Swaps useful, but must be watched

The first tools that became available to Australian wheat growers in the late 1980s were put options traded against Chicago Board of Trade wheat futures. We could use them to protect us from a decline in global wheat prices well in advance of harvest.

They worked, because when there was a year-on-year decline in CBOT futures, our AWB pool returns also declined, by a similar amount. Buying put options early in the calendar year provided protection against the market being lower late in the year.

By 1991 we had a deregulated domestic market, with cash prices on offer during harvest. We soon learnt that those cash prices were driven by pool estimates, and that nearly every year final pool returns outperformed harvest cash prices. However, it did begin to open up a post harvest market, and direct deliveries to domestic end users.

In the early 1990s AWB introduced fixed price forward contracts. They provided an alternative to put options for securing a price base for the upcoming harvest. They could be combined with call options (basically an insurance against CBOT futures rising), to turn them into minimum prices, with upside open and downside protected.

We still have put options, call options and fixed price forward contracts available to us today.

The next big development was the offering of wheat swaps in Australian dollars. Swaps basically allowed us to lock in an Australian dollar CBOT wheat futures contract. They worked for two reasons. Firstly, there was a strong correlation between final pool returns and the $A value of CBOT futures around December and March, and daily forward prices were also strongly linked to CBOT futures values.

As an alternative to fixed price contracts, they performed particularly well, because of the weak basis embodied in forward contracts. Using a swap did not lock in that weak basis. Year after year basis improved, and those who used swaps instead of fixed price forward contracts achieved better final prices by $20 to $120 a tonne (the big gains were in drought years).

As a tool swaps can never be set and forget though. This year swaps appeared to be attractive once again, because of very weak basis embodied in forward contracts. The question now is whether those basis levels will improve by harvest or not. Swaps will only work better than fixed price contracts if they are unwound when basis levels have improved.

Most years that happens without needing to intervene. This year the exit strategy may need to be planned.