The Fudge Factor in Canadian Price Discovery: Market Structure is Key

Volatility1    I am land leveling these days.  It is one of my favorite jobs.  There’s not a lot of time pressure at this time of year and I can sit in my tractor and listen to my satellite radio through my noise canceling headphones.  Almost 100% of the time I am locked and loaded on the business channels coming out of the United States.   I simply enjoy all of the economic bickering.

So today when stock trading was stopped on the NASDAQ exchange there was a little bit of paralysis going through the market.  Analysts were getting panicky and people were talking about the lack of price discovery.  It took about 3 hours but stocks started to be traded again.  In the meantime anybody that was long or short a stock or had any position at all was in a bit in a tizzy.  I thought it was just delicious, because price discovery is something I think deeply about.  In our modern world of frequency trading, a software glitch can make all of that go awry.

We have seen some of that in the past with grain futures prices.  I suppose the spectre for a hiccup in the grain pits at the Chicago Mercantile exchange would cause the same type of angst in agricultural circles.   With most trading done electronically now, the visit to the trading floor at the exchange is fairly quiet.   I really enjoyed my visit there last summer.  That’s where the rubber hits the road with regard to price discovery and it’s something that I believe Canadian agriculture almost completely ignores.

Price discovery here in Canada is done in far away places.  We add basis values to those prices garnered in Chicago.  Yes, we also had basis values to canola prices, which are generated in Winnipeg.  As an Eastern Canadian farmer, we don’t even think about the Winnipeg exchange with regard to generating our grain prices.   Adding or subtracting a basis value from grain traded at Chicago has always been our reality.

I used to think that was a real problem for Canadian agriculture.  However, I don’t feel that way as much anymore because I understand the nuances of grain pricing across North America.  In my mind, basis values are the lubrication of grain movement anywhere.  So give me a futures price and give me a basis and that does it for me.  However, I have learned over the years that basis has many calculations, but one of the largest factors included in basis for grain is the fudge factor.  Nobody can ever seem to figure that one out.

The fudge factor in any basis calculation has to do with market structure.  For instance any market gets its prices from the nature of that market.  That has to do with the size of the market as well as the number of end users and suppliers in the market.  It also has to do with export markets and a host of other factors.  Volume is always key and sometimes the lack of can be very telling.

Take the Ontario corn market for example.  Traditionally, Ontario uses more corn than it produces.  However, that is changing and in 2013 there is still 2 months supply of old crop corn in bins going into September. So that adage is almost over with.  It looks now that Ontario produces much more corn than it needs.  It has led to a situation where Ontario for the last 2 years has had some of the cheapest corn in North America.  This differs from somewhere like Decatur Illinois, which in its surrounding five-county area would produce a lot more corn than many countries.  Needless to say, basis values at times are a dollar higher than Ontario values.  The reason for this is simple.  The Ontario market structure is such where that is all end users have to pay to get their corn.

Corn is one example in Canada but there are many others.  The fudge factor is bigger or smaller depending on the market structure.  The more end users we have the better it is for farmers.  On the contrary if we export everything, we can’t expect to get many breaks.  Our supply-managed industries realized that many years ago.

So never negate the concept of market structure and price discovery.  They go hand-in-hand especially in Eastern Canada.  That’s partly because of our history pricing grain in Chicago and our concentration of supply managed agricultural commodities.  Needless to say, we’ve got some work to do.  We’re a long way away from a software glitch shutting down price discovery. Our prices simply present themselves and for the most part we take them.