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The Road To Volatility

Normally, a two-hour wait in a lineup of trucks at the elevator would have had me fidgeting. This winter it was was different. It was back in January, and I was going to be driving away with over $13 per bushel for the canola I was dumping.

The grower right behind me wasn’t as happy. You see, he had pre-priced his canola back in the spring of 2010. At the time, he was told it was the smart thing to do. But on the same day I was getting $13, he was getting paid only $8.50.

The message from market watchers can be summed up in four words — get used to it. “There is twice as much volatility in grain prices as there was in 1980,” says William Wilson, market analyst at North Dakota State University. “And the volatility will likely increase.”

Lots of factors get blamed for that volatility, including speculators and government policies. The reality, says Wilson, is more basic than that.

The drivers of today’s volatility are tight stocks-to-use ratios. When stocks are so tight, prices move quickly and dramatically because of production or weather problems. As examples, Wilson points to the drought in Russia, and flooding in Australia which curtailed production.

That doesn’t mean that the hedge funds haven’t changed the market. But they’ve done that by adding new demand, which makes prices swing even more abruptly.

The upshot, Wilson says, is that producers must target price risk, and they need to use strategies like hedging and forward contracts to mitigate volatility.

Then I contacted Randy Schnepf, an agricultural policy specialist in Washington, D.C. Schnepf is the author of Price Determination in Agricultural Markets: A Primer, a backgrounder that is distributed to members of the U.S. Congress to help them understand how any legislation they propose might impact commodity prices.

It was clear Schnepf had had calls from other journalists, and he almost went onto autopilot as he outlined the familiar list of factors we’re heard all year. But Schnepf also points out agricultural prices tend to be more volatile than other commodities because of inherent differences between grains and non-agricultural commodities.

Such differences include the seasonality of production, weather, the inelasticity of demand, and the fact that the demand isn’t actually for the grain or oilseed, it’s for the things that get made from them.

As well, the global trade of grains introduces currency volatility and price risks due to agricultural policies that restrict trade, control prices, or subsidize exports.

I hung up thinking that Schnepf’s report should be required reading for all growers, even Canadians. It is a very good description of factors which affect price and volatility even though it was written for an audience that has very little understanding of agricultural production and marketing. But most importantly, the people reading and using Schnepf’s paper are the people who are potentially having the greatest human impact on commodity prices; namely the U.S. Congress.

Schnepf’s paper can be found at http://www.nationalaglawcenter.org/assets/crs/RL33204.pdf.

Next I go to Farms.com where I hear similar analysis from Moe Agostino, risk management consultant. His short educational video entitled Lesson 3: Factors That Cause Volatility in Commodity Markets can be accessed online at www.marketschool.farms.com.

Agostino lists 11 reasons for volatility, including seasonality, weather, speculation, market cycles, international competition, population growth, supply and demand, new demand, government policy, fluctuating dollar value, and the effect of price movement in other commodities.

Agostino says that volatility in the grain markets has increased from 20 per cent in 2008 to 50 per cent today and this means growers could see a 50 per cent jump or fall in prices within one week.

Agostino uses corn as an example. In today’s volatile environment, corn that’s trading at $6 a bushel on Monday would be trading at $9 a bushel by Friday. Or it could plummet to $3.

“I don’t think it (volatility) is going to change, it is only going to get worse!” Agostino says. “You got to keep an eye on all these factors (that impact prices) to see if there are any changes there. We can manage risk and volatility but we can’t predict the future.”

Then I check in with James Hilker, economist at Michigan State University. He also feels growers need to manage the risk of price volatility. “We really don’t know what prices are going to do,” Hilker tells me. “Volatility is 50 per cent higher than it was in 2006 and is now as high as it has ever been.”

While Hilker agrees with Schnepf and Agostino on the factors that contribute to price movement, he feels the real reason that prices are so volatile now is that the stocks-to-use ratios have moved out of the data range which has traditionally been used to determine price.

“Even the market does not know what the commodities prices should be now,” Hilker tells me.

With the just-in-time delivery systems we have now, coupled with very tight stocks and new demand for commodities, there is no room for error, Hilker says.

Since growers cannot set prices, Hilker says, “Growers need to know what the odds are of prices going higher and how much risk you are willing to take of prices falling. A grower has to match their financial situation with the risk of price movement.”

So Hilker, along with three other agricultural economists has developed “probabilistic price forecasting.” This system estimates the likelihood that the cash price predicted by the futures market will actually materialize. In other words, it measures how much risk growers are exposed to in seeking that price.

This information is presented in chart form on a weekly basis for U.S. corn, wheat, soybeans, soybean meal, live cattle and feeder cattle, lean hogs, and milk. Hilker uses the futures prices as well as options to develop these charts.

Growers can go online, and determine what the probability of the real cash price will be in a given futures month. For example, the February 16, 2011 chart for July 2011 wheat revealed there is a 10 per cent chance that the July cash price of wheat would be $6.53 or less. There is a 50 per cent chance the price would be $8.75 or less. And there is only a 10 per cent chance the cash price of wheat would be above $11.74. See the chart on page 36.

By having a real measurement of price volatility, growers are better able to protect themselves. They can evaluate the risk of price movement on unpriced commodities in their bins and decide if they need to minimize the risk by using hedges or options.

Be aware though that the actual risk for Canadian farmers will differ somewhat due to the difference in marketing systems.

Also, Hilker’s system doesn’t take into account movements in the Canadian/U. S. dollar, but since the U.S. commodity markets drive grain prices, these charts will provide valuable information for Canadians as well.CG

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Gerald Pilger

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