When you introduce a Futures contract to an agricultural cash market you suddenly have the ability to solve problems long considered a fixed part of the business. It is the hedging capability that adds a new dimension. Otherwise a supplier must add in his risk to provide fixed prices.
When you remove the risk, by hedging, then the supplier has less risk and his quotes can be tighter. Futures markets are typically available only for the large commodities like grains, energy, metals and the larger soft commodities like coffee and FCOJ. Those industries today couldn’t operate without using Futures because their risk mitigation capability enables companies to operate with tighter margins. For a small commodity like Apple Juice Concentrate (AJC) the Futures contract that was recently launched is a luxury, enabling the industry to solve problems they couldn’t consider in the past.
For European AJC processors, meeting the requirements of brands and private label juice sellers for fixed prices that cover a complete season (year) is difficult because they haven’t yet bought all of their juice apples. The result is higher AJC pricing that factors in the risk of higher juice apple prices. Growers on the other hand have never considered many marketing strategies for their juice apples because most are a byproduct of the fresh apple market. They get priced as they don’t make the grade in packing houses.
New AJC Futures Contract
In late 2012 the MGEX, working with the AJC industry, launched a new AJC Futures contract to help hedge price risk. This can serve as an index for the value of juice apples. The idea is that since the destiny of juice apples is to be juice, there is an inherent price relationship between the value of the juice apples and AJC.
How could this be applied to EU juice apple contracting?
The contracting idea is to index the value of juice apples to the AJC Futures market, enabling forward contracting of juice apples without fixing the price. The juice apples are contracted at an agreed upon discount (or Basis) to AJC Futures based on current equivalent pricing. Once the contract is in place, buyers or sellers price their apples in advance of delivery by buying or selling AJC Futures. Invoice prices are determined when the juice apples are delivered to the buyer based on current values of Futures at that time, less the Basis. At time of delivery the Futures are closed out reflecting a gain or loss on Futures for any price movement.
The first step is to establish the price relationship between the local juice apples and AJC Futures prices. You would expect that the difference is essentially the cost of processing. To make this comparison we convert the value of juice apples to the price of AJC based on the typical yield. For example, a typical yield might be 29.7 gallons AJC per metric ton of apples. In August, Polish juice apples trading at PLN.24/kg equated to USD2.11/gallon of AJC. This was at a time that AJC Futures were trading at USD5.05/gallon, a difference of about USD2.94/gallon. We call this difference the Basis. Charts of pricing and the Basis follow.
‘The contracting idea is to index the value of juice apples to the AJC Futures market, enabling forward contracting of juice apples without fixing the price.’
Once the contract is in place the buyer could purchase Futures, effectively locking in a price for the juice apples and eliminating any risk of higher raw material costs in the contract with their private label or branded customers. If prices of juice apples increased due to a rising Futures price, the buyer would realize a corresponding gain in their Futures position. This would solve the problem for EU AJC processors described earlier.
Benefits and trade-offs for Processors and Growers
Note that the trade-off for both parties is that they are disconnecting their pricing from their local market and indexing to the world price for AJC.
The benefit to end users/processors is that they can fix their costs on product that is already sold. The benefit for growers is that this gives them the ability to price their juice apples in advance, using their own timing, based on their market outlook, but prior to delivery.
The chart below illustrates Polish juice apple prices in PLN/kg, the local currency, and the prices are probably familiar.
The second chart illustrates converting the juice apple price to USD/gallon equivalent AJC and then comparing the resulting value of juice apples to US AJC prices historically. While juice apple prices are more volatile than those of AJC, the relationship is unmistakable.
The Basis is simply the difference between the juice apple value and the US AJC value. For contracting Futures Based we compare juice apple values with AJC Futures prices since 2012, our 3rd chart. The average differences for each season are surprisingly similar. This simply underlines the reality that there is a cost of processing that does not vary as much as the price of apples themselves.
‘For the supplier (grower) it is about maximizing the value of their juice apples….For the supplier (grower) it is about maximizing the value of their juice apples…’
The reason for defining a Basis is that it is necessary when contracting between a supplier and buyer. The Basis is the only pricing element that is negotiated. Usually the understanding begins with establishing current equivalent pricing (from the apple price in PLN/kg to a price that is converted to USD/gallon) and factoring in expectations for the season, or even costs of storage.
So, why go to the trouble? For the buyer (processor) it is about minimizing risk and providing the most competitive quotes to their customers. For the supplier (grower) it is about maximizing the value of their juice apples with the ability to fix the value in advance of delivery. In other words, this may be a better way for both sides to contract. Each is able to benefit in ways not available previously.
Kevin Barley, Futures Specialist, Morgan Stanley
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