COTTON PRICE RISK MANAGEMENT

Africa – EU Cotton PartnershipSeptember, 2007

Roy ParizatCommodity 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

• 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

LESSONS LEARNED

RISK ASSESMENTRisk 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 BuyerDate

ContractedPrice Level in

Tsh/KgPrice Level

equiv in $/kgsVolume in Kgs Jun July Aug Sept

Kgs Seed CottonBoughtKgs Cotton Lint EquivalentKgs Cotton Lint SoldNet Position (Kgs) - throughout the seasonPre-Orders / Forward Sales Agreed - Still Outstanding

1. Risk Position (in Kgs)

RISK ASSESMENTRisk 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)

-3000000

-2500000

-2000000

-1500000

-1000000

-500000

0

500000

1000000

1500000

2000000

Jun July Aug Sept Oct Nov Dec Jan Feb Mar April

Month

Kg

s C

ott

on

Lin

t

True net position(Kgs) includingforward sales -assumed

Cotton Lint Sold(Kgs)

Cotton StocksPurchased (Kgs)

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 TshCosts (various costs of production and transport) (Tsh/Kg) 142Purchase Price - seed cotton (Tsh/Kg) 405Breakeven price for 1kg cotton seed (Tsh/Kg) 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

- 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 .

Risk Management

Back to Back Sales

Structured Finance with Inventory as Collateral

Export Sales with minimum price

guarantee

NYBOT Options Contracts

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)

• 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

RISK MANAGEMENT EDUCATION

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.orgor royparizat@hotmail.com

or jdana@worldbank.org