Opinion & Analysis

How millers can gain from futures market

Investing in futures by millers is one way that companies can benefit from price seesaws. FILE PHOTO | NMG
Investing in futures by millers is one way that companies can benefit from price seesaws. FILE PHOTO | NMG 

In May this year, the government spent as much as Sh6 billion subsidising maize price to cool the rising cost of unga.

Poor rainfall during March-April-May long rains season pushed the price of a two-kilogramme packet of maize flour to Sh150, up from Sh90 last November – helping to raise inflation to 11.48 per cent in April, the highest rate since May 2012.

And because the government had to keep a tight lid on prices to avoid political upheaval, it bust a fast move; 750,000 bags were released to millers at 33.3 per cent discount to the market price of Sh4,500 per kilogramme.

But this got me wondering; what if the government hadn’t subsidised? Would millers have secured lower prices for the country?

The straight answer is yes. But how? Through futures markets. And here’s how the trade would have played out.

But first let’s get some basics. A white maize futures contract on the JSE (Johannesburg Stock Exchange) consists of 100 metric tonnes with an initial margin requirement of 20 per cent—the amount of money that is required to open a buy or sell position on a futures contract.

Hedging/expiry months are set in March, May, July, September and December.

Now, by the start of January, white maize futures in South Africa had already plunged by 12.3 per cent from their December 2016 highs (Sh32,925 per tonne), after much-needed rain suggested good conditions. From the trade set up, going short (selling a position to buy it back later) would have been an obvious trade.

Assuming the Kenyan miller entered the same trade, “selling” 750,000 bags of maize (an equivalent of 67,500 tonnes or 675 futures contracts) for the March 2017 delivery at the prevailing price of Sh27,561 per tonne in January, they would have profited immensely.

This is because maize spot prices dropped by about 50 per cent to Sh13,334 per tonne yielding the contract a handsome profit of Sh960 million.
Remember, without the subsidy programme, the same number of bags would have cost the millers Sh3.3 billion (Sh4,500 x 750,000), instead of Sh2.3 billion (Sh3,000 x 750,000).

However, with the tidy profit, the average cost would be 28.5 per cent lower or Sh2.4 billion when the futures profit is subtracted from the unsubsidised cost. Notice something; the end price falls as if the government had subsidised it – recall the 33.3 per cent government discount.

What’s more, at 20 per cent initial margin, the price of initialising the trade is only at 15 per cent of the notional value.

In other words, instead of laying out the whole of Sh1.86 billion, only Sh372 million would be required.

Even with a 50 per cent initial margin, only Sh558 million or 39 per cent of the notional value will be needed to make the wager. That’s the power of leverage. 

In the end, with the help of the futures market, price per packet of maize flour would have fallen at least to Sh107.5, a step closer to the desired price of Sh100. My point; to guard against exposure to exogenous factors, millers can take the futures route.