Saturday, August 21, 2010

U.S. Farmers Wary of Gaining From Russia's Woes

New York Times article "U.S. Farmers Wary of Gaining From Russia's Woes" (August 19th, 2010) offers a series of quotes from U.S. farmers that simply do not make sense when taken at face value. Specifically, wheat prices have gone up because Russia, a large producer of wheat, appears to have banned exports in the coming year. The New York Times quotes confused farmers that appear to suggest that they don't want to plant wheat, due to uncertainty about Russia's next moves:

Mr. Schroder said he feared that wheat prices were being driven by speculators, as was the case a few years ago, just before the recession, when the price soared and then crashed.

“What is this wheat market? I don’t have a clue, and I’m a professional wheat farmer,” he said. “There’s a complete lack of transparency.”

The problem the Times is pointing out is that farmers only know the current price, while their planting decisions should be based on prices in the future. They are subject to a large variability of even autoregressive prices. Corrections depicts such a movement graphically below, along with 95% error bands (click to enlarge).

A naive Times writer might instinctually think this represented a market failure. This is incorrect. Indeed, commodities futures markets, perennially despised by market-opposing individuals, are the market solution. However, the good news for farmers is that they do not have to bear any of the turbulence or non-transparency in the market at all. All they have to do to look at futures prices to plan their planting patterns. Why might this be?

Historical knowledge that appears to have been lost, even by some ideologically-motivated economists, is the very reason commodities markets, and commodities futures markets, were created. The Chicago Board of Trade (CBOT), to Correction's knowledge the oldest still-operating futures market, was created in 1848 to help farmers cope with fluctuating wheat prices.

The problem was as follows: farmers are often poor and unwilling to bear the risk of producing wheat and holding it until it is to be sold at some unknown price. What the Chicago Board of Trade did, and still does, is homogenize a good--in this case, sort wheat into bundles of the same quality, and allow a futures contract between speculators/investors, who are willing to bear the risk farmers don't want, and farmers, who are able to lock in the current price for their wheat. In this manner, all a farmer has to do is sell a futures contract in order to take all market-based uncertainty out of his decision to plant wheat--in selling the contract, he has, in effect, paid someone to bear the his risk. This allows him to plant the most valuable crop, even if its future prices are highly variable.

Therefore, farmers now only need to look at current futures prices--they should not care about the current price or what they think might happen to the price, only what the current futures price is. If we examine CBOT's wheat futures prices for July 2011, we see that the current futures price of corn is elevated (click to enlarge).

Farmers can lock in this price now. No risk necessary. It is important to note that a very large proportion of farmers do this every year, creating the massive derivative markets we have today. The only "risk" that a farmer would take is that he might miss out on higher prices now. Indeed, this is precisely the example the Times gives:

Another brake on any irrational exuberance over wheat will be farmers’ own suspicions, despite the incentives of higher prices.

Some think they are being played, and that the big run-up is partly, or largely, just market manipulation — like the increase in 2007 and 2008 that drove wheat prices more than twice as high as they are now before a gut-wrenching crash during the global recession.

'I hate to sound negative, but I’ve been burned so many dang times on wheat that I think I’m done,' said Olea McCall, who farms about 4,000 acres near the Kansas border, mostly in corn, wheat and sorghum. Mr. McCall said his attitude was not helped by missing out on the new rise in prices.

'I sold at 4, and three weeks later went to 6,' he said, referring to the price in dollars per bushel.

The Times continues:
“It took 20 years to sort the market out after [the similar 1972-73 Soviet Union crop failure],” Mr. Stulp said of the 1972-73 price bubble.

As much as the Times might write about "irrational" "bubbles" harming farmers, it supports the ridiculousness of the concept with its own quotes. Farmers need not fear any bubbles--they need only to lock in their high prices with futures contract and allow speculators to bear any "bubble" that might be present.

1 comment:

  1. Great analysis. If farmers really think that the current high futures prices are irrationally elevated they can lock in their profit now shorting the futures market now in proportion to their anticipated crop yield. That way if prices drop they profit from their short while if they rise their crops will be sold at those higher prices to compensate on the loss from the short and they will have locked in this price.