Maize farming and the unexploited profitability option
Since the market implosion of 2008, several regulations have been passed – some good, some not so good. You see when the referee says changes are necessary to safeguard financial stability, you’re bound.
For the world of derivatives, the suggestion to force banks to centrally clear their over-the-counter (OTC) derivatives, didn’t matter whether the requirements placed the players at a disadvantage, it had to be done. But some OTC solutions are really beneficial. We shouldn’t have to cut off the industry’s nose just to spite its face.
Be that as it may, I’ll highlight one OTC example (allow me to be futuristic here) I believe has the potential to benefit our farmer community. Let’s talk about “trade options”.
First off, I recognise the term is not a household word, so a simple explanation is in order. In its simplest form, a “trade option” is a contractual agreement between two parties that provides for the payment of a premium to secure the right, but not the obligation, to make or take delivery of the commodity described in the contract.
This type of option has been used for decades by producers, processors and others involved in metals, energy, and financial products businesses.
Here’s how it might work.
A maize flour miller enters a trade option contract with a group of maize farmers in Trans Nzoia. The counterparties agree on the price, the quantity, and the time frame for delivery of the maize. The miller has specified the delivery dates and quantities to coordinate with all its other purchases to achieve a “just in time” delivery system – of course, predicated in part on the miller’s need to maximise operational efficiencies, including availability and attractive pricing of transport costs.
Parties also agree on the millers’ flexibility to adjust the quantities due to unexpected weather conditions, to match production to sales, or to take advantage of a better cash or other contracted price at a particular time. In other words, the miller gets the right, but not the obligation, to take delivery on the set days of a lesser or greater quantity than called for in the contract.
To be clear, the counterparties know exactly what the lesser and the greater amounts are, because those quantities were specified in the option clause of the original deal.
If the local cash price on the delivery date is higher than the contractual price, the miller could exercise the option and buy the maize from the farmers’ group.
However, if the price on the delivery date is lower than the contractual price, the miller could abandon the option and buy from the open market. In the last instance, the farmers get to keep the premiums – but could themselves enter into a similar hedging situation in order to safeguard against fluctuating prices.
If producers, processors, millers and exporters are to be profitable in agriculture, they must have the freedom to find innovative ways such as agricultural trade options to manage their business risks. The options at least broaden the solution dashboard beyond just bank-facilitated OTC trades.
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