"Illiquidity-to-Arrive"; More History Repeating Itself

One of the options available to both livestock and crop producers is the ability to sell their products, and thereby establish a price, well in advance of the delivery of the final product. While this is can be done directly with futures contracts, many if not most producers do it through their packer or grain elevator using what is commonly referred to as forward contracting.

Historically, crop contracts on the Chicago Board of Trade have allowed forward pricing a few years ahead of delivery. For instance, you can price corn in the low $5 a bushel range today out as far as 2010. Livestock contracts have always had a shorter pricing horizon usually a little less than one year to about a year in advance.

Because of this, grain elevators and packers have offered forward contracting opportunities with a supply assurance motive. In a forward contract, you agree to deliver your corn to a certain elevator at a future date and they will offer you a price today based on what they can sell it for ahead in the futures contracts.

     They adjust the price offering to cover their expected basis and the costs of doing this, which includes interest expense on margin money they may have to put up. Then they have locked in a known future supply of grain coming into the elevator and a known cost. Same with packers.

If they do it frequently and continuously, the elevators usually count on having a margin account which is flush with cash when prices fall from hedged sales levels (in which case they earn interest on their margin account) and they pony up margin money when grain prices rise (usually borrowing the money to do this from their line of credit) and it could be a wash over the long run in terms of  margin interest expenses.

The problem with these forward contracting arrangements is that a couple of very bad things can happen in unusual times (in other words, such as now). If elevators forward price grain and the grain price doubles or triples, their margin requirements go through the roof. If they exceed their loan capacity (line of credit) and the banks don't supply more cash, they cannot meet their margin calls and their trading is suspended and the positions can be forcibly liquidated, meaning they lose their margin money.

Now add to that, disgruntled producers who have forward contracted the sale of their corn for say, $3.00/bu and a year or more later when the crop actually comes in, could sell it for $5.00/bu if it hadn't been pre-priced. Some of them are going to tell the elevator to pound sand and sell their corn somewhere else for the $5.00. The elevator is left without the corn and having paid for the difference between $3.00 and whatever price they were forced out at for not paying up their margin calls (say when prices went through $4.50/bu as an example). That's bad news for elevators.  Typically by this point they have completely exhausted their own cash and the cash they could raise from borrowing.  When you are out of cash, you are out of business.

Producers who forward price a couple of years in advance at relatively lower price levels wind up paying escalating input costs when they put the future crop in and have a big moral hazard problem. Should they keep their commitments to the elevator and take a loss when everyone around them is making big money on $5.00/bu corn or should they stiff the elevator and try to recover their now higher input costs?

If you see the analogy to the sub-prime mess, you are able to think in analogies very well.  Lots of elevators have stopped offering forward contracting these days.  Guess why.