Originally published on December 4, 2018 2:39 pm
Farmers know every year they’re going to encounter surprises from things out of their control, like drought or pests.
This year, great growing conditions led to a bin-busting soybean harvest, but a tit-for-tat exchange of tariffs with China meant that country went from being a major buyer to virtually ignoring U.S. soybeans.
That’s caused prices to drop, leaving U.S. farmers and grain elevators struggling to store soybeans until prices or demand improves. Those factors threaten to undermine the soybean futures contract, and federal regulators have until Dec. 10 to review a proposed solution to the problem.
While this might seem like an arcane aspect of farm finances, consumers benefit from the futures market. Many of the processed foods we eat contain soy, but your grocery bill isn’t changing much during this trade war. That’s thanks, in part, to the futures market.
What is it?
A futures contract is an agreement made in advance to either provide a product or pay off the contract on a certain date.
Individual farmers aren’t likely to deal with it beyond monitoring prices, but grain elevators do. They’ll use futures contracts to manage sales and get good deals throughout the year, allowing them to pay farmers a more consistent price and protect them from big drops.
“Futures markets originated in the agricultural industry,” said Russ Behnam, a commissioner with the Commodity Futures Trading Commission, the federal regulatory body. “And they are meant as a price discovery and risk-management tool.”
Large market players can use the futures market to participate as both grain buyers and sellers. Their actions in the futures market are the opposite of what they do in the cash, or physical, market. Harvest Public Media produced this explainer video that details how it works. One key thing is that it brings some stability to the market, which elevators pass onto the farmers who supply the crop.
Benham said the system protects farmers if the price for their crop changes significantly during the growing season.
“The futures contract will act as a sort of counterpoint to the actual physical planting,” he said.
If the cash price — which farmers are paid on the day they deliver grain — drops, those losses will be offset by gains on the futures side. That’s a big simplification, but it speaks to the fundamentals. And this system works as long as the cash price gets pretty close to the price in the futures contract as the expiration date approaches.
University of Illinois agricultural economist Scott Irwin said when the narrowing of the gap between the futures and cash prices, which is called convergence, isn’t on pace, “Houston, we have a problem.”
Economists could see this problem coming for months; in September, one called the soybean futures contract “precarious.”
“Think of it as trying to squeeze the air out of a balloon,” Irwin said. “If you squeeze it at one end, it’s going to show up somewhere.”
Without convergence, the futures contract fails and farmers’ risk is no longer managed. They could lose a lot of money.
The role of storage rates
The futures contract isn’t exclusively about the price per bushel. It costs money to store a crop, which a futures contract must account for because it needs to offer a realistic representation of what’s happening in the physical market.
A year ago, before the trade war, the CME Group, which manages the soybean futures contract, was considering changing the storage rate for soybeans because it didn’t reflect the actual cost.
“Indeed, it was concerning for me when the trade war started and tended to escalate,” said Fred Seamon, CME Group’s executive director of research and product development for agricultural commodities, “and I knew that we would see issues sooner than what we would have otherwise.”
Parts of the Midwest are now practically out of storage space, increasing the cost even more.
Although this problem was anticipated, fixing it isn’t simple or quick, because the futures market is closely regulated. The CME Group has proposed an increase in the storage rate and is waiting for a green light from the Commodity Futures Trading Commission.
“I’m very confident that they’ll approve our proposal,” Seamon said.
The CFTC will issue its decision by Dec, 10, but even if approved, the change won’t go into effect for more than a year.
By then, the trade war could be over. Or maybe U.S. farmers will grow fewer soybeans, or other countries will commit to buying more.
Some observers say market-based responses like that will resolve the problem, not changes to the soybean futures contract. But Seamon says the proposed changes are not meant as a quick fix.
“We’re changing to a rate that represents the true cost and that will be a relevant new rate whether we have a trade war or not,” he said.
Follow Amy on Twitter @AgAmyinAmes
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