But grain dealers don't make money by speculating; they don't want to risk losses due to fluctuations in market prices. To hedge against price risk, when he agreed to buy Maize's corn, Buyer also sold ten corn futures contracts (standardized at 5,000 bushels each) at the $4.00 per bushel futures reference price. In July 2008, the cash market was $7.00 per bushel and the July futures contract was trading at $7.15. Thus, Buyer made a profit of $3.25 per bushel on the contract with Maize (bought for $3.75 but worth $7.00 at delivery). But he also needed to close out his hedge position in the futures market, so he bought ten futures contracts at $7.15 per bushel, a loss of $3.15 per bushel that offset most of his gains on the cash market. Buyer did make $0.10 per bushel through the narrowing basis. He then sent Maize's corn, along with corn from other producers, to a processor, where he made a few more cents per bushel.

That's how grain transactions are generally supposed to work. The seller delivers all the grain called for by the cash forward contract. The futures market, in turn, accurately reflects the cash market, making the buyer's hedge efficient.

Futures/Cash Convergence

Recently, however, the prices of commodities like corn in the cash market and in the futures market at or near expiration of futures contracts have not been as close as in the past. This failure of the two prices to converge is difficult to explain, even for economists. Some commentators—and some within the grain industry—think the cause is excessive speculation. But while the failure to converge has been widely reported, its effects have been less well understood.

In some instances, the difference between the cash price and futures market at the expiration of the futures contract has been as high as $0.55 per bushel for corn and $0.80 for soybeans. A wide gap puts buyers in a difficult position. Assume, for example, that instead of buying ten futures contracts (50,000 bushels) at $7.15 per bushel (a total of 50,000 bushels), Buyer in the above hypothetical had to pay $7.75 because the markets did not converge. In that scenario, Buyer profits $3.25 per bushel on the cash contract with Maize, but loses $3.75 on the hedge position, for a net loss of $0.50 per bushel—$25,000. Buyer has lost a considerable sum because of his hedge position.

Producer Default

Another risk currently faced by buyers of grain is producer default. There is a degree of risk in all contracts that the other party may default. However, record commodity prices and production problems in certain areas have driven counterparty risk for buyers to an unprecedented level.

As 2007 crops were first being delivered to buyers in the fall of 2007, it became clear that grain prices were moving higher. For a significant number of producers, those rising prices proved too great a temptation: Many elected to breach their agreements with buyers and default on 2007 crop contracts. The increase in producer defaults is reflected in the significant number of new arbitration filings with the National Grain & Feed Association, which maintains an arbitration system for its member companies and their contracting parties (roughly 70 percent of the industry).

The 2008 crop may present even greater issues, with the volume of producer defaults likely reaching new highs, for several reasons. First, many farmers forward sold their 2008 crop in 2007 at prices that did not take into account significantly higher 2008 costs. As a lost profit opportunity turns to a loss, the risk of default increases. Extremely poor spring weather exacerbated the problem. Many producers simply may not have enough grain to deliver against their forward contract commitments.

Margin Calls

While the hypothetical buyer's hedge transaction described above is basically accurate, it fails to account for another significant impact of price volatility, the margin call. In the example above, Buyer bought back the ten futures contracts when grain was delivered, inferring the money was spent then. In reality, Buyer would have to pay in increments, as the futures market moved higher, in the form of margin calls, which commodity exchanges use to ensure that parties have funds to cover losses: As the market moves against a party's position, he must deposit money to offset losses.

In the hypothetical, as the futures price moved from $4.00 per bushel to $7.25, Buyer would have to deposit roughly $3.25 per bushel. If, as is typical, this money was borrowed, Buyer would have to pay interest. Thus, unlike a typical year, where the price might move a few dozen cents and Buyer might incur minor interest charges, he is now paying a significant amount of interest. Meanwhile, credit has tightened, and some buyers have had difficulty meeting their margin requirements.

In late summer, market prices moved considerably lower, but remained at historic highs that continued to be cause for concern. Extensive market volatility, too, can itself create significant disruptions, whether the market moves up or down: The downward movement of markets in late July and August caused participants in futures markets to incur extensive margin calls. Thus, while the rapid increase in agricultural commodity prices in 2007 and the first half of 2008 raised issues and caused concern, a rapid retreat to pre-2007 crop price levels would likely create an entirely new set of issues.

The Real Risk Holders

Within the agribusiness community, there is a broad expectation that 2008 and 2009 may see an increased number of defaults on contracts and liquidations among livestock producers, with lawyers, arbitrators, judges and juries having to sort through the ensuing mess. When fully accounted for, all parties in the production chain—and their lenders—will likely have shouldered some of the burden.

In contrast to the farm crisis of the 1980s, however, many "farmers" today are not individuals. Instead, many have formed limited liability companies in order to protect personal assets, including farmland. Thus, while many individual farmers may retain full liability for breaches of commodity contracts, others may simply wind down the contracting LLC.

Historically, the cliché of business with a handshake has been the norm in agriculture. Asking for information about the other party to a contract was seen as impolite. As the use of limited liability companies became widespread, though, old habits did not change. Many industry participants failed to recognize the impact of limited liability entities.

Of course, someone has to carry financial losses. If the seller is an LLC without sufficient assets to cover its obligations, the next party in the chain, the buyer, may find itself on the hook. In 2008 and 2009, many buyers of grain may find themselves writing off significant amounts of producer liability. For some, the costs could not come at a worse time, as many are already strapped by margin calls, higher interest costs, increased fuel costs and other factors. For some buyers, the future may be dictated by market conditions beyond their control. To a significant extent, however, buyers may suffer due to their failure to adequately assess and guard against counterparty risk.

If a grain buyer fails, the losses will move to the next level—the buyer's lender. To a significant extent, lenders, too, are at the mercy of market conditions, such as debtors' higher operating costs. They cannot go back in time and force buyers to be more diligent in contracting with limited liability companies. Lenders cannot undo the fact that many farmers over-sold 2008 crops.

Many grain and livestock producers may go out of business due to market volatility. Many buyers of grain—including dealers, feed companies and processors—may also suffer. The ultimate outcome is predictable: fewer market participants. Given the capital barriers to market entry, they may be lost forever.
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