Farmers believe in the virtue of hard work and you ask only for a reasonable long-term return on your investments in land and capital. Speculators are those nasty commodity traders whose greed knows no bounds and who are to blame for those destructive boom-and-bust commodity markets. Gamblers are pitiful fools who deprive themselves — and their families — of their money and dignity.
The truth is that few of us qualify only as investors. The lines between hedging, speculating and gambling are easily crossed without even realizing it.
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The standard was set by Benjamin Graham, remembered as “the father of value investing” but famous as mentor to the legendary Warren Buffet. Threequarters of a century ago, Graham in his dry but plain English spelled out the difference: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Does a farmer who puts six figures into the ground each spring (much of it done on credit) and bets the weather will co-operate meet Graham’s definition of an investor? I’m afraid not.
At the same time that Graham was defining speculation, a comedian named Joe E. Lewis was capturing the gambler’s dilemma when, on the way to the racetrack, he cracked, “I sure hope I break even tonight. I really need the money.”
Given the dismal growing conditions in much of the country this year, that last quote might be a little too true for comfort for many Canadian farmers. But every year, many farmers slide down the slippery slope from prudent investment to speculation, and some unwittingly cross the line into gambling.
Farms have been lost that way. Great companies, too. Cook Industries was the third-largest grain company in the world when, in the 1970s, founder Ned Cook decided to short soybeans. He ended up losing $80 million and, eventually, his company.
We’re enduring what is arguably the greatest economic crisis since the Great Depression because CEOs made overleveraged bets, while their board of directors looked on, on things such as derivatives and subprime mortgages.
The danger exists for every commodity farmer operating outside of supply management or, to a much lesser extent, the Canadian Wheat Board’s price pooling system. But before you manage that risk, you need to understand it. What is the difference between hedging, speculating and gambling?
Let’s take canola growers John and Mary as an example.
This year they got their canola in and conditions didn’t look too bad despite the cool, late spring. Weather remained a gamble but they mitigated some of that risk with crop insurance. In late May, they saw November canola futures were at $445 per tonne and decided to lock in their entire anticipated canola harvest, 1,500 tonnes, at that price by selling November futures.
This is a true hedge. John and Mary have now greatly mitigated their price risk.
Just down the road, neighbours David and Wendy are in a similar situation but, convinced that markets will strengthen, opted not to hedge by selling November futures.
Come autumn, David and Wendy have a storage problem and decide to sell the 1,500 tonnes of canola they’ve harvested. They’ve spent a lot of time studying the oil-seeds markets and have decided prices will likely strengthen in coming months. So they price and deliver 1,500 tonnes and simultaneously buy 1,500 tonnes of May canola futures so they are still in the market.
David and Wendy are betting canola prices will rise. They are speculators.
Now, let’s assume markets crash and David and Wendy lose confidence in their analysis. What to do? Their paper losses are significant, perhaps more than they can afford. David and Wendy decide to buy more canola futures because “surely the price just has to go up.” Now, they are gamblers. They may win or they may lose, but they are gamblers. Is this where they wanted to be?
If you buy me a beer and ask me why markets are likely to go up, I’ll give you half a dozen good reasons. Ask me to explain why markets are poised to go down, and I can do that, too. Ask for the truth and I’ll tell you the market is more or less random, especially in the short term.
Ned Cook forgot that. He was as well connected and as knowledgeable about grain futures as anybody could be. No doubt his intelligence, experience and insider knowledge gave him the confidence to make the bet that ruined his company.
So, what to do?
First, make sure that your marketing strategy is not driven by lack of storage.
Second, make sure it’s not driven by cash flow needs. Those are two big reasons why so many farmers find themselves tempted, like David and Wendy, to roll the dice on a wager they can ill afford to lose.
Third, do your homework and know your break-evens. Take profits when the opportunity arises. Spreading sales throughout the year will also take out the lows — which is a better strategy than trying to time the highs.
Finally, if you’re using futures and options markets to hedge your crop, always ask yourself the difficult question: “In taking or holding this market position, am I doing it as an investor, a speculator, or a gambler?” CG
Currently head of the department of agribusiness and agricultural economics at the University of Manitoba’s faculty of agricultural and food sciences, Brian Oleson has had a ringside seat for major developments in the grain business over the past four decades as a policy analyst for Agriculture Canada and as both sales rep and senior executive with the Canadian Wheat Board.
