Grain swaps have been a popular marketing tool for farmers and traders over the years.
On the surface, these are relatively easy products to use and - in many cases - can be very valuable selling tools.
There are many dynamics around entering swaps and the potential benefits. But sometimes their use is far from straightforward.
Digging into the farm business may be needed to determine an individual grower's requirements and risk profile.
There should also be an understanding about whether the broader market environment appears favourable for swap products.
A swap typically involves selling - or buying - a futures contract on another exchange and converting it into Australian dollars.
For example, with wheat, a typical swap product would involve selling a Chicago Futures contract and converting it to Australian currency to obtain a local wheat price.
The process is simple enough, but it is not without risks.
Multiple factors should be considered prior to entering into swap products.
These include the individual farmer's risk profile, local conditions, production risks and local market dynamics, which include considering the factors driving local values.
Assessment of global market relativity is important and involves looking at how Australian values compare with global values.
Global market dynamics are another factor, along with the key drivers of these factors.
This is a broader risk discussion, but it is essential to determine if swaps are appropriate from a risk perspective.
The key driver for using swap products is typically to mitigate local production risks.
Forward selling physical grain in dry seasons can leave farmers vulnerable to market volatility.
Recent seasons in Australia have highlighted this point very clearly.
The 2018-19 and 2019-20 domestic grain seasons were notable for severe drought conditions across much of the east coast.
This decimated grain production, created significant domestic supply issues and led to a surge in local grain values.
In these seasons, Australian domestic premiums traded well above global benchmarks to such an extent that sizeable volumes of grain were shipped from Western Australia and South Australia to east coast ports to cover our domestic deficit.
The local market dynamics in those two seasons were ideal for farmers to use swap products, as local prices outpaced global values.
This enabled farmers to have some sales in place and mitigate some of the local production risks.
They were subsequently able to maintain exposure to local market strength driven by the east coast drought conditions.
Conditions in the 2020-21 season resulted in Australian crop production returning "in style".
There was a substantial rebound to record levels across parts of the east coast, and this was a fantastic result for grain farmers - and the overall Australian grains industry.
The main downside was a weakening of grain values in Australia relative to global values.
The 2021-22 season is also shaping-up nicely.
There were some favourable conditions during the early part of this season, resulting in domestic values lagging behind global markets.
The local market dynamics in place last year are again unfolding this season, and are quite the opposite to the 2018-19 and 2019-20 seasons.
These conditions are not necessarily bad for swap products, but the market structure is different and bears examination.
Australian crop production is ticking along quite nicely so far in 2021.
But the global balance sheet appears to be tightening significantly, which elevates the risks associated with swap products to some degree.
Global market dynamics are changing.
Much of this has been due to production losses inflicted across the major exporting zones of Russia and North America.
As well as losing about 18 million tonnes of production, there have also been some quality issues in Europe.
This has further tightened the supply of milling wheat across the major exporters.
As a result, global wheat values have been driven higher and widened the spread to prices in Australia.
Adding further fuel to the fire is Russia, which is the world's biggest wheat exporter, imposing a floating export tax.
This has completely distorted export values in the region and, in many respects, mostly taken Russian exports out of play.
A healthy supply of wheat still exists in Russia, but it is not realistically available for the market today.
The market dynamics in North America warrant particular attention for swap sellers.
When there are significant production issues in this region, risks will elevate due to the majority of swap products being traded via the Chicago Futures Exchange.
A tight balance sheet in the US market creates a situation where the US futures markets can trade for an extended period at elevated levels.
This can skew the value of swap products, and add significant unwanted risk in extreme situations - such as occurred in 2008.
The US and Canada have collectively lost 13.5 million tonnes in expected wheat production since the US Department of Agriculture's June World Agricultural Supply and Demand Estimate (WASDE) report.
This has tightened likely domestic stocks to multi-year lows.
The global market is trying to understand if there is a need for extra US exports to cover a potential shortfall in global milling wheat stocks.
This equation is far from clear, as global demand is yet to be fully determined.
But there are risks at play, and it is likely the market will trade cautiously.
US futures values can remain high for much of the season, or until we get more clarity about global demand.
The bottom line here is that risks have increased for swap sellers this season.
Global wheat values have rallied sharply in the past six weeks.
Australian values have also rallied, but we are noticeably lagging behind the global market.
The sudden rally in wheat values has caught many global consumers by surprise.
It will take time for the market to adjust to these higher values, or to start rationing elastic demand.
The challenge for swap sellers today is that the global market has not yet found equilibrium, and risks can remain elevated for some time.
Global wheat demand remains unclear.
This will ultimately determine how tight we get for global stocks, and where wheat values will need to trade to balance supply.
If global milling wheat demand remains strong against tightening supply, there are upside risks for wheat markets.
Ultimately, futures prices can easily out-perform physical markets in a bull market and create additional risks for swap sellers.
So, in the current environment, some caution is warranted.
- Note, this information is of a general nature only and should not be regarded as specific to any particular situation. Readers are encouraged to seek appropriate professional advice based on their personal circumstances. There is significant risk associated with trading futures and derivative products.
