Introduction
According to the U.S. Department of Labor's Bureau of Labor Statistics, the cost of food, as that term is used in the Consumer Price Index (CPI), increased 5.1 percent for the year that ended May 31, 2008. Unfortunately, commodity price increases since then—driven by changes in demand, poor weather conditions, and possibly excessive speculation in agricultural futures markets—suggest that this increase could be just the beginning of higher food prices for consumers.
The economic factors that contribute to higher commodity prices have been discussed widely in both government and the media, but those factors are not the subject of this paper. Rather, this paper considers the impact of higher commodity prices on certain segments of the agricultural sector and the legal issues that flow from such market conditions. The impact of current market conditions, and the resulting legal consequences, may mean higher food prices for some time to come. Indeed, the effects may be serious and far-reaching enough to raise the possibility of a new farm crisis.
Commodity Price Increases
Just as the U.S. Labor Department closely follows consumer prices, the Department of Agriculture, through its National Agricultural Statistics Service (NASS), tracks agricultural prices, including the cost of grains, oilseeds, fruits, livestock, milk and poultry. NASS's June 27, 2008, agricultural price report documented a number of dramatic short- and medium-term price increases:
- The cost of farm products rose 7.3 percent from just a
month earlier. Compared to June 2007, preliminary figures
showed an 18 percent increase in that All Farm Products
Index.
- The Crop Index, which includes wheat, corn and soybeans,
among other crops, rose 11 percent in a single month. From
June 2007 to June 2008, this index rose 35 percent.
Impact on Farmers
Given current record-breaking commodity prices, American consumers might reasonably assume that the nation's farmers are prospering. In fact, many are. Others—both crop farmers and livestock producers—are facing potential financial collapse.
To understand why many crop-producing farmers are under financial strain, it is necessary to have a basic understanding of how many of them market their crops. Like most businesspeople, farmers plan ahead. Thus, in the summer of 2007, when grain farmers saw futures prices for the 2007 crop, including the July 2008 futures contracts for corn and soybeans, trading at what were then considered to be high prices ($4.00 per bushel for corn and $9.00 per bushel for soybeans), many farmers chose to "forward contract" their 2007 crop to grain buyers—to sell the 2007 crop before it was harvested, for a fixed price, and for delivery at a specified time in the future.
Under a standard forward contract, a grain farmer agrees to deliver a certain number of bushels months, or even years, later. In return, the farmer is guaranteed a price tied to the applicable futures reference price, minus the basis (the difference between the futures price and the local cash price). Assume, for example, that in September 2007, Mr. Maize, a grain farmer, observed July 2008 corn futures trading at $4.00 per bushel. He called his local grain elevator (Buyer), and with a basis of $0.25 (to account for the local market variation), contracted to sell 50,000 bushels at $3.75 per bushel for delivery by the end of July 2008. When the time for delivery arrived, though, Mr. Maize had to deliver a crop worth more than $7.00 per bushel and accept payment of $3.75 per bushel. At minimum, that represents a lost profit opportunity of $3.25 per bushel.
For some farmers, however, more than simply a missed profit opportunity is at stake. Between September 2007 and June 2008, many costs increased considerably, including rent (which has risen on pace with record land prices), diesel fuel and fertilizer. For the most part, those higher post-September 2007 costs were not input costs for the 2007 crop so Mr. Maize may therefore enjoy a profit on the 2007 crop, even at the $3.75 per bushel price.
Vary the hypothetical, however, and the outcome changes dramatically.
Assume that in September 2007, instead of selling 50,000 bushels for July 2008 delivery, Mr. Maize sold 50,000 bushels of his 2008 crop for November 2008 delivery, also at the same $3.75 per bushel. But in 2008, Mr. Maize has had to pay higher rent to several of his landlords. He may even have actually lost some of his production acres because he could not afford to pay the higher rent. Meanwhile, the spring of 2008 was very wet, and of his remaining available acres, Mr. Maize only got about 90 percent planted to corn before it was too late. He lost another 10 percent of his corn crop to flooding and was unable to replant. Mr. Maize also experienced considerably higher fertilizer costs in 2008 (three times higher than just a few years before) and dramatically higher fuel costs as well. Finally, because of its late planting, and the wet conditions through June, the corn did not dry in the field and Mr. Maize had to incur considerable costs for propane to dry it prior to shipment (or pay a considerable fee to Buyer for drying).
In November 2008, Mr. Maize delivers his entire crop—just 40,000 bushels—to Buyer. Buyer then invoices Mr. Maize $3.00 per bushel on the undelivered 10,000 bushels—$30,000. When fully accounted for, Mr. Maize has lost a considerable sum on the crop he produced and remains indebted to the Buyer.
Livestock producers, who are but one step removed from this process, are experiencing similar tectonic shifts due to higher feed costs. Put simply, the prices paid for livestock have not kept pace with crop price increases and the resulting higher feed prices. As a result, many livestock producers are paying more to feed and house the livestock than the animals are worth when ready for harvest.
Impact on Buyers of Grain
Buyers of grain include grain dealers, feed companies and processors. They too may be negatively impacted by higher grain prices. Grain buyers do not typically profit by speculating as to the price of grain. Rather, grain dealers profit by gathering quantities of grain, storing it and trading it for marginally higher prices. Grain processors, such as feed companies, ethanol companies and food processors, profit by converting the raw commodity into a more valuable product, which they then sell to further users. To understand how buyers avoid price speculation while entering into forward contracts for the purchase of grain, it is necessary to understand how they use futures markets to hedge their price risk.
Let's look again at Mr. Maize. In September 2007, he agreed to sell 50,000 bushels of corn, via a forward contract, to Buyer—typically, his local grain elevator—for $3.75 per bushel, with delivery by July 2008. But grain dealers don't make money by speculating; they don't want to risk losses due to large fluctuations in market prices. To hedge against risk, on the date he agreed to buy Maize's corn, Buyer also sold ten corn futures contracts (which are standardized at 5,000 bushels) at the $4.00 per bushel futures reference price in the Maize contract. When July 2008 arrived, the cash market was $7.00 per bushel and the July futures contract was trading at $7.15. Thus, Buyer made a profit of $3.25 per bushel on the contract with Mr. Maize (bought for $3.75 but worth $7.00 at delivery). However, at the time of delivery, Buyer also needed to close out his hedge position in the futures market, so he bought ten corn futures contracts at $7.15 per bushel, a loss of $3.15 per bushel that offsets most of Buyer's gains on the cash market. Buyer does make $0.10 per bushel through the narrowing basis. He then ships Maize's corn, along with corn from other producers, via train to a processor, where Buyer makes an additional profit of a few cents per bushel.
That's how grain transactions are generally supposed to work. The grain-producing seller delivers all the grain called for by the cash forward contract. The futures market, in turn, is supposed to accurately reflect the cash market, making the hedge efficient. Lately, however, that has not been the reality for many commodity transactions.
Futures/Cash Convergence
Recently, the price of certain commodities, including corn, soybeans and wheat, in the cash market and in the futures market at or near the expiration of the futures contract are not as close as they have been historically. This failure of the two prices to converge is difficult to explain, even for economists. Some commentators—and some within the grain industry—think the cause is excessive speculation in the commodity markets. But while the failure to converge has been widely reported in financial and trade publications, this paper focuses on the lesser-noticed but very significant effects of that situation within the greater context of commodity price increases.
In some instances, the price difference between the cash price and futures market at the expiration of the futures contract has been as high as $0.55 per bushel for corn and $0.80 for soybeans. In the Maize example above, which assumes functional futures markets and delivery in full by Mr. Maize, the hedge losses were offset by the gains on the cash contract, and Buyer actually made $0.10 through the narrowing basis. A wide gap, in contrast, puts Buyer in a difficult position. Assume, for example, that instead of buying the ten futures contracts at $7.15 per bushel (for a total of 50,000 bushels). Buyer had to pay $7.75 because the futures market did not converge with the cash market, as was expected. In that scenario, Buyer profits $3.25 per bushel on the cash contract with Maize, but loses $3.75 on the hedge position, for a net loss of $0.50 per bushel—$25,000. Buyer has lost a considerable sum of money because of his hedge position.
Producer Default
Another risk currently faced by buyers of grain is producer default. There is a certain degree of risk in contracts that the other party may default. However, record commodity prices and production problems, primarily caused by inclement weather, have driven counterparty risk for grain buyers to an unprecedented level.
As 2007 crops were being delivered to grain buyers in the fall of 2007, it became clear that grain prices were moving higher. For a significant number of grain producers, those rising prices proved to be too great a temptation: Many simply elected to breach their agreements with grain buyers and default on their 2007 crop contracts. While some have claimed that such defaults result from higher input costs, particularly fuel, such increased costs generally are irrelevant to the 2007 crop, since last year's input costs would already have been known, and considered in the grain producer's decision to forward sell. The significant increase in producer defaults is reflected by the significant number of new arbitration filings with the National Grain & Feed Association, which maintains an arbitration system for its member companies and their contracting parties, roughly 70 percent of the industry.
The 2008 crop may present even greater issues, with the volume of producer defaults likely reaching new highs. This year's crop is of greater concern for several reasons. First, many farmers forward sold their 2008 crop in 2007, at prices that were then considered high, but that did not take into account farmers' significantly higher costs in 2008. Suddenly, Mr. Maize and producers like him may not make a profit on $4.00 a bushel corn.
Extremely poor weather has exacerbated the problem, causing fewer acres to be planted, and many planted acres to be flooded. Delayed planting may also reduce yield. Cumulatively, these weather conditions may cause a short crop, restricting supply and driving commodity prices even higher.
Many producers simply may not have enough grain to deliver against their forward contract commitments. Others may have the bushels to deliver but their deteriorating financial situations may result in the seizure of collateral by lenders. In that case, lenders would likely seek to avoid forward grain contracts so they can take advantage of higher prices in the spot (cash) market. In short, 2008 defaults may not be limited to those who breach for price, it may include those who have no choice but to breach and pay damages, to the extent they can.
Margin Calls
While the hypothetical grain buyer's hedge transaction described above is basically accurate, it fails to account for another significant impact of price volatility, the margin call. In the example above, Buyer bought back the futures contracts at the time grain was delivered on the cash contracts, inferring that the money was expended then. In reality, Buyer would have to pay that money in increments, as the futures market was moving higher, in the form of margin calls, which commodity exchanges use to ensure that parties have sufficient funds to cover any losses they incur. As the market moves against a party's position, that party is required to deposit money to offset the losses. These deposits are known as margin calls.
In the above hypothetical, as the futures price moved from $4.00 per bushel to $7.25, Buyer would have had to deposit roughly $3.25 per bushel in margin calls. If, as is typical, this money was borrowed, Buyer would have to pay interest on these margin amounts. Thus, unlike a typical year, where the price might move at most a few dozen cents and Buyer might incur minor interest charges, the market has moved whole dollars, and Buyer is paying significant interest costs. This movement has occurred at a time when credit has generally tightened, and some buyers have had difficulty meeting their margin requirements.
The Real Risk Holders
The foregoing issues are generally known within the agribusiness community, where there is a broad expectation that, in the absence of material changes in commodity prices or input costs, 2008 and 2009 may see an increased number of liquidations among livestock producers, as well as an increased number of defaults on contracts by both grain and livestock producers. Determining who will actually bear the financial losses, however, may be the task of lawyers, arbitrators, judges and juries for several years to come. It is reasonable to assume that when the losses are fully accounted for, all parties in the production chain—and their lenders—will have shouldered some of the burden.
But in contrast to the farm crisis of the 1980s, many of the "farmers" involved in this new farm crisis are not individuals. Instead, many farmers have formed limited liability companies in order to protect their personal assets, including farmland.
Historically, the cliché of business with a handshake has been the norm in the agricultural sector. Asking for information about a counterparty to a contract was seen as impolite. Knowing the other party through personal connections counted for a great deal in business decisions. As the use of limited liability companies became widespread among producers, old habits did not change.
Many industry participants have failed to recognize the impact of limited liability entities, thus, while many individual farmers may retain full liability for their breaches of commodity contracts, others may simply wind down the contracting LLC.
Of course, financial losses have to be carried by someone. If the seller on the contract is a limited liability company without sufficient assets to cover its obligations, the next party in the chain, the buyer, may find itself on the hook. In 2008 and 2009, many buyers of grain may find themselves simply writing off significant amounts of producer liability. For some buyers, the costs could not come at a worse time, as many are already strapped by margin calls, higher interest costs, increased fuel costs and the failure of the futures market to converge with the cash market. It is reasonable to assume that some grain buyers may not survive this financial peril. To some extent, whether an individual buyer survives may be dictated by market conditions beyond its control. However, to a significant extent, buyers may suffer due to their failure to adequately assess and guard against counterparty risk.
If a grain buyer fails, the losses will move on to the next level—the buyer's lender. Lenders are keenly aware of the higher operating costs currently facing their grain-buying debtors. To a significant extent, however, lenders are at the mercy of the market. The course of their debtors has been set by decisions made long ago. The lender cannot go back and force the buyer to be more diligent in contracting with limited liability companies. The lender cannot undo the fact that many farmers over-sold their 2008 crop. Finally, omnipotent as they may seem to debtors, lenders cannot control the weather.
To be sure, many grain and livestock producers may go out of business as a result of this potential new farm crisis. Many buyers of grain, including grain dealers, feed companies and processors, may also suffer. The ultimate outcome is predictable: fewer market participants. And, given the capital barriers to market entry, these participants may be lost forever.
Of course, the one group that is sure to pay a price for the present situation had no role in its creation—the consumer. While much of the immediate cost will be borne by industry participants, a significant portion of the long term costs will surely be passed along to consumers in the form of higher food prices. Thus the real cost of this new farm crisis may be paid a few dollars at a time, at the grocery store.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
