Rising food prices: What hedging can and cannot do

The World Bank this past week announced the creation of The Agriculture Price Risk Management (APRM) tool, jointly offered by the IFC, the World Bank Group’s private sector arm, and J.P. Morgan. The IFC and J.P. Morgan will each commit approximately $200 million in guarantees and letters of credit to enhance the collateral required from farmers, food processors and consumers in developing countries, to enable these groups to trade derivatives that hedge the price of commodities such as corn, wheat, soybean, rice, sugar, cocoa, milk and live cattle.

[1]

This initiative comes as the G-20 agriculture ministers met for the first time with an agenda that included the threat posed by rising food prices. The U.N. Food and Agricultural Organization says global food prices surged to record levels in 2011, based on data going back to 1990. Higher food prices have contributed to global imbalances, triggered protectionist policies, and caused social unrest in several countries. The poor are disproportionally hurt because their meager budgets allocate a much larger fraction to food staples. The World Bank estimates that “since June last year, rising and volatile food prices have led to an estimated 44 million more people living in poverty – under $1.25 a day. There are close to one billion hungry people worldwide – or one in seven people on the globe.”

The hedging program is one of a number of actions proposed earlier by the World Bank President, Robert Zoellick. These include transparent information about stockpiles, R&D to increase crop resilience and yields, improvements in weather forecasting techniques, better logistics and transportation, effective relief efforts, international cooperation.

The idea behind the APRM is to combine the credibility of the World Bank with J.P. Morgan’s expertise in derivatives. Developing countries suffer from a lack of reliable information (company accounts and national statistics), and institutions that help enforce contracts, both crucial for capital markets to function.  The on-the-ground presence of the World Bank combined with its extensive and long-term local relations put it in a unique position to screen local players and induce compliance. Only the seal of approval and the credit from the World Bank grants companies access to capital markets.

Hedging cash flow volatility can facilitate investments by agricultural producers and food processing companies. But there is often far too much enchantment and many illusions about what hedging can accomplish.

Hedging can help with short-term price volatility, moderating fluctuations in cash flows and incomes. But hedging does not make prices permanently cheaper nor prevent them from rising if that is their long-term direction.

In fact, hedging by local producers and processers doesn’t necessarily protect local consumers from short-term price volatility. Profits and losses on a hedge go to smoothing investment, and are not necessarily passed along in product prices. Only if the consumers themselves hedge, or if government procurement institutions hedge on their behalf and guarantee the pass through, are consumers protected.

One might think that the gains from hedging a price increase would be passed through to consumers, keeping prices stable at a lower level. Unfortunately, this is not the case. The gains and losses to the importer are a sunk cost to its production and pricing decisions. Most people not trained in economics do not understand this and governments as well as consumers will certainly feel outraged with what they consider an unethical act on the part of the (perfectly rational) importer.

Another problem limiting the effectiveness of hedging is basis risk. Most established derivative markets trade on specific types of agricultural commodities delivered into developed country markets. The prices in developing countries, while correlated with these exchange traded commodity prices, do not match them exactly. Weather conditions in Ukraine and in Kansas are very different, and the price at which the Ukrainian farmer sells his crop in Ternopil is partly determined by regional supply and demand conditions, the power of local intermediaries, and the agricultural policies of the Ukrainian government, such as export bans and subsidies. These differences are clear in 2011: the spread between the price of the Ukrainian farmer’s crop and the price of the derivatives can move badly against the farmer.

Basis risk limits the effectiveness of hedging. Indeed, a failure to acknowledge the limited effectiveness can lead to over hedging which actually increases the risk producers and processors face.

Finally, hedging is no quick fix to the fundamental tragedy of poverty and the difficulty millions of people face in paying the high cost of food. Hedging can only smooth out the peaks and troughs of volatile food prices, delivering a more stable price, but not a lower one. And no amount of financial engineering can change the long-term direction of prices. At best, by smoothing cash flow, hedging gives local businesses breathing room to respond to changing prices. The real task is economic development, and hedging is just a minor tactic in that project.


[1] Source: Dow Jones Futures. The prices include the cost of rolling contracts as they mature. Agricultural products have historically been in contango, so rolling has cost that the hedger needs to incur.

2 Comments

  1. Posted August 23, 2011 at 3:10 pm | Permalink

    Brett,
    This is a general characteristic of financial hedging. The investment and operating decisions of the firm are separable from the financial transactions. No matter what purely financial hedge the company has in place, it can optimize its operating decisions to maximize its profits given the market prices it faces, and the same operating decision optimizes its profits independent of its financial hedge.

  2. Posted August 23, 2011 at 3:05 pm | Permalink

    John/Antonio – Thanks for the post. Very informative. I do have one quick question. You have indicated the following:

    “One might think that the gains from hedging a price increase would be passed through to consumers, keeping prices stable at a lower level. Unfortunately, this is not the case. The gains and losses to the importer are a sunk cost to its production and pricing decisions.”

    Could you possibly expand a little on this statement and detail how gains or losses on hedged inputs for example are in the end a sunken cost for producers? Thanks.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s