COTTON PRICE RISK
MANAGEMENT
Africa – EU Cotton Partnership
September, 2007
Roy Parizat
Commodity Risk Management Group
The World Bank
OUTLINE
• Overview of CRMG
• Lessons Learned to Date
• Current Activities
COMMODITY RISK MANAGEMENT
GROUP OBJECTIVES:
• Test market-based solutions for managing price risk
• Provide education to organizations interested in improving their
internal risk management practices
• Diminish the gap between developing country markets & the
financial markets
• Empower clients to analyze risk, make changes in the way they
trade, and/or use international market products when conditions look
right
LESSONS LEARNED
• Start with proper risk assessment
• Risk management solutions are diverse
– can incorporate changes in the way sales contracts are negotiated
– can incorporate price protection on NYBOT market
• Organizational capacity is important
– takes time & attention
• Significant need for more education
• Local banks have a role and can add value to the process
• Requires willingness to “learn by doing”
– patience in trying different approaches
RISK ASSESMENT
Risk Position Report
Overall aim is to improve internal risk mgmt practices
Risk Position Report
•
•
•
•
Requires detailed information on purchases / sales
can help to quantify overall organizational risk
is a good business tool if updated & monitored regularly
can be used to evaluate different marketing or risk mgmt strategies
Contract
Kgs Seed CottonBought
Kgs Cotton Lint Equivalent
Kgs Cotton Lint Sold
Net Position (Kgs) - throughout the season
Pre-Orders / Forward Sales Agreed - Still Outstanding
Buyer
1. Risk Position (in Kgs)
Date
Price Level in
Price Level Volume
Contracted
Tsh/Kg
equiv in $/kgs in Kgs
Jun
July
Aug
Sept
RISK ASSESMENT
Risk Position Report
Overall aim is to improve internal risk mgmt practices
Risk Position Report – graphic representation
Position throughout the season can be shown diagramatically to improve
comprehension and understanding of a clients risk position
Example of clients - Net Risk Position
(assumes significant volume of forward sales entered into at season start)
True net position
(Kgs) including
forward sales assumed
2000000
1500000
1000000
Kgs Cotton Lint
•
500000
0
Jun
-500000
Cotton Lint Sold
(Kgs)
July
Aug
Sept
Oct
Nov
Dec
Jan
Feb
Mar
April
-1000000
-1500000
Cotton Stocks
Purchased (Kgs)
-2000000
-2500000
-3000000
Month
RISK ASSESMENT
Breakeven Price Analysis
Breakeven Price Analysis
•
•
•
Breakeven price = sales price level at which all costs are covered
Expressed in local price terms and equivalent NYBOT price
Conservative risk management strategy is to protect the breakeven price:
• Either through forward sales
• Or with price protection on the NYBOT market
Breakeven Price Calculation
Costs (various costs of production and transport) (Tsh/Kg)
Purchase Price - seed cotton (Tsh/Kg)
Breakeven price for 1kg cotton seed (Tsh/Kg)
Tsh
142
405
547
x3 conversion to lint (Tsh/Kg)
1641
Minus profits from sale of cotton seed (Tsh earned from 3kgs of seed cotton production)
145
Breakeven Price for 1 kg of Lint FOT (TSh/Kg)
1496
Conversion to Tsh / lb
679
Conversion to USD / lb
$0.53
Fob Costs and CIF Costs (USD/lb)
$0.04
Target Protection Price on International Market (USD/lb)
$0.570
RISK MANAGEMENT SOLUTIONS CAN BE
DIVERSE
Risk Management
Export Sales with
minimum price
guarantee
Back to
Back
Sales
Structured
Finance with
Inventory as
Collateral
NYBOT Options Contracts
- Solutions will have different costs / benefits at different times depending on the
market
- Need to explore, look at alternatives, monitor pricing regularly
Once you have determined your risk position, evaluate the costs, benefits, and
impacts of different risk management solutions in order to identify the best solution/s
for your business .
CURRENT ACTIVITIES IN EAST
AFRICA
•
Continuing supporting risk management through local bank – CRDB
Tanzania
•
CRDB Bank is major lender to agriculture – large portfolio in cotton (and
coffee)
•
Faces default risk, non-repayment of bank loan when clients make
losses due to unfavorable price movements
•
CRDB directly shares the risks of the clients they are lending to:
– For Cotton – current marketing systems have high levels of risk, for
example:
a) purchases prices are paid when seed cotton purchased from farmers but sales prices
may not be known for many months (long position)
-- risk is that prices will fall
b) contract sales can be fixed early on in season before cotton is purchased (short
position)
-- risk is that prices will rise
PROBLEMS OF GOING “LONG”
•
•
If prices rise between purchase and sale, ginners are
profitable and make additional profits
If prices fall between purchase and sale, ginners:
Potential Reaction
Potential Impact
May avoid making sales in order to avoid
losses
Negative cash flow then impacts ability to
continue to buy product
May be forced to lower the purchase price
to farmers
Unable to secure sufficient seed cotton at lower
price (competition amongst ginners high)
May default on sales because they can
not procure enough product
Bad reputation in the international market
May have very high losses
Loss of services to farmers / ability to repay
loans
WHY INVOLVE THE BANKS?
• Price risk influences both the outreach, quantity, and cost of
lending available
• Banks have very strong commercial incentive for clients to improve
profitability
• Risk management is a financial activity
• Can be added to financial services offered by banks
– CRDB provides regular market/price updates to cotton clients
• Working with banks provides advantages for ginners
– Local banks already have working relationships with ginners
– Clients can do business with a local phone call, through an existing
relationship
CONSTRAINTS FOR TAKE-UP
• Credit Risk
– International providers not currently willing to take credit risk
• Will require cash in advance payment of premium
– This limits products available to options contracts which can be
paid for upfront
• Options contracts can be expensive
i.e. for Put Options
– Cost is high when market prices are low
– Cost is high when covering longer period of time (6-8 months)
But the reverse is also true:
– Cost is low when market prices are high
– Cost is low when covering shorter period of time (3-5 months)
RISK MANAGEMENT EDUCATION
• How to design the risk position of the organization, intepret it and
quantify it in to capture the actual magnitude of the risk.
• How the cotton futures market works and the mechanics of the
contracts for futures and options
• Understanding the difference between the physical & financial
market
• How to manage a market account
PREREQUISITES
•
•
•
•
•
Commercial and administrative strength within an organization
Management with sufficient autonomy to make decisions
Availability of timely information on internal business
Sufficient Volume
Good understanding of the local cotton market in order to analyze basis risk
For more information please
contact
www.itf-commrisk.org
or [email protected]
or [email protected]