2007 was marked by significant volatility in the price of agricultural raw materials. This was evidenced by the increase in the price of wheat, which practically doubled in relation to the previous year.
This high price volatility makes forecasts by the various market players extremely difficult, whether they are agricultural producers, private speculators or national governments; this is because decisions regarding agricultural production are almost irreversible, the time between the decision to produce and actual production is often long and climate factors impact the final quantities obtained.
In this context, futures markets appear as tools for reducing the risks related to market instability, all the more so since the liberalization of international agricultural trade is accompanied by a dismantling of national regulation mechanisms. The markets have, therefore, expanded significantly since the 1990s and today play a key role in how prices are set worldwide.
However, although in theory futures markets can reduce the risks linked to price volatility, there is no denying that fluctuations in the worldwide agricultural markets have never been so high, as has been the case for farmers’ incomes. What, then, can explain the current price and income instability, given that economic players are increasingly turning to the futures markets? Are the markets a sufficient condition for the price regulation of agricultural raw materials? Or are their effects overall uncertain and incapable of filling the void left by the elimination of regulatory mechanisms from national agricultural policies?
I. Futures markets: Reducing uncertainty to minimize the negative effects caused by the price volatility of agricultural raw materials.
All acknowledge that agricultural markets are volatile and this past year has only reinforced this established fact. The most significant example of this has been the increase in the price of American and French wheat, by 67 percent and 77 percent, respectively.
Economists and international experts all agree that the price volatility of agricultural raw materials is due to rigidity in demand and the agricultural sector’s high exposure to exogenous risks – primarily weather-related – which cause a structural gap between supply and demand. Indeed, consumers will not eat more if production increases, and would prefer not to eat less if production were to become insufficient.
Consequently, government authorities and private organizations have worked out “ways” to counter this volatility, including via the implementation of agricultural policies such as the Common Agricultural Policy (CAP) in Europe, which in particular aim to stabilize prices and ensure adequate income for farmers, as well as via the expansion of futures markets. The same is true in the United States with the “Farm Bill” and in Japan with the price of rice.
Contrary to “ordinary” or so-called physical markets, futures markets1 do not involve an immediate trade in physical assets, but rather trade in the promise of a purchase or sale. This allows the various economic players to hedge against the inherent risks of a transaction or to benefit from those risks by speculating how prices may evolve, in the hopes of making a profit.
A farmer thus hedges by selling on the futures market, via a contract, a portion of his/her production at a given time. To do this, while the farmer’s crop is still standing or in inventory, an optimal2 and objective3 price are set beforehand that covers costs and provides a margin. A sell order is then submitted. The farmer regularly monitors the futures market prices and, at the same time, enquires with his/her storage organization4- most often a cooperative – about the price levels on the physical markets. The deviation between these two prices, called “the base,” fluctuates over time, increasing as well as decreasing. If the “physical” price is acceptable, the farmer can sell on the physical market and release his position on the futures market (in other words, the farmer buys back the contract submitted to this market), or, failing that, speculates.
The intent of the speculation operation is therefore to buy or sell futures contracts with a view to making a profit. A speculator buys or sells, anticipating the movements of future prices, yet has no intention of proceeding with a physical transaction, whether on the futures market or physical market.
Two conditions are necessary in order for the futures markets to allow market players to insure themselves against unexpected future risks: application of the Law of Large Numbers to the considered risks, and the pooling of risks. In fact, these two conditions form the basis for the longevity and operation of banking and automobile insurance organizations, which consider, respectively, the probability that all clients would withdraw their financial funds on the same day and that all those they insure would have an accident for which they are responsible at the same time to be almost nil.
And yet, while these two characteristics, which are fundamental to the development of private insurance mechanisms, can be observed on most economic markets, this is not the case for the agricultural sector, which strongly minimizes the relevance of futures markets as the favored mechanism for addressing the elimination of existing regulatory policies.
II. An insufficient instrument given the progressive liberalization of agricultural markets, calling for the implementation of specific regulatory tools.
In addition to the two factors noted above – the rigidity of demand and the high exposure to climate factors – agricultural markets stand apart from other economic markets in the following three ways:
> Agricultural prices are much more volatile than industrial or service prices, making them extremely difficult to forecast.
> Decisions regarding current production (not just investment decisions) made in the year “N-1” are almost entirely irreversible before year “N”.
> There is at once the production of physical assets, forward markets and option contracts (by-products), theoretically authorizing complete or partial hedging and above all speculation.
When taken together, these characteristics show that the agricultural sector is, in addition to exogenous risks, also subject to endogenous risks – in other words, risks that arise from the very fundamentals of agricultural markets, as underscored by:
> The imperfect market structures of most agricultural products, as is the case with corn, for which the United States alone produces over 40 percent of corn traded globally.
> Miniaturization and structural mistakes in the expectations of agricultural producers who do not have access to full information (particularly the price at which they will be able to sell their products) at the time of planting.
> The proliferation of private speculative funds in the agricultural area, which exist due to the fact that volatility can be a source of sizeable profits in the short term… yet which make mistakes (buying when prices increase and selling when they decrease), thereby amplifying price volatility.
These are all elements that reveal one of the main specificities of agricultural markets: the volatility of agricultural prices generates its own volatility.
And yet, the existence of these endogenous risks calls into question the very logic of insuring agricultural risk via futures markets. Contrary to exogenous risks, which are insurable (albeit at high cost), and whose effects can be mitigated via market liberalization (pooling of risks), with endogenous risks, it is impossible for a private organization to concretely assess the level of risk to which farmers are exposed, and to finance any compensation should the need arise.
Furthermore, the full market liberalization advocated by the WTO, which assumes a dismantling of the regulatory policy instruments of agricultural markets, has a high risk of increasing price volatility and, therefore, the inherent risks, without a private insurance organization being able to respond to this situation via the futures markets.
That is why it is essential to maintain an agricultural policy of regulation at the national and supranational level, since by definition, the national government is the insurer of last resort; i.e., the only entity that can bear such risks and indemnify the various economic players, particularly the agricultural producers.
Moreover, futures markets are not within the reach of all farmers, insofar as they represent a real cost: any lot bought or sold on the futures market requires a margin deposit and the payment of daily charges (margin calls), representing a considerable immobilization of capital. Access to information, an absolute prerequisite for the proper use of these tools, results in an additional cost that not everyone can assume.
Beyond cost, a farmer’s production level must be adequate to meet all of the requirements for entering the futures market. According to Charles Marchand, a farmer in Saint Jean sur Vilaine (35), “on Euronext,5 the minimum entry for wheat is 50 tons. That can represent a large share of total production, and that is not in line with our production cycle.”6 Mastering this tool also requires the ability to assimilate complex economic knowledge. Moreover, although the tool is increasingly used, a large majority of farmers in developing countries, who in general are very poor and ill-informed and have limited production levels, do not use them.
The futures markets have a considerable and increasing influence on the direction of worldwide agricultural markets and yet their actual impact as an insurance instrument is little-known and overestimated. Furthermore, although mechanisms for insuring against agricultural risks are essential given climate risks, the specificities of the agricultural sector now more than ever justify the maintenance of public regulatory mechanisms.
It is, therefore, essential that we gain instruments for understanding this complex reality and for determining the principles of a national and supranational governance that would inform the functioning of agricultural market regulation in a context of measured market liberalization.
It is within this perspective that WOAgri is developing the WOAGRI economic simulation model, one of the key characteristics of which is modeling the impact of exogenous and endogenous risks, as well as of the level of influence that speculators have on the price volatility of agricultural raw materials.
1 Futures markets can be one of two types. In a forward market, the buyer commits to purchasing a given quantity, at a given time, at a previously set price and the seller “promises” to sell this quantity on the specified date. For a conditional futures market, the buyer/seller places an “option” to buy/sell and indicates the price below which he/she would be ready to buy/sell.
2 The primary goal is to secure the selling price, rather than maximize it.
3 The target price is calculated from the per-ton production cost and corresponds to the reality of the business of agriculture.
4 The storage organization handles the collection, storage and sale of agricultural raw materials.
5 First pan-European stock exchange, merged in 2007 with the New York Stock Exchange Group to form NYSE Euronext.
6 See the article published on June 28, 2009 on the www.web-agri.fr site. “Utiliser les surfaces pour l'énergie verte ou l'alimentation - la concurrence s'installe.” |