Three Major Staple Grains See Rare Simultaneous Decline: How Can Derivatives Solve the Agricultural Puzzle?
“If you control oil, you control all nations; if you control food, you control all people.” As former U.S. Secretary of State Kissinger said, food security is crucial to a country.
At the 4th Risk Management and Agricultural Development Forum, jointly hosted recently by the Ministry of Agriculture and the China Securities Regulatory Commission, experts pointed out that corn prices had suffered their worst plunge in fifteen years, driving the three major staple grains to a rare across-the-board decline. The market volatility and even panic since the start of this year have sounded an alarm for our country's food security. Currently, the difficulties facing the grain market affect the vital interests of the broad masses of farmers. Although our country's total grain output has achieved an “eleven consecutive increases,” behind this abundance, the “distant concern” of how to resolve risk seems to be gradually becoming a “near worry.”
Simultaneous Decline of Staple Grains Catches All Off Guard; Agricultural Predicament Urgently Needs Solving
A review by China Securities Journal reporters found that the key node in this grain price anomaly was September 18, 2015. At that time, the National Development and Reform Commission, the State Administration of Grain, the Ministry of Finance, and the Agricultural Development Bank jointly issued a document announcing this year's corn purchase and storage price. The listed purchase price was 1 yuan per jin, down 10.7% from last year's average price of 1.12 yuan per jin.
For this unexpected change, the commodity futures market was the first to react. That day, corn futures prices fell 3.64% (the limit-down board was 4%), open interest increased by 320,000 lots, accounting for 24% of the original level. On that day alone, 500 million yuan of funds entered the corn futures market.
On the spot side, after the state announced the temporary storage price for corn in Northeast China, corn purchase prices in Henan, Shandong, Jiangsu, Anhui and other places fell rapidly, dropping more than 20% year-on-year, a decline never seen since 2000.
Affected by the decline in corn prices, rice and wheat prices fell in tandem. In early October, wheat prices in Shandong and Hebei slid rapidly, hitting a 6-month low, and even triggering a certain degree of market panic. This was also a situation not encountered for many years.
“This grain price decline had two unexpected aspects. The first unexpected aspect was that this price adjustment was originally aimed at corn purchase and storage in Northeast China, with the price lowered by one mao two, but unexpectedly corn prices in North China and the Huang-Huai-Hai region fell by more than 20% as well. The second unexpected aspect was that what was originally adjusted was the corn purchase and storage price, but after all that, wheat instead underwent a ‘cliff-style drop’ in a short period!” Speaking about the recent grain price fluctuations, an industry insider told China Securities Journal reporters.
If the essence of risk is “uncertainty,” then these two “unexpected aspects” precisely reflect from one side the enormous risks facing our country's agricultural industry.
Speaking about the risks and problems facing our country's agriculture, Li Huatian, deputy general manager of the Second Client Department of the Agricultural Development Bank of China, pointed out that the first is that resources are relatively tight. Our country has little arable land per capita, with only 1.3 mu per capita, one quarter of the world average, and resources are tight overall.
The second is the deterioration of the ecological environment. Our country suffers serious soil erosion and desertification every year, and land loss caused by the urbanization process can reach the area of a medium-sized county. At the same time, the excessive use of chemical fertilizers and pesticides has damaged the ecological environment and seriously affected agricultural production.
The third is the accelerating transfer of rural labor. A large amount of rural labor has transferred out, the quality of the agricultural labor force has declined, and the problems of labor force aging and rural hollowing out have become increasingly prominent. Who will farm the land and how to farm it have become key questions.
The fourth is low production efficiency. Our country's agricultural production efficiency is equivalent to 30% of the global average, and the contribution of science and technology to agriculture is below the world average.
The fifth is the lack of international competitiveness. Our country's agricultural product market lacks pricing power. In addition, domestic and international product prices are inverted, and domestic agricultural product inventories are high. The double squeeze of cost and the price ceiling effect brings great constraints to agricultural development. As industry insiders say, “When the international market sneezes, the Chinese market certainly catches a cold.”
Great Changes in Agriculture, Rural Areas and Farmers Create a Window of Opportunity for Solutions
“Our country's agriculture has already entered a new stage of high input, high cost and high risk.” Zhang Hecheng, director of the Market and Economic Information Department of the Ministry of Agriculture, said that the background and internal causes of agricultural market risk formation in the new period lie in four aspects: first, profound changes on the demand side of agriculture under the new economic normal; second, the pains of reform brought by improving the agricultural product price mechanism; third, the far-reaching impact of sustained domestic and international price inversion; and fourth, the lagging construction of agricultural information and market service systems.
It is worth noting that in this new stage, a transformation is being nurtured and fermented in the agricultural field, which may create opportunities to solve the agricultural predicament.
First, “Internet+” joining hands with financial factors is expected to enhance our country's agricultural competitiveness. Vice Minister of Agriculture Qu Dongyu pointed out that a key point in current agricultural development lies in continuing to push financial resources to flow into the “three rural issues” field. Relevant departments have already issued many institutional arrangements, among which the financial industry is the main force in implementing policy. Therefore, the financial industry should continue to tilt toward agriculture.
At the same time, it is also necessary to actively explore rural internet finance development models. The current financial industry has rich forms; for example, the emergence of small and micro financial services such as Ant Financial forms a competitive landscape with the traditional financial industry, helping to prompt the financial industry to provide better services for agriculture.
Lin Zhiyong, vice president of PICC Property and Casualty Company Limited, also introduced that around “Internet + agriculture,” the company has signed cooperation agreements with multiple agricultural internet enterprises, integrating insurance services into the sale and purchase of agricultural materials, covering the entire industrial chain of agricultural production, agricultural product circulation and sales, and relying on the company's institutional outlets across villages to build an integrated online and offline rural comprehensive service platform.
Second, the demand for green environmental protection promotes the improvement of agricultural quality. Chen Tao, chairman of Louis Dreyfus (China) Trading Co., Ltd., said that data show that as much as 92% of the pesticides used worldwide are produced in China. In addition, China's pesticide consumption is 3 times the world average, and food safety problems are prominent.
Zheng Xinli, executive vice chairman of the China Center for International Economic Exchanges, also pointed out that the problem of agricultural pollution is seriously incompatible with the broad Chinese public's requirements for food safety. The heavy use of chemical fertilizers and pesticides in agricultural production makes the export of agricultural products difficult. Developing organic food, green food and pollution-free food, reducing the use of chemical fertilizers and pesticides, and ensuring food safety are urgent tasks for agricultural development.
Third, “small agriculture” becomes “large agriculture.” It is understood that the current rural population is more than 600 million, but the main body of the labor force is the elderly, women and others, mainly weak labor. This current situation does not meet the needs of agricultural modernization and agricultural mechanization development. Therefore, large-scale operation should be developed, attracting high-quality labor through land transfer and concentration, prompting “small agriculture” to become “large agriculture.”
According to Zheng Xinli, there is an example in Henan Province. In a village in the province, more than 10,000 mu of land were all contracted by one laborer. He purchased a full set of agricultural machinery, planting wheat in one season and corn in another. During busy farming periods he hired short-term workers; ordinarily it was just one person. Subcontracting the land from farming households for large-scale operation is a very good change. “Under agricultural modernization, not to mention farming 10,000 mu, on the plains one laborer has the conditions to farm one or two thousand mu. Even in rice paddies in the south, with the help of mechanization, one laborer is fully capable of farming 500 mu of paddy field.”
⟦NL> Small Derivatives, Reviving a Big Game
“If there were no futures varieties, we would not trade; without hedging, we would not buy or sell. Therefore, strictly executing no one-sided transactions at all can ensure that our profits are always locked in, and we always know before the trade actually occurs how much the profit or loss will be.” Chen Tao said that Louis Dreyfus's assets have achieved an annual return of 20%-27%, a degree of stability that many peers find hard to match, and even better than the other three major grain traders. One key lies in the high use of derivatives.
The supply and demand characteristics of agricultural products differ from industrial goods. Industrial goods can be supplied evenly and consumed evenly across all 12 months of the year. Agricultural products, however, are seasonal; at harvest time there is a large supply in a short period, but as time passes the supply becomes smaller and smaller. Therefore, sometimes supply exceeds demand and sometimes demand exceeds supply, thus creating market turbulence.
When farming is small-scale and household-based, farmers' awareness of risk may not yet be strong, but if we promote the scaling up and mechanization of agriculture so that the agricultural products produced become bulk commodities, then strict risk control is needed, and derivatives can play a very important role in this.
For example, internationally, the United States, Mexico, Canada, Brazil and other countries have successively launched pilot projects involving options in agricultural production. From 1993 to 1995, the U.S. government selected 21 counties in 7 states to carry out a grain options pilot project, with more than 1,000 corn producers and 300 wheat producers participating. Project results showed that options played a clear role in increasing farmers' income. A 2011 survey showed that more than 70% of farm owners or producers used options directly or indirectly to serve agricultural production. From 1996 to 2000, the Mexican government's actual total expenditure on this project was 262 million pesos (about 31 million U.S. dollars), while farmers bore a total expenditure of 192 million pesos, but total income reached 445 million pesos. Options played a significant role in improving government fiscal subsidies and helping producers avoid risk and increase income.
“At present, we all wait until harvest time, when farmers bring their grain to buy and sell, and this certainly means supply exceeds demand. In countries with developed agricultural markets, before harvest at least 50% of grain or products have already been sold, and there is certainly a risk control link. To achieve this effect, there must be derivatives, tools for price discovery and hedging. Louis Dreyfus uses basis trading in all variety transactions.” Chen Tao said.
It is worth noting that our country's agriculture-related enterprises are also continuously making progress in using derivatives. Liu Shengxi, general manager of Zhejiang Yongan Capital Management Co., Ltd., introduced a successful case of using over-the-counter options. In 2013, after Yuntianhua Cooperative stored corn, it planned to sell 1,000 tons of corn within two months, with the price calculated according to the Changchun area purchase price at the time of trading. At the beginning of that month, the Changchun corn purchase price was 2,200 yuan/ton. Faced with this situation, in order to prevent future corn price declines, the cooperative hedged the agreed corn sales volume, with a hedging target of 1,000 tons. On February 17, 2014, Yuntianhua Cooperative signed an over-the-counter put option trading contract and transaction confirmation with Yongan Capital, clarifying important contents such as the execution price, premium amount and expiration date negotiated by both parties. From the final result, on the spot side, the corn spot price rose from 2,200 yuan/ton to 2,260 yuan/ton, and Yuntianhua Cooperative made a spot profit of 60,000 yuan. On the over-the-counter options side, because the closing price of the corn futures 1405 contract on the expiration date was higher than the agreed execution price, Yuntianhua Cooperative abandoned execution of the put option and lost a premium of 27,090 yuan. During the life of the option, Yuntianhua Cooperative made a total profit of 32,910 yuan, which by calculation was better than directly using the futures market for short hedging.