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HOW THE ORANGE JUICE FUTURES MARKET IS USED AND WHAT’S DIFFERENT ABOUT IT

Allen Morris

Commodity Futures Markets

A futures contract is an obligation to deliver (if sold) or receive (if bought) a commodity in a future time period at a specific price. The contract also specifies the future month for delivery, the quantity of the commodity and measures of its quality or grade. However, only a small percentage of futures contracts sold end in delivery. By contrast, a cash market is the market created by the physical buying and selling of the commodity.

One of the most important aspects of commodity futures markets that enable effective risk management is that prices for futures contracts and cash prices for the physical commodity are highly correlated. This is because of market forces that equalize futures and cash markets. For example, if futures prices are lower than cash prices, when adjustments are made for quality specifications, storage time, delivery location and any other differences, traders will buy the commodity on the lower-priced futures market and sell it on the higher-priced cash market to make a profit. The buying pressure pushes the low futures prices up and the selling pressure pushes the high cash prices down. The reverse trading happens if futures prices are too high relative to cash market prices. This process is called convergence, and is similar to arbitrage, which is buying and selling that equalizes two cash markets for a commodity, net of their cost, location, and/or quality differences. In most futures and spot cash markets, this is efficient enough that the markets equalize without requiring actual delivery on the futures obligation. The difference in cash and futures markets is called the “basis,” and in efficiently functioning futures markets is mostly the result of differences in quality specifications, storage time, and delivery location.

Since futures and cash markets are so closely related to each other, very few futures contracts are actually held until delivery. Most positions are reversed, i.e. purchased contracts are sold and sold contracts are bought, prior to delivery. The cash market is the true means of commercial purchase and sale of product and the futures market is used as a “risk hedge” against cash market price moves. For example, if in August a producer wishes to sell his commodity in January, he can sell January futures. Then in January when he is physically selling his commodity on the cash market, he can buy back (reverse) his futures contract. Since the futures and cash markets are so closely related, this makes the producer a seller (of cash) and buyer (of futures) during the same time period. Any adverse price moves that might happen to him as a seller are offset by benefits he receives as a buyer, and vice-versa. Since he has established opposite but equal positions as both buyer and seller, he has “hedged” his price risk, thus the term hedging. A processor who wishes to buy a commodity in some future time period can hedge his risk by

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buying futures contracts for delivery in that time period, similarly making him both a buyer and seller when he sells the futures contracts as he is buying the cash commodity. Hedging is the process that enables the producer and the buyer to establish a forward price for their commodity. Hedging with commodity futures, then, is simply a means to meet a forward commodity price objective. If making a net profit from trading futures plays any role in the trading decision of a cash buyer or seller, he is a speculator, taking the risks that hedgers seek to avoid.

Speculators are not concerned with hedging adverse moves in commodity prices. They are simply concerned with buying and selling futures contracts to make a profit. Speculators are critical to the effective functioning of a futures market because they bear the price risk that hedgers seek to avoid, and they help equalize futures and cash markets via arbitrage.

Other than shifting risk from hedgers to speculators, another important function of commodity futures markets is price discovery. In this role, futures markets create large competitive markets of buyers and sellers whose collective information about supply and demand conditions for a commodity far exceeds that of any single buyer or seller. This large number of buyers and sellers and their numerous purchase and sale transactions usually provides an objective and competitive valuation of commodities.

The Frozen Concentrated Orange Juice Futures Market

Overview

Note: An NFC futures contract was approved by the exchange in 2006, but it (predictably) died a year later because of lack of liquidity. NFC price risk can be managed using FCOJ futures since both are orange juice. The price difference between the two, mostly storage and shipping costs, simply becomes part of the basis in a hedging strategy.

An FCOJ futures contract is for 15,000 pounds of solids, USDA Grade A, not less than 62.5 brix, 14-19 ratio, and 94 score. In addition to the United States, an FCOJ futures contract may contain juice from oranges produced in Brazil, Mexico, and Costa Rica. Contract months are January, March, May, July, September, and November. FCOJ futures contracts trade 18 months out, but similar to other commodity futures contracts, the nearest three contract months have the most liquidity. The nearby month expires on the 15th business day from the last business day of the month, and the next contract then becomes the near month. Trading hours are 8:00 AM – 2:00 PM, New York time. Delivery of an FCOJ futures contract may be made at exchange licensed warehouses (tank farms) located in Florida, Delaware and New Jersey.

Similar to all commodity futures hedging, FCOJ futures hedging can be broadly categorized into two basic types: buying hedges to protect the risk of un-priced product to be purchased and selling hedges to protect the known value of product already owned or being produced. A buying hedge is called a long hedge, since buyers of futures are considered “long” a futures

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position, while a selling hedge is called a short hedge, since sellers of futures are considered “short” a futures position. Exhibits 1 and 2 provide examples of basic buying and selling (long and short) hedges using FCOJ futures. Exhibits 3 and 4 provide examples of the impact of incorrectly predicting the difference between cash and futures, the basis, at the time a hedge is lifted on achieving the desired amount of price risk protection.

Exhibit 1. Futures Buying Hedge Example.

Price risk of un-priced FCOJ to be acquired. Price objective: $1.50 In September, a processor decides he must purchase FCOJ in January for no more than $1.50 per pound solids. The processor fears that a potential freeze creates undue risk for this objective. Assumptions: 1. Cash price will be $.10 above futures price at time the hedge is lifted (basis is $.10 over) 2. Forward pricing objective is $1.50 Cash Price Increase Scenario Futures Cash Basis Sep. Buy Jan Contract at $1.40 $1.50 $.10 Jan. Sell Jan Contract at $1.60 $1.70 $.10 +$.20 -$.20 Effective Price: $1.70 - $.20 = $1.50; The buyer paid $1.70 for the cash product, but the futures profit of $.20 made the effective price $1.50, the buyer’s objective Cash Price Decrease Scenario Sep. Buy Jan. Contract at 1.40 1.50 $.10 Jan. Sell Jan. Contract at 1.30 1.40 $.10 -$.10 +$.15 Effective Price: $1.40 - $.10 = $1.50. The buyer paid $1.40 for the cash product, but the futures loss of $.10 brought the effective price to $1.50, the buyer’s objective

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Exhibit 2. Futures Selling Hedge Example. Price risk of priced FCOJ stored in inventory. Price objective: 1.57 A processor owns FCOJ that he has paid $1.57 for. He fears that a large Florida orange crop in the coming season may lower concentrate prices, reducing the value of his inventory. Assumptions: 1. Cash price will be $.12 above futures price at time the hedge is lifted (basis is $.12 over) 2. Desired price protection is $1.57 Cash Price Increase Scenario Futures Cash Basis Jul. Sell Jan Contract at $1.45 $1.57 $.12 Jan. Buy Jan Contract at $1.70 $1.82 $.12 -$.25 +$.25 Effective Price: $1.82 - $.25 = $1.57; The seller sold the cash product for $1.82, but the $.25 futures loss made the effective price $1.57, the seller’s objective. Cash Price Decrease Scenario Futures Cash Basis Jul. Sell Jan. Contract at 1.45 1.57 $.12 Jan. Buy Jan. Contract at 1.30 1.42 $.12 +$.15 -$.15 Effective Price: $1.42 + $.15 = $1.57. The seller sold the cash product for $1.42, but the $.15 futures profit made the effective price $1.57, the seller’s objective.

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Exhibit 3. Example of Futures Buying Hedge Example Where Basis is Larger Than Predicted Price risk of un-priced FCOJ to be acquired. Price objective: $1.50 In September, a processor decides he must purchase FCOJ in January for no more than $1.50 per pound solids. The processor fears that a potential freeze creates undue risk for this objective. Assumptions: 1. Cash price will be $.10 above futures price at time the hedge is lifted (basis is $.10 over) 2. Cash price is really $.20 above futures (basis is $.20) at time hedge is removed, rather than $.10 as was predicted Cash Price Increase Scenario Futures Cash Basis Sep. Buy Jan Contract at $1.40 $1.50 $.10 Jan. Sell Jan Contract at $1.60 $1.80 $.20 +$.20 -$.30 Effective Price: $1.80 - $.20 = $1.60; The buyer paid $1.80 for the cash product, but the futures profit of $.20 brought the effective price to $1.60, $.10 above the buyers objective, the amount that the basis changed unpredictably. Cash Price Decrease Scenario Sep. Buy Jan. Contract at 1.40 1.50 $.10 Jan. Sell Jan. Contract at 1.30 1.50 $.20 -$.10 +$.00 Effective Price: $1.50 + $.10 = $1.60. The buyer paid $1.50 for the cash product, but the futures loss of $.10 brought the effective price to $1.60, $.10 above the buyer’s objective, the amount that the basis changed unpredictably.

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Exhibit 4. Example of Futures Selling Hedge with Basis Smaller Than Predicted Price risk of priced FCOJ stored in inventory. Price objective: $1.57 A processor owns FCOJ that he has paid $1.57 for. He fears that a large Florida orange crop in the coming season may lower concentrate prices, reducing the value of his inventory. Assumptions: 1. Cash price will be $.15 above futures price at time the hedge is lifted (basis is $.15 over) 2. Cash price is really $.10 above futures (basis is $.10 over) at time hedge is removed, rather than $.15 as was predicted Cash Price Increase Scenario Futures Cash Basis Jul. Sell Jan Contract at $1.42 $1.57 $.15 Jan. Buy Jan Contract at $1.80 $1.90 $.10 -$.38 +$.33 Effective Price: $1.90 - $.38 = $1.52. The seller sold the cash product for $1.90, but the $.38 futures loss made the effective price $1.52, $.05 below the seller’s objective, the amount that the basis changed unpredictably. Cash Price Decrease Scenario Futures Cash Basis Jul. Sell Jan. Contract at 1.42 1.57 $.15 Jan. Buy Jan. Contract at 1.30 1.40 $.10 +$.12 -$.17 Effective Price: $1.40 + $.12 = $1.52; The seller sold the cash product for $1.40, but the $.12 futures profit made the effective price $1.52, $.05 below the seller’s objective, the amount that the basis changed unpredictably.

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The Realities of Hedging with FCOJ Futures

Most cash orange juice transactions are between the largest four or five sellers and the largest four or five buyers. And they tend to be with forward contracts with volume, and often weeks or longer before delivery of product, price commitments. If the cash price is established for several weeks or longer prior to product delivery, each day’s largely unpredictable fluctuation in the futures price during this period is an equally unpredictable fluctuation in the basis. Moreover, an adverse weather forecast or some other unexpected event impacting supply or demand can cause large (unpredictable) changes in futures prices and thus in this case, the basis. These buying and selling commitments protect both buyers and sellers in an industry where two countries and 8 – 10 firms account for the majority of the commodity bought and sold, but they leave little to no room for the buyer and seller to opportunistically trade physical product in a large, heavily traded spot cash market, which is why one doesn’t exist. This absence of a large, daily traded spot cash orange juice market significantly limits market forces to enable convergence, which is one reason the FCOJ futures to cash basis is more difficult to predict than in many futures markets.

In order for a long hedge to effectively protect the price risk of a commodity to be bought, the selling price of that commodity must be known, or fixed through a forward sale. If the selling price is not known or fixed and is highly correlated with the price of the commodity used to make that final product, long hedges will often not be effective. This situation largely applies to brands and private label (end users). For example, if an end user bought futures to protect the price of raw product to be acquired, then both the raw product (including futures) and retail prices for the final product declined, the end user hedger would have a futures loss with no offsetting cash gain.

As it turns out, another difference between FCOJ futures and many other markets is that retail orange juice price changes are highly correlated with changes in bulk orange juice and even orange prices (Exhibits 5 and 6). That’s because the orange juice brands can raise their selling prices when fruit prices increase significantly, and they must ultimately lower their retail prices if fruit prices decline substantially. This doesn’t happen with products like cereals or soft drinks to anywhere near the degree it does with orange juice. The reason for this is that raw fruit prices are a much larger percentage of the retail orange juice price than, for example, wheat is of cereal prices or sweeteners are of soft drink prices. For example, wheat is only 6 percent of the prices of cereals and bakery products and sweeteners are less than 4 percent of soft drink prices. That is the reason that the retail prices of bread or soft drinks no longer fluctuate with wheat or sweetener prices, although record swings in these commodity prices, such as occurred as a result of crops being diverted into ethanol production, can impact retail prices somewhat.

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Although between the 1980s and the 2000s, orange prices declined from 37 to 25 percent of retail OJ prices, and this decline led to a one year lag in the correlation between changes in orange and retail prices, orange prices are still a much larger percentage of retail OJ prices than these other commodities. While this phenomenon has only contributed to a one year lag between OJ and orange prices, if oranges continue to become a smaller component of OJ’s cost of goods, the correlation between orange and retail prices will decline no matter what lag period is used. When/if this happens, long hedges will be more effective for un-priced bulk OJ to be acquired and growers will bear even more of the risk of price volatility in the citrus industry than they do now. Unfortunately, citrus growers do not have federal price support programs to protect them like sugar, corn and wheat growers have. What this means is that the OJ end users cannot use the FCOJ futures market as effectively as bulk processors to hedge their commodity price risk. But then with the ability to change their selling prices in response to changes in fruit and bulk juice prices, they do not need to. However, with the longer lag time between changes in retail and fruit prices, the effectiveness of hedging using FCOJ futures should be improving for these end users.

Since oranges are not deliverable against a hedge, using FCOJ futures to protect orange prices is called cross-hedging. Unless a processor gives the grower a futures-based fruit price, which means that the basis is fixed contractually, cross hedging for a grower can be unnecessarily risky. However, some fruit dealers who are experienced futures traders do effectively hedge orange purchases and sales, using both FCOJ futures and options.

The FCOJ futures market, then, is a market where the end users have little incentive to use it for buying hedges to protect price risk of un-priced raw product and limited ability to do so, and that offers limited-to-no opportunity for market forces to converge cash and futures markets. The result is a futures market much more thinly traded than traditional commodities like sugar, corn or wheat, heavily influenced by speculators, that isn’t always a reliable short-term price discovery mechanism and one with a basis that is difficult to predict. However, pricing mechanisms, called Exchanges of Futures for Physicals” have evolved that enable buyers and sellers to mitigate the unpredictability of this basis in many situations.

Exchanges of Futures for Physicals

An exchange of futures for physicals, or EFP, is a transaction where buyers and sellers of futures contracts are also buyers and sellers of the physical (cash) product. The parties agree on where delivery of the product will be made, a delivery schedule, juice quality specifications, and most importantly, the basis to futures prices. For example, an EFP may be for 96 score Valencia concentrate, 12-12.3 brix, 15-17 ratio, bacteria less than 200 CFU/ML, delivered to Citrusco’s Lake Wales plant at the rate of 12 tankers per day from May 7 – 10, at $.20 over May FCOJ futures. If it is for NFC, it would obviously be at a basis considerably above $.20 over. This would be 32,000 lbs. solids X 48 tankers / 15,000 lbs. solids per futures contract = about 102

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futures contracts of concentrate; or 5,500 gallons NFC X 1.047 (12 brix) X 48 tankers / 15,000 = about 18 futures contracts. Each party must have open futures contracts for this transaction to work. An intriguing aspect of an EFP is that the buyer and seller can each have very different prices.

Assume that between March and September, cash concentrate prices decline from $1.95 to $1.45 per lb. solids and futures prices decline from $1.85 to $1.30. When futures prices began to decline, on June 1 the seller sold 100 November futures contracts at $1.65 to hedge against further price declines. On September 15, the buyer (an OJ brand) purchased 100 November contracts at $1.31 to lock in this price, fearing that a low October crop forecast would drive prices back up. However, the October crop forecast was in line with expectations and futures and cash prices remained firm.

The buyer contacts his futures broker to find out if there is a processor who has a short futures position that would be interested in delivering product with an EFP and tells the broker the specs he needs. The broker has such a seller. They agree on $.10 over November futures as their price, do the transaction, and their broker notifies the commodity futures exchange which cancels delivery and/or contract reversal obligations of the buyer and seller by “crossing off” their contracts. The buyer’s actual purchase price is $1.31 + $.10 = $1.41. The seller’s actual selling price is $1.65 + $.10 = $1.75. The cash market remains at $1.45. The buyer and seller were able to transfer favorable positions in the futures market to a favorable cash transaction for the physical product, thus the term “Exchange of Futures for Physicals.”

An EFP transaction entails establishing an EFP price and an invoice price. The EFP price can be set arbitrarily because it has no effect on the buyer’s and seller’s actual transaction prices. It is needed only for the futures exchange to use when crossing off contracts on their books. But the invoice price is needed to facilitate the actual purchase and sale of the physical product. The invoice price must be the EFP price plus or minus any premiums or discounts to futures agreed upon by the parties. Exhibits 7A and 7B show EFP transactions with EFP prices at both ends of the example cash price swing. The buyer’s and seller’s actual prices remain the same.

Factors affecting EFP premiums include whether it is NFC or concentrate, quality specifications such as color, flavor, ratio, overall score, fruit variety; delivery location; delivery schedule, storage time, payment terms and a number of other things. Anything that the parties agree is correlated with FCOJ futures can be priced using EFPs. When I was at Tropicana, I even bought oranges a few times with an EFP pricing mechanism. What an EFP does is set the futures-to-cash market basis contractually, which mitigates the risk of its unpredictability.

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Exhibit 7A. Use of Exchange of Futures for Physicals

Example A. EFP Price is $1.45

Buyer’s Transaction Buyer’s purchase of November futures $1.31 EFP price (crossed off as futures sell) 1.45 Buyer’s futures profit .14 Invoice Price for cash transaction 1.55 (EFP price plus $.10 premium) Adjusted for futures gain -.14 Buyer’s actual price 1.41 Seller’s Transaction Sellers sale of November 1.65 EFP price (crossed off as futures buy) 1.45 Seller’s futures profit .20 Invoice price for cash transaction 1.55 Adjusted for futures gain +.20 Seller’s actual price 1.75

Cash market price $1.45

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Exhibit 7B. Use of Exchange of Futures for Physicals

Example B. EFP Price is $1.95

Buyer’s Transaction Buyer’s purchase of November futures $1.31 EFP price (crossed off as futures sell) 1.95 Buyer’s futures profit .64 Invoice Price for cash transaction 2.05 (EFP price plus $.10 premium) Adjusted for futures gain -.64 Buyer’s actual price 1.41 Seller’s Transaction Sellers sale of November 1.65 EFP price (crossed off as futures buy) 1.95 Seller’s futures loss .30 Invoice price for cash transaction 2.05 Adjusted for futures loss -.30 Seller’s actual price 1.75

Cash market price $1.45

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Limitations to Exchanges of Futures for Physicals Typically, an EFP occurs when a seller with a short futures position seeks a buyer who already has a favorable long position or can readily put one in place, or vice-versa with a buyer seeking a seller. If the parties agree on a premium to futures before either or both have a futures position, such as in a multi-year contract or too far in advance for enough market liquidity to get a position on, the premiums to futures agreed upon (the basis), may not work because the basis established by market forces may change between the time the parties agree to it contractually and the time the futures positions can be put on. So EFPs tend to be opportunistic pricing mechanisms. They have improved FCOJ futures market volume and open interest (futures positions not yet reversed) somewhat, but FCOJ is still a thinly traded market, part of which is also due to the fact that the orange juice market is not as big as other food markets like cereals and soft drinks.

Exhibit 8. Delivery and Carrying Costs for FCOJ Futures Contracts Costs in $ per Contract (15,000 Lbs. Solids) Taking Delivery, Carrying for Taking Delivery 2 Months and Redelivering Broker Commission – in 20.00 20.00 Broker Commission – out 20.00 Handling out1 250.00 0.00 Storage2 450.00 600.00 Interest3 4.19 4.97 Total cost 724.19 644.97 Total cost per pound solids $.0483 .0430 1 One-half of handling in and out fee

2 1.5 months storage at $300 per month

3 Interest of 4.75% per year, compounded monthly on commission, handling and 1.5 months storage costs. Interest on value of juice is not included. Source: Intercontinental Exchange (ICE)