Many times when having conversations with people who are not in the commodity industry, they obviously ask what you are making exactly. I try then to explain that we are making software for specific industries such as cocoa, coffee, sugar, grains etc. That it is very specific because our clients run next to their ‘normal’ administration also a derivatives administration. Most of the times people ask a second question, why do commodity traders hedge?
That is a real proper question, why are they doing that? I then try to explain that these people must protect themselves against market price fluctuations. Before I notice I have lost them as I get into too much details about futures, options, OTC’s, position management. Obviously they try to escape from the conversation as the stuff gets over complicated and the result is that I was still not able to answer why they run also a derivatives administration.
The question itself remains very valid, many times I take for granted that everybody wants to ‘hedge themselves against market price fluctuations. As a company should focus on its added value, instead of speculating (gambling) on a price move. However in my experience taking that for granted appears to be not so obvious.
Instruments to protect yourself against the risk
Being a commodity trader, seller or buyer there are instruments to protect yourself against this risk, but there is a limited amount of commodities which have these instruments. Is a cocoa trader luckier than a quinoa or saffron trader? As there instruments for cocoa but not for Quinoa or Saffron? Why are there actually no instruments for these commodities and for many others, like Wool, Cement, Tea Nuts, Bananas, Chemicals etc. The list is endless. The reason is very technical as such commodities require standardization in a contract and it requires a liquid market. The latter means that it is necessary having people who buy and sell enough to be sure it gets bought or sold.
A liquid market can simply be explained by putting your self made painting on eBay. Someone might like it and buy it, but it can be easily the case that it never sells. Self made paintings is an example of a non-liquid market. Standardization is also easy to explain: When I ask you what coffee you want, you might say with milk or with sugar. You don’t really question the coffee itself, or you must be so picky to demand real arabica beans. With tea it is a different story. I would probably ask you what kind of tea, earl grey, breakfast tea, green tea and so, where most of them are again underlying blends of multiple types.
Commodities which can be standardized
For this reason we find usually commodities on an exchange which can be standardized. For coffee there are two main types: Robusta and Arabica, well, that you can standardize. In the past there have been initiatives to create these contracts. I have seen a Salmon future or plastic ones but many times liquidity was a problem. When we look in history there have been many more. A potato futures market in Amsterdam was still active until the 90’s. I had to think about yesterday as I saw farmers handing out potatoes to the public as they have become worthless and many articles pop up about complaining farmers. Regional article or people are even waiting in queues to get them for free Regional article. Reuters already wrote an article about it early April this year. Would these farmers have protected themselves when instruments would have been available? In this case because of Corona, the potato price dropped, what would have happened when the price would have been sky high, I guess they would have taken the profit and nobody would have heard of it.
The essence here is that these farmers are gambling on the price, admitted that they actually have no other option. However you could say, why go into all this trouble and investing of growing them? Sell the tractors and land and use the money for some speculation on the exchange as you are gambling anyway. You save yourself the trouble and hard work.
The futures market
The futures market has been founded to avoid these situations. The same problem which exists today for potatoes also existed for grains, metals, sugar etc. in the past. In that sense nothing is new. Some exchanges are more than 200 years old. In its simplest form, the forward future contract protects you against a higher price in the future when you are a buyer and lower price in the future when you are a seller. In the years exchanges exist people invented many additional derivatives which can make it difficult to comprehend what is there, and probably even more difficult to administrate, but the basics can be understood quickly. Talking about administration, it also explains why a CTRM (Commodity Trade & Risk Management) system is much more than an ERP (Enterprise Resource Planning) system. The CTRM system for commodity traders is specialized to deal with these futures, options and match them against physicals to check if you are really hedged, often referred to as position management.
Protecting your selling or buying price is probably the difference between failure and success. Admitted it requires extra work and knowledge but it is definitely worthwhile. It will at least avoid to hand out your crop for free to the public. When you like to learn more, there is sufficient education material available from the exchanges, or browse the knowledge section at the Agiboo site.
I guess it answered the question why they are hedging but I still didn’t figure out why people would not hedge when the instruments are available. They must have their reasons.