Durum pricing and risk strategies International Pasta Organization I.P.O. World Pasta Day 2007 Mexico City

1. Durum pricing and risk strategiesInternational Pasta Organization (I.P.O.) World Pasta Day 2007Mexico City By Dr. William W Wilson University Distinguished Professor North Dakota State University October 25, 2007 bwilson@ndsuext.nodak.edu

3. Topics Changes in world s/d for durum World North America Changes due to biofuels etc. Price relations Prices and spreads Risk and returns in production Risk in purchasing� Contracting Management Implications Implications of suppliers and marketers

4. 2007 Dramatic stories in world durum and pasta Mexico (and, recently, Nicaragua): Protesting over high tortilla prices Italy protests over increases in pasta prices Tunisia changes domestic durum prices� Venezuela: Import durum prices exceed break-even level for pasta US: Fairly sharp food price inflation Many countries Changing size of packages Blending and looking for alternative ingredients for pasta mfg. Expansion in pressure on non-traditional regions

6. Tunisia Due to the continuing increase �of prices of cereals on the international market and in order to rationalize �and take advantage of �the country's existing potential for field crops, on October 2, 2007, �President �Ben Ali decided to increase farmgate prices for cereals, as follows:Durum wheat �from $ 269/mt to $326/mt , i.e. a 22% increase�this the first time in Tunisia's history that increases of farmgate prices for cereals are announced before planting time. �Farmers have reacted very positively indicating that they will spare no efforts in investing what is needed to assure a very good grain crop next year.

7. Back doorIs there a legal way to cash in on the U.S. durum market? Several durum growers in southwestern Saskatchewan, who for obvious reasons wish to remain anonymous, are looking into whether there is a way to haul durum to Duluth, legally outside the Wheat Board monopoly. It is no simple task ��.. The Wheat Board�s latest pool return outlook � $11 after elevator and freight charges are deducted. It has been quoting export prices of around $19 a bushel at St. Lawrence ports but no one outside the Board knows whether any sales are being made at these levels. Last week elevators in North Dakota were offering $15.50�

8. World Durum Production World production has declined for 3 straight years Reductions in numerous producing countries and regions Most important are reduced production in: EU, Morocco, N.America, Syria, Turkey and Tunisia

9. US Durum Supply/Demand Longer-term production declines Escalation in imports Stocks: lowest level in recent history, declining since 1980

10. Canada: Durum Supply/Demand Reduced production for 2 years More volatile production in past 7 years Stocks to near lowest level in 20 years

11. Prices: No. 1 Mpls HAD Price Prices typically in the 200$/mt range 2007 has escalated to radically high values

12. Spread: HAD vs. Mpls HRS Futures Prices Longer term Typically, this spread is in the $50/mt range Recent escalation to 250$/mt + is unprecedented

13. Durum: Stocks/Use vs. Price Spread Inverse relation between stocks/use vs. price spreads Results do not capture 07 crop quality No experience at these levels making projections very difficult and risky Current trades exceed these values, suggesting current values are overpriced Current cumulative average spread for 2007/08 is $115/M Oct. 12, 2007 was $342/MT The forecast value for 2007/08 is $106/MT

14. Durum Price Risk and Changes in 2007/08 The distribution of spreads has shifted (increased) within the crop year This projection has a wide range and the probabilities of alternative values are shown The probability the premium <106/mt is .55 The probability the premiums>125$/mt is .10 Current trades are less than these values, suggesting current values are a good value relative to the projection. The probability the actual price will exceed current offers is about .1

15. Volatility CBOT Wheat Futures Two major factors impacting prices in the coming 6-10 years Increase in price level (due to a multitude of factors, including bio-fuels) Increase in price risk (risk is about 2 times as great as normal, and even greater in durum)

16. Ethanol/Biofuels--Highlights

17. EIA Corn Ethanol Forecast 2006

18. August 2007 Ethanol Plant Locations

19. Current capacity RFA Current eth prod cap 6.2 mgy Cap under constructions 6.4 Total 12.6 (exceeds EIA 2006)

22. Longer term impacts of ethanol/biodiesel Price impacts: In equilibrium, the ethanol means Corn=4$/b Soybeans=$9/b Wheat=$6-7/b Durum=$7.50+ Barley (feed)=$4 M. Barley=$5 Area shifts toward Increased corn and soybeans and canola Reduced small grains Reduced stocks of all grains For small grains, requires re-building stocks and providing incentives to retain area relative to biofuel crops

23. GM crops Impact 1 Changing locations on production and displacing other crops, notably small grains Impact 2 Changing technology growth rates

24. Soybean Area 1995

25. Soybean Area 2004

26. Change in Soybean Area 2004-1995

27. US and Canadian Canola Production

29. Change in All Wheat Planted Area 2005-1995

30. Durum Production 2006

31. Yield Technology Potential National Corn Growers Association indicated ...We can easily foresee a 15 billion corn crop by 2015...That�s enough to support production of 15 to 18 billion gallons of ethanol per year and still supply the feed industry and exports, with some room for growth. (as reported by Zdrojewski, 2006). Attributed to prospective advances in corn genetics and some acreage increase. They indicated historic yield trends by 2010 would be 162 b/a and 173 by 2015. Planted area would need to be about 90 million acres, up from 71 this year, which would be the highest plantings on record (the previous high was 75 million acres in 1986). The difference would come from CRP.

32. Monsanto�s GM Corn Pipelinefrom Fraley, July 31, 2007

34. Implications RR2 in soybeans is in process of being commercialized Value 5b/a is about 35$acre For durum wheat this means opportunity cost to produce these crops will escalate 58c/b $21/mt

36. Implications Drought tolerance in corn (and soybeans and canola) 8 years away Value 12b/a is about 36$acre Opportunity cost of producing these crops will escalate 60c/b 22$/mt Geography Drought tolerant crops would make significant inroads into traditional small grain regions

37. Durum Budget Comparison2008 North West ND North West North Dakota Planning Region 2008 Prices current in NW North Dakota 2007 Expenses Expenses will be going up in 2008 Seed price increase in durum

38. Returns to Labor & Mgmt

39. Returns/acre and Risk Durum is more risky relative to HRS and Feed Barley For grower to be indifferent in returns per acre, its return Could decrease relative to HRS Would have to increase relative to barley

40. Risk in purchasing� Strategy alternatives Nothing: shorter term spot purchases Long forward contracts Long HRS futures as cross-hedge Long basis (spread) contracts as partial hedge Risk Model to evaluate amongst these strategies

41. Prices Oct 16 for September 2008 Risk attributable to futures and spreads is near similar Correlation-- July 2002 to current Correlation=. 91 and R2=.82 Hedge ratio=-31.77+1.54*MGE Futures in $/MT Change in HAD=1.54*Change in MGE Futures Basis current MGE Futures, implies Mpls futures at 9.45/b Technically, this is the minimum risk hedge ratio

42. September Futures and Basis Probability Distribution

43. Strategy and RiskChange in Payoffs by Strategy

44. Processor Short 20,000 mt per month Results for one month Strategies No positions Long cash Long futures Long basis

45. Risk of Change in Payoffs by Strategy

46. VAR by Strategy (20,000 MT)5% Var for 1 month Value at risk (measure or risk) Maximum value we could lose in one month at which we are 95% confident For unhedged this the most we could lose in one month is $2.5 mill For long cash $0/mt, and for others is less

47. Management Response to Risk: Diversify�Longer Term! Changes: Higher prices and greater risk for 4-8 years Normal responses to risk in commodity markets Geographic diversification: Increase the geographic scope of purchases Buffer stocks (temporal diversification) For non-hedgable commodities, this is an appropriate strategy Accumulate stocks when prices are low; draw down stocks when prices are high Costs are important; but in many cases would be less than the cost associated with market volatility Contracts (above) Increase in contracting for a portion of purchases Hedge (cross-hedge) Transfer a portion of risks to 3rd party Strategic Risk Management: Requires assessment and use of each of above for portions of purchases Strategic questions How much should be allocated to each strategy How should these change over time Elaborate on each

48. Buffer Stocks Temporal diversification�intercrop year Common in many industries and provides partial risk protection against�just the opposite of JIT Price and spread risk Quantity and quality risks Concept Accumulate stocks when prices are low Draw down stocks when prices are high Accrue costs of storage See attached

50. Major contract provisions Mega competition for acres from all crops Response: Escalation in contracting Examples in N. America Canola 2 year contracts Ethanol corn has 3 year contracts M Barley has 1 year contract with option on 2nd year Issuing contracts now up to 14 months prior to harvest Relaxed quality requirements Durum: 2007 there was one new contract issued in spring for new crop (pre-planting) delivery

51. Competing Contracts for Specialty Grains: Common Features/Summary Pricing Some are simple fixed price; others are basis or spreads or ratios to futures or multiple futures Grower has option to timing of pricing Minimum price features and in some cases average price features Act of God: Guaranteed vs. non-guaranteed delivery Price difference about 20$/mt Premiums and Discounts for Quality Deviations Market values at harvest Pre-specified in contract: Explicit high quality premium Right of first refusal on Surplus production Typical, at market prices (as opposed to contract prices) Storage Options Most require on-farm storage; buyers call; storage fee following specified time; and on-farm samples submitted Agronomics Named varieties Certified seed bought from buyer Declare or buyer recommends acres for specified production Innovations (provisions) Insurance

52. Implications of suppliers and marketers Major changes in durum Reduced stocks Increased risks of price changes and quantities End-users will demand much more in terms of risk reducing mechanisms and more forward looking than traditionally Futures in durum unlikely (too small, too much concentration among intermediaries)

53. Implications of suppliers and marketers Implications for suppliers Develop mechanisms to facilitate buyer demands Innovative contracting Facilitate More longer-forward looking transactions (minimally pre-planting, and potentially multi year) Buffer stock strategies Geographical diversification Identify growers and work with them and lenders to foster greater participation in these types of relations

54. Risk Premiums Relative to Durum ($/A)

55. Risk Premiums Relative to Durum ($/A), by Risk Attitude

56. VAR by Strategy ($/MT)5% Var for 1 day Value at risk (measure or risk) Maximum value we could lose in one day at which we are 95% confident for unhedged this the most we could lose in one day is $98/mt For long cash $0/mt, for long futures $73/mt, for long basis $64/mt