OUT OF OPTIONS

Northwestern Financial Review, May 15-May 31, 2008 by Hilgert, Jackie

Bankers advised to pay close attention to ag sector as price volatility brings new challenges

Debbie Borg and her husband, Terry, operate a farm in Wakefield they say is "average for Nebraska." Their land is a 50-50 split between corn and soybeans, and they feed a healthy number of cattle from their own stores. By this time of year, the Borg s typically have 60 percent of their crop marketed. "Farmers have been taught to sell their crops into the next year and that's what we had been doing," Debbie Borg explained.

But not this year.

This spring, the Borgs and thousands of producers like them, have had the risk management tools they depend upon called forward or hedge-to-arrive contracts - pulled away from them by grain elevators as the game of selling commodities futures gets increasingly costly to play.

For their part, elevators are just trying to survive as margin calls force them to pour more of their operating capital onto the trading floor. As a result, elevators are turning to lenders to up their credit limits - again and again and again; some of them have maxed out their lines and so lenders are turning to participations to help these elevators hold their positions.

Why all the volatility in the commodities sector? The answer to that question depends a lot upon who you ask but fingers are starting to point in the direction of Wall Street and Washington. Back on Main Street, Jeff Gerhardt at the State Bank of Newman Grove, Neb., summed up recent developments in commodity risk management this way: "There's a lot of nervousness out there. One customer told me 'I liked it better when there was $2 corn."'

Pent up demand

As an economic sector, farmers are faring better than their manufacturing and service industry brethren. Farm commodities are in demand and prices are strong.

Farmers planted 93.6 million acres of corn in 2007 and harvested 13 billion bushels - a record. Two decades ago, all that corn might sit in storage waiting for a buyer, but not today. Exports are strong as China and India make economic gains and the demand for protein increases. Meanwhile, ethanol grabs 30 percent of the corn pie as mandates to increase production are met.

Weather affects pricing as well. Drought in Australia destroyed 100 percent of that country's wheat crop for two consecutive growing seasons. World wheat consumption has exceeded production in six of the last eight years.

Meanwhile, soybean growers have strong markets as biodiesel production in the European Union pushes soybean prices higher. Throw in a weak dollar and right now corn futures are at record highs. Other commodities, while down slightly in 2008, are coming off record increases in 2007: rice up 118 percent, wheat up 95 percent, soybeans up 88 percent.

As positive as this all seems for grain producers, price increases like these bring consequences, such as livestock producers who are bleeding money all over their feedlots. Eric Walhof of First National Bank in Sioux Center, Iowa, says he's seeing cattle guys losing $75 a head and hog producers losing $15 to $30 a head. "These prices are a blessing to half my portfolio and a curse to anyone who has to feed this grain," Walhof said.

Record commodity prices have also attracted attention from pension funds and hedge funds. Many of these funds allocate significant portions of their assets to commodities as a diversification strategy. A Wall Street Journal article reports as much as $200 billion has poured into commoditylinked index funds in the last seven year. Some estimate that index funds already own all of this year's crop and all of next year's crop. Much of this new money flooded in after the Commodities Futures Trading Commission expanded the limits for index fund involvement, a move meant to liquefy the market.

"The problem is, all this money moves in and out of the commodities market without regard to traditional market forces, supply and demand," commented Bill Dankbar, a commodities broker with North Star Rail Intermodal, which manages grain transportation in Minnesota and the Dakotas. The result is little market predictability and huge swings in the market that make it difficult for traditional players to compete.

Changing dynamics

First National's Walhof said elevators in northwest Iowa are offering forward contracts on corn and beans, but only out to fall 2008. That's a shift from previous years, when contracts could be rolled forward one, two, and sometimes three years.

Just west of Sioux Center, over in Nebraska, elevators are pouring every dime they make into margin calls and relying on banks to increase their credit lines. Yet even that wasn't enough to save Nebraska's Alvo Grain and Feed from failure last month, raising concern among other elevator operators, and their farm customers.

Borg's elevator in eastern Nebraska is owned by Cargill. The elevator has limited its forward contracting options considerably, but not totally. "Our Cargill advisor has been very helpful, giving us a new option to sell our beans for November delivery, guaranteeing $11.71," Debbie Borg said. She also could go directly to the board of trade herself, she explained, if she put forward $10,000. "Marketing is very complicated."