Market-Based Solutions for

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• Market-Based Solutions for
• Commodity
• Price Risk Management

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Craig Baker Commodity Risk Management
Group, World Bank
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World Banks Commodity Risk Management Group

• Part of Agriculture Rural Development Dept.
• Funded by Swiss Secretariat for Economic Affairs,
  Netherlands Ministry of Foreign Affairs and
  European Commission
• Core team focused on price weather risk
  management
• research, policy advice, innovation, technical
  assistance, and piloting market-based
  management solutions
• Currently engaged on
• Cotton Price Risk Management Projects Tanzania
  / Mozambique / West Africa
• Coffee Price Risk Management Projects Tanzania
  
• Maize Price Risk Management Projects Malawi /
  Zambia

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Agenda

• Alternative Approaches
• The Problems
• Can Risk Management Tools Help?
• Employment of Risk Management Tools
• Overview of Risk Management Products
• Examples Malawi and Tanzania
• Lessons Learned

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Alternative Approaches

• We should be managing risks instead
  of managing crises

Dr. Abera Deressa, State Minister for Agriculture
and Development, Ethiopia

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Commodity Price Risk Management Problems
Burkina Faso -2005/6 - 110m in Cotton Debt
El Salvador 2001/2 - 250m Coffee Debt

• African Food Aid 800m in 2006

Senegal 2006 - 20m Cotton Debt
What or who is Next?
Guatemala 2001/2 - 100 million small coffee
farmer debt
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The Problems Consequences

• Maize Price Volatility
• Poor planning uncertainty about government /
  donor responses constrains commercial responses
• Limited trust between government and private
  sector
• Crisis Management everything done at the last
  minute when costs are high transport corridors
  are constrained
• Emergency / crisis-driven operations divert
  resources from more sustainable programs
• Cotton Coffee Price Volatility
• Poor or non-existent risk assessment techniques
• Poor or non-existent risk management techniques
• Trading losses at intermediary level (cooperative
  / ginner) have a negative impact on farmers,
  financial institutions, and sector as a whole

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Can Risk Management Tools Help?

• to replace costly, inefficient, disruptive ex
  post responses
• with cheaper, more efficient, targeted ex ante
  responses
• that include (and stimulate growth of) the
  private sector

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Employment of Risk Management Tools Through..

• Producers
• Risk managing sale prices to cover cost of
  inputs
• Improvements
• Need to understand how the global market moves
  affects local prices
• Need confidence that producer price is
  competitive in the market
• Very difficult to access risk management markets
  directly so best approach is to access price risk
  mgmt solutions through market intermediaries
• Cooperatives / Buyers / Traders / Processors
• Risk managing price volatility in between time
  of purchase sale avoiding trading losses
  caused by intra-seasonal price volatility
  maintaining own credit-worthiness and ability to
  pay back loans managing farmer credit risk when
  extending loans for inputs production
• Improvements
• Need to understand be able to quantify risk
  throughout the season
• Need to offer competitive prices to farmers and
  be confident of ability to pay that price
• Need to improve management of intra-seasonal
  price and credit exposures
• Need to understand global markets improve
  negotiating power

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Employment of Risk Management Tools (cont)..

• Banks / Financiers
• Risk - managing credit risk for financing
  farmers market intermediaries
• Improvements
• Need to improve risk assessment capabilities
  monitoring throughout the season
• Need to offer risk management solutions to
  borrowers
• Balance extending / increasing credit without
  increasing risks
• Can play a critical role in helping a country
  gain access to financial markets
• Governments
• Risk - managing food supplies / reserves
  reducing the need for and cost of policy
  interventions
• Improvements
• Need to build confidence in commercial solutions
• Need improved planning

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Price Risk Management (Hedging) Products

• Two main products
• Futures Contract
• Option Contract
• A financial agreement between two parties that
  gives the buyer the right but not the obligation
  to buy or sell a futures contract within a
  specific period of time at a specific price
  level
• Has an upfront cost Akin to insurance
• Standardized contracts that specify
• Price
• Quantity
• Delivery date
• Settlement Date

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Option Contracts..
PUT Option Contingent Export CALL Option Contingent Import
Definition PUTS purchase the right but not the obligation to SELL a specific futures contract at a specified price within a specified time CALLS purchase the right but not the obligation to BUY specific futures contract at a specified price within a specified time
Offers Protection against prices moving down against prices moving up
What You Get If market moves down, you receive the difference between price protected and the prevailing market price If market moves up, you receive the difference between price protected and the prevailing market price
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Malawi Example

• Managing Maize Price Risks for Food Security

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Malawi 2005/6 Food Crisis

• In 2005/6
• 400,000 mt food shortage predicted for Malawi
• 1.5 - 2.0 million mt food shortage predicted
  regionally
• Peak hungry season was Dec / Jan
• Government did not want to be responsible for all
  importing
• Prices tend to spike when there is a shortage
• AND higher local prices mean higher of
  population cant afford food so humanitarian
  needs increase

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Maize Price Volatility
Continued disincentives to private sector trade
In 2005/6, although South Africa had a 6 million
mt and falling prices, surplus commercial exports
were not moving efficiently to countries with
deficits
Leading to
Leading to
Intervention to maintain sales at subsidized
prices
Potentially higher levels of humanitarian need
Leading to
Leading to
Increasing local prices in the region
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Why was the Government of Malawi interested in a
Risk Management approach?

• In the context of food security
• Concern about local price increases
• Concern about regional (S.African) price
  increases
• Concerned about private sectors ability
  willingness to bring in commercial imports
• Concerned about response to humanitarian appeals
• Alternative to policy interventions
• Wanted a contingency plan in case any of the
  above moved the wrong way

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South African Futures Exchange - SAFEX

• A division of Johannesburg Stock Exchange
• Started in 1995 after liberalization of
  agricultural markets in RSA, traded 3.5bn in
  last financial year
• Trades white maize, yellow maize, wheat,
  sunflower, soybeans
• 200,000 mt of maize traded daily and volumes
  are growing
• Used by producers, traders, processors for price
  discovery and price risk management
• Increasingly being used as a benchmark for maize
  prices in the region
• Equally NYBOT /CotlookA / CBOT for other
  commodities

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A Comparison
Malawi 2005/6 Malawi 2006/7
Conditions Deficit of 250k - 400k mt Expected Surplus gt 500k mt
Effects Increased Prices Food Insecurity Political Interventions Donor Interventions Falling Prices Insecurity of Rural Household Incomes Post Harvest Losses
Solution A CALL Option A PUT Option
Results The Right to buy at a capped price flexible Private Sector Involvement Price Stability Food Security Market Based Intervention The Right to sell at a capped price flexible Price Stability due to exports Income Stability Market Based Intervention
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Conclusions

• Governments have difficulty knowing how to
  respond without good alternatives
• Market solutions exist, make use of financial
  structures
• These structures create possibilities for private
  sector involvement
• Ultimately these structures can be implemented by
  the private sector for the good of the farmer
• Emergencies are disruptive to longer term
  development programs
• Need new mechanisms which transfer business to
  local traders to support long-term market
  strengthening objectives
• Investment in risk management strategies help
  improve budgeting can ring-fence emergency
  response, with known cost in advance, saving
  resources for more sustainable, long-term
  programs
• Better coordination and ex ante planning is
  required so as not to always be operating in
  crisis mode with associated debilitating costs

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Tanzania

• Managing Cotton and Coffee Price Risks

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Risk Assessment is the First Step

• Every actor in a commodity chain has risk that is
  determined by its business practices
• Price Fixing
• Purchases and Sales Patterns
• Volumes of Purchases and Sales
• Types of Contracts
• Levels of Credit
• Risk Assessment understanding how purchase
  sales patterns influence risk

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What Creates Price Risk?

• Fixing Prices
• For either purchases or sales
• 2. Time
• Buying or fixing a price before selling selling
  or fixing a sales price before buying
• Longer time between purchases sales more risk
  
• 3. Volume
• The more purchased and sold without managing
  risk, the larger the exposure

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Impacts of Price Risk

• Example producer prices fixed at the beginning
  of the season.
• If prices rise between purchase and sale, farmers
  groups / ginners are profitable and able to
  return profits to the farmer in form of 2nd
  payments
• If prices fall between purchase and sale, farmer
  groups/ ginners
• May avoid making sales in order to avoid losses
  
• May be forced to lower the purchase price to
  farmers
• May default on sales because can not procure
  enough product
• May make sales and book losses
• May not have cash to continue paying farmers
• May go out of business

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Three Risk Assessment Tools

1. Position Analysis
2. Breakeven Analysis
3. Mark to Market Analysis

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Tool 1 POSITION ANALYSIS

• What is your position relative to the
  market?In which direction is your exposure?

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Position Analysis

• If you
• 1) Buy before you sellor 2) Sell before you
  buy you are at risk and have taken a
  position

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Long Position
Position Analysis
Short Position

• Purchase price is known
• Because you either own - or have an obligation to
  buy - the physical product at a fixed price
• Sales price is unknown
• Risk is that market will move down

• Sales price is known
• Because you have sold - or have an obligation to
  sell - the physical product at a fixed price
• Purchase price is unknown
• Risk is that market will move up

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Example Hypothetical Position Analysis for a
Cotton Ginner
Is this a long or a short position?
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Tool 2 Breakeven Analysis

• Breaking even covering costs
• What is the price level at which you are breaking
  even?

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Determining Costs

• Costs change over time depending on changes in
• Fixed cost Transport, Ginning, Milling,
  Roasting
• Variable cost Purchase price
• Look at costs in terms of unit costsUsh/Kg

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Tanzania ExampleHypothetical Breakeven Analysis
for Cotton
Costs (ginning, transportation, levies,etc) 150
Purchase Price 250
Breakeven Price 1kg / seed 400
X 3 (conversion to lint) 1200
- Profits from sale of cotton seed (140)
Breakeven Purchase Price 250 Tsh/ kg 1060
Conversion to /lb 0. 44 /lb
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Nextidentify what price the local breakeven
represents on the international market
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Hypothetical Comparison of Local and
International Market Prices
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Breakeven Analysis
Adding in Costs to determineequivalent
international Breakeven Price
Breakeven Costs 0. 44 /lb
/- Quality Differential .03
FOB Costs (Dar Port) .06
Breakeven Price on the International Market 0.53 /lb
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Tool 3 Mark to Market Analysis

• Compares breakeven level vs. current market level
  
• What is the current exposure quantified in
  terms?

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Mark to Market Analysis
Example if current market is lower than
breakeven
Breakeven Price on the International Market 0.53 / lb
Current Market Price 0.48 / lb
Difference (0.05 / lb) 30,000 mt
X Volume (0.05 / lb) 30,000 mt
Mark to Market Profit / Loss (3,306,930)
Conversion (0.05 / lb) x 2204.62 110.231 /
mt x 30,000 mt ( 3,306,930)
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Mark to Market Analysis
Example if current market is higher than
breakeven
Breakeven Price on the International Market 0.53 / lb
Current Market Price 0.56 / lb
Differential (0.03 / lb) 30,000 mt
X volume (0.03 / lb) 30,000 mt
Mark to Market Profit / Loss 1,198,154
Conversion 0.03 / lb x 2204.62 66.13 / mt
x 30,000 mt 1,198,154
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Risk Assessment - Summary

• 1) Position
• As of August, long 30,000 mt
• 2) Breakeven
• 0.44 / lb at local level
• 0.53 / lb at international level
• 3) Mark to Market
• If current market is .48 / lb, have a mark to
  market loss of ( 3.3 million)

All three should be monitored continuously
throughout the season
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Impact on Financial Institutions

• Problems lending to the ag sector include low
  collateral, infrastructure, knowledge, price
  volatility, no access to market (phones), weather
  risk, ag technology
• Banks have experienced adverse consequences of
  volatility and this affects willingness to supply
  competitively priced credit to the Agricultural
  sector
• Credit supplied is therefore often based on
  conservative collateralised schemes and very
  little innovation exists in terms of lending
  products
• High cost of finance erodes margins for all
• Objective improve risk management to assure
  continued engagement of banking sector in cotton
  and coffee financing

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Price Risk Management Solutions
Back to Back Trading
Exchange-traded and OTC Futures, Swaps, Options
Negotiating improved / more creative pricing
formulas for physical purchases sales
Fixed Price Specialty Market Sales (w very high
premiums)
Negotiating physical contracts with formulas that
include price protection
Lending linked to Price Hedge Instruments
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Lesson Learned

• In cotton
• magnitude of potential losses has increased
  urgency from banks perspective
• this season ginners sold forward without price
  protection - are now having problems procuring to
  meet those sales
• In coffee
• arabica market - concern about correlation
  between local and global prices hedging helped
  some groups offer a higher purchase price to
  farmers because they felt protected at that
  level
• rising coffee prices in 04/05 decreased
  interest in risk management but then prices fell
  at end of 06 and some groups made losses now
  want to use the tools
• Price risk tools if carefully applied may yield
• Reduced cost of borrowing from banks
• Increase access to credit as confidence of
  repayment increases
• Stability of earnings secure minimum operating
  margin
• Assurance of price to be offered farmers
• Capacity building for improved risk management
  also strengthens marketing / financial knowledge
  
• Capacity building on these issues takes time