Saturday, May 19, 2012
As we enter the new "un-CWB" market, we will be looking at marketing grain in a familiar way – but there could be substantial differences to what we know. The recently announced CWB pools look to be similar to their previous offerings - and there may be more pools offered. But I'm talking not talking about pooling; I’m talking about the open market. And marketing wheat in the open market could be quite different than what we are used to.
We already have experience in marketing canola with futures and basis – and a wee bit with other crops like barley and domestic feed wheat (and, if you've been around as long as me, flax and rye too). But with wheat and durum, in western Canada we could be faced with a difference that we will be well-advised to think carefully about.
There are many aspects about this market that will be new - real protein spreads (not muted by pooling); grade and protein discounts or premiums that can't be locked-in with a forward contract, and new delivery opportunities, unfettered by Contract Calls. Also, we will see real market pricing in the form of futures and basis.
One of the biggest challenges could be using Minneapolis wheat futures – a US dollar futures contract – to hedge and manage price risk on wheat priced in Canadian dollars.
First, using any US dollar based futures contract, there is price risk in Canada simply due to the fact that the Canadian dollar is not at par with the US (most of the time). And second, there is basis risk that comes from a change in the exchange rate. Neither of these will be familiar to most people in Western Canada.
Let's look at the first one. If Minneapolis wheat futures are at 7.90 and the fob basis on the west coast is 80 over, then the flat price on the west coast is $8.70 US fob. Assuming an exchange rate of 0.90, and assuming US and Canadian west coast values are the same, this translates to a Canadian west coast value of $9.67 Cdn. If futures drop to 6.90 US but the US fob basis remains at 80 over, the US flat price is now $7.70 US, and assuming no change to the exchange rate, the Canadian flat price changes to 8.55 Cdn. Futures dropped $1.00 but the Canadian price dropped $1.12/bu.
The lesson here is that a conventional 1:1 (or pound for pound) hedge will not provide the coverage you might expect. Even though the exchange rate didn’t change, you have a foreign exchange based price change; it’s what is called “non-volatile foreign exchange risk”. The answer is to include a foreign exchange position to your hedge – and here’s where the complication just begins.
The second oddity is the impact of foreign exchange on a basis contract – just one aspect of what is called “volatile foreign exchange risk”. In Eastern Canada, the foreign exchange rate (and risk) is imbedded in the basis. For example, if CBOT corn futures are at $5.00 US and the local cash basis is 1.25 over, the corn cash price (futures plus basis) in Ontario is $6.25 Cdn.
Note I didn't say whether the basis was in US dollars or Canadian. That's because it's neither. If it was in USD, then the resulting cash price would be $6.25 US. If the basis is in Canadian dollars, then you'd be adding a US dollar amount to a Canadian dollar amount and you can’t really do that and still make sense.
Imbedding the currency rate in the basis makes it really easy to talk about cash grain prices in Canadian dollars – it’s as if they assume the futures are in Canadian dollars – but it adds a risk component to the basis unfamiliar to most people in Western Canada and complicating risk management processes.
For example, let's say Dec Minneapolis wheat futures are at $7.90 US , the Cdn/US exchange rate is 0.92US (one Canadian dollar = 92 cents US) and the cash market in Western Canada for fall delivery works out to $7.00 Cdn. Using the Eastern Canadian approach, this would mean the cash basis is 90 under. (7.00 - 7.90 = -90)
Now, what happens when the exchange rate goes to 0.98 but the Minneapolis futures remains at $7.90 and the world value of wheat doesn't change either? The change in the exchange rate alone would mean that cash wheat in Western Canada would change from $7.00 to $6.57 (Canadian dollar strength means commodity prices weaken in Canadian dollar terms – something we’re all used to). But what we’re not used to is that this would translate to a change in the basis – in this case, to 133 under, down from 90 under.
In this example, even though the underlying fundamentals of the wheat market didn't change at all, the basis dropped 43 cents per bushel. To most of us, that’s counter-intuitive. Think about the same situation with canola; when the Canadian dollar strengthens (pushing the flat price of canola lower), the canola basis remains unchanged. In other words, the exchange rate has no impact on the canola basis. Clearly it has an impact on the flat price - just not the basis.
So there's the difference. A weak Canadian dollar will impact Canadian cash prices, but if we use a US futures contract, the impact on the cash price would be found in the basis.
All this would make life somewhat more complicated for both the farmer and the grain merchandiser. For a farmer it will be more difficult to effectively manage the price risk of wheat using a US-based futures contract and get the result he wants. Same goes for a merchandiser who will necessarily need to add a risk component to his pricing. Both will need to understand the foreign exchange implications to their marketing strategies, and just as importantly, they will need both the facilities and knowledge of how to manage that risk.
I have heard people questioning why the new ICE futures contracts are not listed and trading in US dollars. The value of Western Canadian wheat is determined globally and so some think the futures contract should reflect that. However, as described above, that would just complicate life (and increase costs) in Western Canada. Even though the value of the majority of Western Canadian canola and its products are determined globally, the ICE canola contract is in Canadian dollars and works extremely well for Western Canadian interests as well as for foreign buyers. The same could not be said if it was traded in US dollars.
Trading spring wheat futures for Western Canada in Canadian dollars just makes common sense. It reduces risks and avoids unfamiliar risks as outlined above. There are many reasons why the new ICE contracts should be supported. The potential impact of foreign exchange on our competitiveness is just one of them.
Posted by John De Pape at 6:52 PM