Market-Based Solutions for Commodity Price Risk Management

ALL ACP AGRICULTURAL COMMODITIES PROGRAMME European Commission ACP Group of States Market-Based Solutions for Commodity Price Risk Management + - Craig Baker Commodity Risk Management Group, World Bank

Agenda • What Creates Price Risk? • Impacts of Price Risk; • Can Risk Management Tools Help? • Overview of Risk Management Tools; • Application of Risk Management Tools; • Risk Assessment; • Lessons Learned; • Not Covered (due to time) – Actual examples of successful implementations + -

What Creates Price Risk? • Fixing prices for eitherpurchases or sales; • Volume: • The more volume purchased and sold without managing risk, the larger the exposure • Time: • When buying or fixing a price before selling OR selling or fixing a sales price before buying; ….. more time between purchases & sales = more risk

Impacts of Price Risk • Example: producer prices fixed at the beginning of the season; • If prices risebetween purchase and sale, farmers groups / ginners are profitable and: • Profits are returned to farmer in the form of 2nd payment; • Balance sheets remain in tact, loans are repaid and finance is available for the following season • If prices fall between purchase and sale, farmer groups/ ginners: • May avoid making sales in order to avoid losses; • May be forced to lower the purchase price to farmers; • May default on sales because can not procure enough product; • May make sales and book losses; • May not have cash to continue paying farmers; • May go out of business

Some Examples… African Food Aid $800m in 2006 Burkina Faso -2005/6 - $110m in Cotton Debt African Food Aid $900m in 2007 Senegal – 2006 - $20m Cotton Debt What or who is Next? El Salvador – 2001/2 - $250m Coffee Debt

Impact on Financial Institutions • Existing challenges in agri-lending include: low collateral, infrastructure, knowledge, price volatility, market access (phones), weather (climate) risk, agri technology; • Banks have experienced adverse consequences of volatility and this affects willingness to supply competitively priced credit to the agricultural sector; • Credit supplied is therefore often based on conservative collateralised schemes and very little innovation exists in terms of lending products; • High cost of finance erodes margins for all; • Objective: improve risk management to assure continued engagement of banking sector in agricultural financing

Can Risk Management Tools Help? toreplace costly, inefficient, disruptive ex post responses with cheaper, more efficient, targeted ex ante responses that stimulate private sector agricultural lending

“Derivatives are financial weapons of mass destruction” Warren Buffet It is not the plain vanilla contracts that Buffet was referring to when making these statements but rather the overall lack of understanding of exposures arising from exotic contracts that are impossible to price and bring about long terms obligations. We need to demystify risk management and separate it from speculation! Overview of Price Risk Management (Hedging) Tools…

Two main products: Futures Contract; Option Contract: A financial agreement between two parties that gives the buyer the right but not the obligation to buy or sell a futures contract within a specific period of time at a specific price level; Has an upfront cost – Akin to insurance; Standardised contracts that specify: Price; Quantity; Delivery date; Settlement Date Overview of Price Risk Management (Hedging) Tools…

Option Contracts…..

Application of Risk Management Tools…. Governments • Risk- managing food supplies / reserves; reducing the need for and cost of policy interventions • Assist Governments with the: • Need to build confidence in commercial solutions; • Need improved planning Producers • Risk – managing sale prices to cover cost of inputs • Assists Producers with the:: • Need to understand how the global market moves & affects local prices; • Need for confidence that producer price is competitive in the market; • BUT generally very difficult to access risk management markets directly so best approach is to access price risk mgmt solutions through market intermediaries

Application of Risk Management Tools… Market Intermediaries (Cooperatives / Buyers / Traders / Processors) • Risk – managing price volatility in between time of purchase & sale; avoiding trading losses caused by intra-seasonal price volatility; maintaining own credit-worthiness and ability to pay back loans; managing farmer credit risk when extending loans for inputs & production • Assists Market Intermediaries with the: • Need to understand & be able to quantify risk throughout the season; • Need to offer competitive prices to farmers and be confident of ability to pay that price; • Need to improve management of intra-seasonal price and credit exposures; • Need to understand global markets & improve negotiating power Banks / Financiers • Risk - managing credit risk for financing farmers & market intermediaries • Assists Banks / Financiers with the: • Need to improve risk assessment capabilities & monitoring throughout the season; • Need to offer risk management solutions to borrowers; • Need to balance extending / increasing credit without increasing risks; • Can play a critical role in helping a country gain access to financial markets

Risk Assessment is the First Step! “Risk comes from not knowing what you're doing” Warren Buffet • Every participant in a commodity chain has risk that is determined by its business practices: • Price Fixing; • Purchases and Sales Patterns; • Volumes of Purchases and Sales; • Types of Contracts; • Levels of Credit • Risk Assessment = understanding how purchase & sales patterns influence risk; • Banks / Financiers should be using these tools and assist Market Intermediaries with the adoption of these practices!

Three Risk Assessment Tools Position Analysis: • What is your (client’s) position relative to the market? • In which direction is your (client’s) exposure? • If you: • BUY before you SELL (long position); or • SELL before you BUY (short position) ...you (your clients) are at risk and have taken a position • LONG positions = risk of prices moving down; • SHORT positions = risk of prices moving up

Three Risk Assessment Tools Breakeven Analysis: • Breaking even = covering costs; • Costs change over time depending on changes in: • Fixed costs – Transport, Ginning, Milling, Roasting; • Variable costs – Purchase price • Asses costs in terms of unit costs…Ush/Kg; • What is the price level at which you (your clients) are breaking even? Mark to Market Analysis: • Compares breakeven level vs. current market level; • What is the current exposure quantified in $ terms?

“We should be managing risks instead of managing crises” The Alternative Approach.... Dr. Abera Deressa

Lesson Learned Price risk tools if carefully applied may yield: • Reduced cost of borrowing from banks; • Increase access to creditas confidence of repayment increases; • Stability of earnings & secure minimum operating margin; • Assurance of price to be offered farmers; • Capacity building for improved risk management also strengthens marketing / financial knowledge; • Ensure that it is not just another cost in the value chain... • Capacity building on these issues takes time…

Market-Based Solutions for Commodity Price Risk Management