Price Discovery in Canadian Crops and Livestock
Price discovery is the process by which buyers and sellers interact to arrive at a price for a given asset specific to quantity, quality and time. It requires a marketplace and rules governing the transaction. The benefits to a well-functioning market economy of having excellent price discovery cannot be underestimated.
Economists cite three important functions of prices in a market economy; 1) the signalling function; 2) the transmission of preferences and; 3) the rationing function. Prices are the signal used by market participants to adjust production and consumption and thereby allocate scarce resources between competing uses. Consumers indicate their preferences by their purchasing decisions and prices can respond to those choices. In times of shortages for a particular good or service, prices can increase, thereby allocating only to those buyers that need the good the most. The price mechanism in a market economy is what Adam Smith called the “invisible hand” and it works because each party is pursuing their own interest. Price discovery is foundational for the development of new risk management instruments and thereby being able to manage price risk through hedging.
It is important to understand that true price discovery is the result of a competitive market in which many buyers and sellers are transacting within well defined rules. The quintessential price discovery mechanism is an active futures market with large volume and open interest. The CME Group corn futures contract is the king of agricultural commodities when it comes to trading volume and open interest and is as close to a text-book perfect example of price discovery as one can find. Price discovery in Canadian cereals, pulses, oilseeds and livestock markets has unfortunately lagged the developments in the U.S.
Price discovery flowing from a futures market is much different than markets in which prices are set by a group of large market participants without being based directly on transactions. For example, the London Interbank Offered Rate (LIBOR) is determined daily by 18 large banks with the bottom and top 25% being dropped and the remaining 50% averaged. This is known as a “fix” and is, in my opinion, vastly inferior in its price discovery value for obvious reasons of manipulation. The largest market manipulation scandal in history is going to be LIBOR and large fines have already being levied (see my article on Market Manipulation). The concept of valuation is also distinct from price discovery. In the absence of market prices, many financial assets and liabilities are valued using financial models such as discounted cash flow, relative valuation using similar assets or option pricing models (see Ron’s article on Mark-to-Market).
At the turn of the 20th century, the Winnipeg wheat futures contract was one of the three key wheat markets in the world along with Chicago and Liverpool. The Winnipeg Commodity Exchange (now part of ICE Canada), in its 127 year history has traded many Canadian agricultural commodities including canola, feed wheat, barley, oats, rye, flaxseed, feed peas, milling wheat and durum. Today, the only active agricultural futures contract in Canada is canola. Gibson Capital has been involved with many agricultural futures markets and we are strong advocates of this type of market, but unfortunately it is highly unlikely Canada will have a new agricultural futures contract anytime soon. The last successful agricultural futures market in the U.S. was lean hogs, established in 1997 as a replacement for the live hog futures contract. Therefore, other price discovery mechanisms must be developed and implemented to provide these benefits to producers, processors and the economy a whole.
Another potential source of price discovery is an electronic exchange for cash markets. Similar to a futures contract, an electronic exchange requires a well defined set of rules for the marketplace and the commodity must be standardized in terms of size of contract, delivery mechanism, quality and a host of other details. The biggest challenge is likely the clearing of trades, in other words the mechanism by which buyer and seller exchange funds and have the confidence that the trade is rock solid with respect to performance by the other party. Futures exchanges provide this function by guaranteeing the trade with the backing of the capital of all of its members. The exchange becomes the buyer to each seller and the seller to each buyer. Electronic cash exchanges have been tried in Canada, such as AgriLink, but have failed. The reasons for failure are difficult to know with certainty, but could include too much concentration in the sector reducing the number of traders below a critical level, too many variables with respect to quality and a clearing function that was too complicated and did not have sufficient capital. Another reason could be simple economics – many market participants were unwilling to pay enough for clearing to become a profitable business for private enterprise.
Auction markets are another venue for price discovery. The cattle markets in Canada are a great example of auction markets at work. Buyers and sellers get together at over 80 different auction markets in Canada. Animals can remain on the farm or feedlot and be sold via the internet and bidding can also take place offsite. Market summaries are available online and for some of the auctions in farm newspapers such as the Western Producer on a weekly basis. One valuable extension to the auction market’s price discovery role is the Cattle Price Insurance Program (CPIP) being offered by AFSC in Alberta. In order to settle its contracts with producers, AFSC calculates a daily price for feeder cattle based on all transactions reported from its 20 or so participating auction markets in Alberta. After removing outliers and standardizing prices at 850 pounds using a scale, a settlement price is determined. Prices are also calculated for steer calves weighing 550 to 650 pounds. These prices provide a very good estimate of Alberta steer prices since they are based on many transactions, although producers need to adjust prices for their geographic area and also consider quality.
On the other hand, the fed cattle market in Western Canada has little in the way of auction markets and operates largely using private negotiations between the feedlots and the two packers in Alberta. Canfax, the market information division of the Canadian Cattlemen’s Association, surveys some of its feedlot members to determine the price of fed cattle on that day. This survey forms the basis on which AFSC settles the CPIP Fed cattle program. Surveys are always vulnerable to the availability of its voluntary participants and there is no direct check on the accuracy of the prices being reported. Nevertheless, in the absence of mandatory price reporting and having all of the prices at which the packers are buying cattle, it is a second best solution that helps cattle producers.
Cash brokers in cereal grains, pulses and oilseeds are another source of price information and provide their clients with daily and weekly market commentary including their estimate of market prices, both spot and forward. These are based on actual transactions (if they occurred) and would be a good source of representative prices for each market. These prices are typically not available to the general public and so the benefits accrue to a small number of market participants. Cattle buyers would also be an excellent source of price information, but again, it is also private.
Market surveys such as those published by the various provincial agricultural departments rely on the good will of the participants to provide their prices. The sample size is usually fairly small and bids are often reported, but this is rarely the price at which markets transact. The bid/ask spread can be very wide in some markets and so using the bid is not always an accurate indication of the true market price. Also, at times prices do not change for a long time which is indicative of poor price reporting. The grain companies in Canada also provide their customers with prices online, but these would also be bids (or indications only) and are typically not available to the public.
The USDA enacted the Livestock Mandatory Price Reporting Act in 1999 which required packers to disclose price and volume information for cattle, swine and lamb. No such law exists in Canada and all price reporting is voluntary, thereby reducing the quantity and quality of price information in Canada. There is a rationale for having government involved in the collection and dissemination of market prices since the benefits flow throughout the entire economy and so can be considered a “public good”. This is especially the case for commodities which do not have a futures market and there is little else available to provide price discovery. For over 90 years, the USDA has embraced the “public good” role of price collection and dissemination.
The hog market in Canada operates in a unique way in that price discovery actually takes place in the U.S. While the Canadian cattle markets are based on U.S. futures and cash prices, there is still a “basis” that regulates the supply and demand in Canada. The hog market does not use a basis, but rather Canadian hog prices are calculated using a formula based on the prices from a number of different USDA daily cash hog reports. The formula adjusts for currency, imperial to metric, the different dressing percentages and a grading premium. Every few years, the formula is reviewed by producers and packers and adjustments may be made based on negotiations. Without USDA cash hog prices, there would be no Canadian hog prices under the current system.
The wheat market in Canada is tied to the three U.S. futures markets. Hard red spring wheat in Canada is priced on a basis to the Minneapolis Grain Exchange spring wheat futures contract. ICE Futures Canada has listed durum and milling wheat futures specific to Canada, but these contracts are inactive. With the ending of the CWB’s export monopoly, milling wheat, durum and feed wheat are tied directly to the global price for these commodities. Price discovery in wheat is limited to cash brokers, bids from grain companies (including the CWB) and a number of producer associations posting prices on their websites.
Beans, peas, lentils, and canary seed do not have a futures market or even a viable cross hedge. These commodities are traded flat (see Ron’s article entitled The Opaque World of Commodity Trading). Price discovery includes transactions between Canadian processors and bids (both spot and forward) available to farmers. Market prices are available for clients from a number of private firms that specialize in market information for pulses and special crops. Flaxseed is also traded in a similar fashion with little in the way of price discovery.
One innovative price discovery project developed by Gibson Capital is the Feed Pea Benchmark published bi-weekly by the Alberta Pulse Growers. Feed peas are used primarily in hog rations and their nutritional value can be estimated using least cost formulation. This is an example of relative valuation, where the value of feed peas is derived from the ingredients in a typical hog grower ration. The ingredient prices for the ration such as barley, feed wheat, corn, canola meal, soymeal, canola oil, lysine, among others, are determined by brokers active in those markets and the value of feed peas is calculated using least cost feed formulation software. While the benchmark is not a price, it does provide some information to producers of the value of feed peas, and market prices (when available) tend to track the benchmark fairly closely.
The likely evolution of price discovery in Canadian agriculture is the expansion of forward price programs offered by industry along with insurance-based option pricing offered by government. The livestock price insurance offered in Alberta is expected to be expanded to all of Western Canada in 2014. I think another trend will be the increasing use of technology to broadcast bids to farmers, using SMS, email, Twitter, etc., and there may be some attempts to consolidate these bids into a single platform. Partnerships and cooperation between farmer organizations, government and some private companies could facilitate the development of price indices which are needed to better settle existing crop revenue insurance contracts and launch new risk management products.
The challenges for Canadian agricultural price discovery are the increasing concentration of the grain handling business, vertical integration, the inability to launch new futures contracts and the lack of government funding for price collection and dissemination. With the removal of the CWB’s export monopoly, there has been an influx of new entrants such as cash brokers, producer consultants, and merchandisers. This is good news as it promotes a more competitive marketplace and paves the way for better price discovery.
Iebeling Kaastra, CFA