Q: What is a Market?
A: Nothing more than an aggregate survey of selling prices
Q: How confident should we be that data gathered by the USDA, Urner Barry and some of the futures exchanges accurately represent real market conditions?
A: It depends on the degree of market transparency and the level of trading volume.
In December 2005 the Government Accountability Office (GAO) report on the Livestock Mandatory Price Reporting program confirmed need for legislative reforms. GAO found that many meat packers didn’t report data to the USDA correctly, and in some instances failed to file price reports altogether. Gaps in reporting affected the accuracy of price reports and resulted in incorrect market information for buyers and sellers.
GAO evaluated 844 audits and found that packers incorrectly reported or failed to report required information 64% of the time. Since the enactment of the reporting program in 1999, only twice have packers been fined for noncompliance, and these were later waived in return for an agreement to comply in the future. Bottom-line: USDA and Urner Barry may not be perfect, but they are the only market benchmarks we have to work with on a large number of commodities items. Just be aware that this less-than-perfect survey system can occasionally lead to large and counter-intuitive price swings.
Q: What can be hedged?
A: Coffee, soybean oil, pork bellies, corn, wheat and any other commodity where you or your supplier can buy a financial instrument – a futures or options contract. There has also been progress with dairy products in recent years with futures and swaps.
Q: What about proteins?
A: Cattle contracts are difficult if you are just using a few steak cuts and ground beef. What does your supplier (or you) do with the rest of the animal? Poultry is usually hedged by managing cost inputs (corn & soymeal).
Q: What happens when you ask a vendor to go out 6 months to a year on a contract?
A: 1) You are asking them to take on commodity risk. Sometimes they can hedge these risks in the market and sometimes they can’t. 2) You are asking them to make a financial and production commitment. 3) In today’s environment, you are often asking them to take on fuel market risk.
If your supplier is assuming the commodity risk on a long term contact, and is not hedged, this can be a high risk situation for both of you. Obviously, vendors can’t shoulder this risk without building in some wiggle room. So the less buttoned down and the longer term the contract is, the more “insurance” has to be built into your price. Sometimes that premium will outweigh the cost of spot market buying.
Q: Should I contract or ride the market?
A: The overall goals of contracting, forward buying and hedging are: 1) risk management and 2) improving the odds in your favor. But make sure management is on board and understands that successfully managing risk is very different from successfully “playing the market.” Politics, not economics, is the biggest threat to a good risk management program