Expect the unexpected A tale of losses in hedging in agro-commodities

Can you think of a way by which a farmer can sell his produce above his cost of production, does hedging at the highest prices in years and books huge loss? Let us explore what happened in the year 2008 in the U.S. Wheat market and CBoT still reeling under that, trying desperately to fix that.. Circa year 2007, investors all over the world realize that there is an asset class other than forex, bonds and equities, which is dormant and has potential of big returns. So what do they do? They just jump in the bandwagon and start buying everything. They are also told that there are nearly 2.5 billion hungry people in Chindia, who are getting wealthier and so hungrier for commodities. All the more reasons to buy them but then the problem arose; how to store them, how to dematerialize them? Big question, with a simple solution; buy derivatives, buy futures used for hedging by farmers, become counterparties to the producers. We are now in 2008, where more and more investors put their money in funds, which were tracking commodity indices and their profits were surging. Commodity index funds were selling like hot cakes and were attracting money from all the quarters. So where is the problem? Farmers got easy counterparties, who are ready to buy at any price and not willing to sell and their number was just increasing. Overall impact, rise in the prices of their produce!!! Farmers got incentive to increase production meaning higher production, big profits and in the end more money. Everyone was happy with the situation but then suddenly the buyers in the cash market realized that they have lot of agriculture produce and the actual demand is not so high, so why to pay high prices and the markets got laden with those commodities. Cash prices begin to fall while commodity index funds were still buying the derivatives.

Here we start the story of classic short squeeze in US wheat market in 2008.
Simple calculations for illustration: October, 2007: o Farmer plants wheat crop in his 2000 acre farm, puts fertilizers, pesticides etc. o Cost of production for farmer: $4 per bushel (invests $320,000) (yield= 40 bushels per acre)

Disclaimer: We believe that information provided here is correct to the best of our knowledge but we do not guarantee its accuracy. Opinions
expressed herein are personal to the analysts & do not solicit any offer to buy or sell any security. All rights for these reports are reserved by Futures First and no part of this publication may be reproduced or distributed in any form or by any means or stored in any database without the written permission of Futures First.

January, 2008: o Price on CBoT exchange for July08 contract (harvest month): $8 per bushel o Profit to be locked in: $4 per bushel (100 %!!) o Farmer gets short at the exchange paying the initial margin. ($16000) ($1000 per contract of 5000 bushels) February, 2008: o More funds come for buying and prices shoot up to $10 per bushel o Farmer gets calls from clearing house to pay mark to market margin ($2 per bushel; thereby $160,000) o Big money, from where he will get it? Takes more debt and pays to the clearing house. March, 2008: o Some more investors put their money into commodity index funds and they buy some more commodities, wheat prices go to $13 per bushel. o Farmer ideally should be very happy. Market price=$13, cost of production=$4, net profit=$9. Total profit on a 2000 acre farm=$720,000 on an investment of $320,000. A whopping 125% in just six months! o What actually happens; he receives calls for more margin money, unable to provide that, clearing house has to cut his short positions at $13. o Losses paid= $400,000! o And market gets fresh entries from long side, all the more reasons to go up! July, 2008: o Crop is harvested and is ready to be sold in cash market. o Prices in the cash market=$7.50. Farmers profit=$280,000; losses from hedging=$400,000; net profit= -$120,000. Wheat prices rose to record highs (never seen before prices), farmer does hedging at never seen before prices (locking in 100% profit!) and ends up losing big amount. Thats a small story of how brutal can be the market forces. Circa today; cash markets are still running lower than those fancy derivatives. CFTC and CME Group are doing all that they can do to fulfill the purpose of these markets, provide efficient hedging tool which effectively means cash and futures should converge at expiry. Markets can remain irrational longer than you can remain solvent.
As quoted in When Genius Failed (2000) by Roger Lowenstein, p. 123; actually "Markets can remain irrational a lot longer than you and I can remain solvent." from A. Gary Shilling, Forbes (1993) v. 151, issue. 4, pg. 236.

Disclaimer: We believe that information provided here is correct to the best of our knowledge but we do not guarantee its accuracy. Opinions
expressed herein are personal to the analysts & do not solicit any offer to buy or sell any security. All rights for these reports are reserved by Futures First and no part of this publication may be reproduced or distributed in any form or by any means or stored in any database without the written permission of Futures First.

Wheat Prices at CBoT

Source: Bloomberg

The famous 500 year chart of Wheat prices (displayed at CBoT)

Source: CBoT

Disclaimer: We believe that information provided here is correct to the best of our knowledge but we do not guarantee its accuracy. Opinions
expressed herein are personal to the analysts & do not solicit any offer to buy or sell any security. All rights for these reports are reserved by Futures First and no part of this publication may be reproduced or distributed in any form or by any means or stored in any database without the written permission of Futures First.