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Low Prices and Low Volatility Could Be a Recipe for Disaster!

We are pleased to present a new Earthscan from Routledge blog post written by John Williams, author of Agricultural Supply Chains and the Challenge of Price Risk.

With a new entry every fortnight, blog posts written by various Earthscan from Routledge authors will be displayed both on the Routledge website and on the Earthscan from Routledge Facebook page. Each post within Facebook will be open to comments so please feel free to voice your thoughts!

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Low prices and low volatility could be a recipe for disaster!

BY JOHN WILLIAMS, author of Agricultural Supply Chains and the Challenge of Price Risk

Low prices and volatility is a situation similar to the period prior to 2006 when the Food and Agriculture Organization found that the unprofitability of farmers could lead to decreased plantings and global food shortages, particularly in marginal dry-land countries where there was no farm subsidies. Low prices has largely resulted from increasing agricultural surpluses in most countries due to more favourable weather conditions, whereas low volatility has been exacerbated by funds flowing away from commodities towards equities at the same time that tightened US regulations have restricted trading by fund managers.

A reduction in the US ethanol fuel mandate occurred on 15th November 2013 which released a further 13 million tonne of corn back onto the US domestic market. This has also not helped grain prices which have generally been falling since July 2012. Far from having global food shortages and high prices for 2013, the resulting surpluses and low prices are now currently undermining the incentive for farmers to sow crops for 2014 because of a lack of profitability.

Risk management has also been affected during 2013 because of lack of volatility has restricted the hedging opportunities for farmers, who are being trapped by low prices, a lack of price volatility to provide forward pricing opportunities, and rising farm input costs. The cost-price squeeze has increased and the farmer’s terms of trade has decreased. Managing price risk was never going to be easy! This is explained further in my newly released book, Agricultural Supply Chains and the Challenge of Price Risk.

Whilst farmers in the food bowl countries of Europe, USA, India, and China receive subsidies which partially offset the effect of skewness against low prices, the more marginal dry-land farmers in other countries with no farm subsidies are seriously impacted through decreasing profitability. Yet these marginal dry-land countries provide much of the global exportable surpluses.

The paradox is that by keeping agricultural prices and volatility artificially low because of concerns over food ‘insecurity’, these pricing policies might be actually leading to the very problem that most people fear. Intervening into markets and supply chains could have serious reactionary and unintended consequences such as food shortages.

It might be considered that food manufacturers and end users should be the beneficiaries of such price skewness and low volatility. However, the changing dynamics of competing supply chains in deregulated markets, the increasing fickleness of global consumers and their purchasing behavior, and currency exchange relativities have not made it easy for agricultural buyers. High currency rates in countries outside of the USA may have favored cheaper imported ingredients, but it has also increased foreign competition through imports of cheaper finished products at a time when exports are increasingly uncompetitive.

These factors make this new book highly relevant and timely. Many global agricultural transactions still occur ad hoc with no recognizable spot market. There can be no forward market when there are no strong local linkages between merchants and end users. Without such clustering of commercial activity, there can be no forward market and no price risk management. The book therefore begins by investigating how these commercial linkages can form forward markets, and how these are so vital in managing price risk. Supply disruptions cause the formalization of the forward market into futures markets to protect credit risk.

The book covers the limitations to price risk management, post harvest dilemmas for both buyers and sellers, the introduction of flexibility in pricing through the use of options and over-the-counter products, strategy evaluation, managing currency risk, as well as the role of arbitrage in market efficiency. It is designed to meet many of the issues currently arising in global food and fiber supply chains.

See also my recently released journal article: Wheat and corn price skewness and volatility: Risk management implications for farmers and end users.