Hedging: The "Longs" and "Shorts" of It All

Several years ago, Ohio State University agricultural economist Carl Zulauf researched the question of whether producers were better or worse off using a systematic hedging system to price their hogs. He investigated the price received from habitually selling hogs on the futures market four or six months into the future and compared that to the price received if the producer simply sold on the cash market.

Zulauf's conclusions held no big surprises to veteran hog market observers and producers -- you got a lower price when you hedged.

There is a very good reason for that result. Someone else is taking a good portion of the risk when you hedge and you have to pay him or her to do it. But that raises the question: Why isn't there someone who actually wants to take the opposite position so we don't have to compensate them?

Which brought us to the point of just who might be natural short- and long-position holders in the hog futures markets. Of course, hog producers are natural "shorts." They have the physical commodity and in order to hedge, they need to take an opposite position in the futures market. By that reasoning, packers should be natural "longs" since they need the physical commodity (i.e. are short physical hogs) and would take the other side on the futures market. The same argument could be made for meat buyers who may be able to cross-hedge various wholesale cuts in the hog contracts.

But the reality of the situation is that packers did not hedge their hog needs often. The reason is that they are margin players. If hogs go up, they can push up meat prices to cover costs. It may take a few days or weeks, but they can eventually get that done.

This lack of long positions leads to packers frequently ending up in net short positions in the hog futures market because they systematically sell futures to manage the risk they take on when they do cash contracts with producers. The cash contracts make them long in physical hogs, so they become hog hedgers to manage that risk.

Bottom line: There were not many natural long position holders in hog futures and, thus, the shorts had to pay speculators to take the risk. As Milton Friedman pointed out: "There's no such thing as a free lunch."

Enter commodity index funds. Economic literature has for many years identified commodities as a useful component for balancing an investment portfolio because they tend to be negatively correlated with equities. Goldman Sachs initiated its commodity index in the early '90s as an investment tool that allowed portfolio managers to hold commodities without trading individual products or contracts. They got little traction until commodities started to take off in the late '90s.

The Goldman Sachs Fund and others are now a major force in commodity markets. Each fund is potentially unique in the products it buys, the proportions of different commodities or commodity classes that are held, and how they re-balance (never, frequently based on rules, actively managed, etc.). But one thing is consistent: They are long commodities. They own futures contracts because they think commodity prices will rise.

Having a natural long in the market is almost certainly good for pork producers. The funds actually want to be long and will probably do so without extracting a risk premium. I'm not aware of any formal research that has looked at whether this new natural long agent does, in fact, reduce the risk shifting cost of hedging hogs, but that result is certainly logical and would make a very good working hypothesis for a project

On the other hand, producers need to be aware of how the indexes operate in order to build effective personal strategies. The key issue is "the roll" -- when the Goldman (and many other funds) roll from being long in one contract to being long in the succeeding contract(s). This action puts downward pressure on the nearby contract and upward pressure on deferred contracts.

The Goldman index rolls on the 5th to the 10th business days of the month prior to expiration. Today, for instance, is the last day of the role out of June Lean Hogs and into July. There are other funds that are moving away from this time period by a few days on either side, since commodity volumes at the Chicago Mercantile Exchange (CME) basically double during the roll and it taxes the system somewhat. But this lengthening of the roll period will likely smooth the effect of the funds by spreading out the sell-buy activity.

So what does all of this mean to you?

First, be aware and watchful of your position as the roll period approaches. This month's roll has been rather uneventful from a price movement standpoint, but some can be pretty exciting, especially if cash markets are declining at the same time (i.e. January of this year). The buy side of the roll, though, may provide selling opportunities for producers.

Second, remember what you already know: New things can be good or bad, depending on your vantage point. Anecdotal evidence from cattle traders is that commodity funds have supported cattle prices by $4 to $7 over the past couple of years. Commodity fund ownership often exceeds 10% of cattle on feed. Such a positive price effect is great for feeders but hard on packer margins.

Third, realize that we do not have much solid research on the effect of the funds, especially on Lean Hogs. We think they have a positive impact; 50,000 to 60,000 long contracts have to affect the market, don't they? But I don't know of any hard and fast evidence at present.

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Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: steve@paragoneconomics.com