A Model for Lowering Inter-Annual Revenue Variability for the Cotton Chain in WCA Countries

by Jean CordierProfessor, Agrocampus Rennes

ITF CRM annual meeting, Pretoria, May 16, 2006

A model developed with the support of the French Foreign Ministry and the Agence Française de Développement (AFD)

– Introduction : the « producer » problem– The model and its assumptions– Results– Advantages and limits

ITF CRM annual meeting, TUT, Pretoria, May 16, 2006

A Model for Lowering Inter-Annual Revenue Variability for the Cotton Chain in WCA Countries

INTRODUCTION : THE « PRODUCER* » PROBLEM

Reference market price Ft

FOB price (basis = 50)

… Revenue = P.Q

decrease increase

Cost of production

Ft

Ft - 50 •

* « Producer » = ginner + farmer

- Risk concern of the producer : price and quantity

- Risk concern of the ginner : quantity and price

f(relationship P - G)

Risk on revenue

INTRODUCTION : THE « PRODUCER » PROBLEM

Risk perception :

- Revenue variability … σ

- Value at Risk : Prob 5 %

Revenue(t) < 174 F.CFA

Impact on :

- Short Term invest. choices

- Long Term invest. choices

Impact on chain competitivity

σ

Shocks and crisis

300

500

700

900

1 100

1 300

1 500

2006

2009

2012

2015

2018

2021

2024

2027

2030

Réel

Plancher

Shock Crisis

INTRODUCTION : THE « PRODUCER » PROBLEM

Productivity gains

In a competitive market, price is fluctuating through time above and below cost of production

THE « PRODUCER » PROBLEM AND ITS « ANSWER »

700 Reference market price Ft

650

FOB price (basis = 50)

And with the benefit of a price lift

With a floor price

decrease increase

Cost of production

Ft

Ft - 50

Being profitable

•

OBJECTIVE OF THE MODEL

1. Reduce the revenue variability of the global Cotton Chain in WCA countries

o Directly from price risk management

o Indirectly from cultivated surface management

o … nothing, to the present time, on crop yield/weather risk management

2. Improve the VaR(5%) of the cotton producer

3. Share the residual risk between ginners and producers

CONTEXT OF THE MODEL = WCA COUNTRIES

• Unicity of farmer cotton price through space

• Unicity of price through time (within a crop year)

• March(t) Posted Price for Oct-November delivery t

• Posted price payment at delivery (Oct-Nov) and price bonus at the end of the crop year

• Organisation of (most) WCA cotton chains

CONTEXT OF THE MODEL = WCA COUNTRIES

Nominal cotton price (cts/lb)

30,0040,0050,0060,00

70,0080,0090,00

100,00

1975

-76

1977

-78

1979

-80

1981

-82

1983

-84

1985

-86

1987

-88

1989

-90

1991

-92

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

EUR/USD exchange rate

0,50

0,70

0,90

1,10

1,30

1,50

1,70

1975

-76

1977

-78

1979

-80

1981

-82

1983

-84

1985

-86

1987

-88

1989

-90

1991

-92

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

- A fixed exchange rate EUR/F.CFA

- A devaluation between EUR/F.CFA in 1994

Crop yield in BF

0

500

1 000

1 500

THE PROPOSED MODEL AS A SECOND BEST

Reference market price Ft

FOB price (basis = 50)

decrease increase

Cost of production

THE MODEL

1. Use of reference markets (NYBOT/Cotlook A and exchange rate USD/EUR to define a « fair » CIF-FCFA reference price

2. Define the basis Bt for eliciting the WCA FOB-FCFA price Bt = transportation cost minus quality premium

3. Design « price layers » with respect to probability of occurrence

→ Layer A : Risk retention layer Prob(Layer A) ≈ 90 %– Layer B : Market instrum. layer Prob(Layer A) ≈ 10 %– Layer C : Market failure layer Prob(Layer A) ≈ 1-5

%

4. Design tools matching each layer with portfolio consistency and governance potential

5. Define a formula pricing for sharing cotton value between ginners and producers

THE PROPOSED MODEL

Reference market price Ft

FOB price (basis = 50)

decrease increase

Cost of production

ABC

TOOLS ORGANIZATION IN THE MODEL

• « Risk retention layer » = Layer A

Intra-annual smoothing : selling diversification using futures and forward contracts (private basis)

Inter-annual smoothing : price and revenue smoothing using a Buffer Fund and a Withdrawal Right (private professional basis)

• « Market insurance layer » = Layer B

Risk transfer to market : price derivative contract (« bear put spread »)

• « Market failure layer » = Layer C

External support : local covered eventually by internationalGovernance of crisis (early signals, crisis procedure implementation)

ASSUMPTIONS OF MODEL SIMULATION FOR BURKINA FASO

• Lognormal price distribution for the world cotton price in cts/lb (NYBOT or Cotlook A) LN(St) has a normal distribution : N(0 ; 0,20)

• Normal distribution for the exchange rate USD/EURO : N(1,15 ; 0,22)

• Normal distribution for farm cotton yield : N(1063 ; 113)

• Normal distribution for cultivated area : N(700000 ; 70000)

• No current distribution on FOB-to-CIF cost or quality premium

0

200

400

600

800

1 000

1 200

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33

Moving Average smoothing

PARAMETRIZATION TESTED

• Pivot price calculated using first order exponential smoothing (4 years and α = 0,7)

• Price layers : A > 700, 600 > B > 700 and C < 600

• Upper bound = 110 % of pivot priceLower bound = 90 % of pivot price

• Percentage of surplus given to the Buffer Fund (BF) = 100 %

• Maximum size of the Buffer Fund = 15 % of pivot priceMaximum size of the Withdrawal Right (WR) = 15 % of pivot price

• Formula for sharing cotton FOB value between the ginner and the producer :

• Ginner margin : M = 200 + 0,1*P• Producer price : PProd. = (PFOB – M)* 0,42

Revenu filière Burkina Faso

140

240

340

440

540

640

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Fonds de lissage et Droit tiragedu Burkina Faso

-80,0

-60,0

-40,0

-20,0

0,0

20,0

40,0

60,0

80,0

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

THE BUFFER FUND « AUGMENTED » WITH WITHDRAWAL RIGHT

Example of simulation :

Distribution for Prix producteur initial (B61)

Mean = 213,1876

X <= 139.55%

X <= 311.2395%

0

1

2

3

4

5

6

7

8

50 150 250 350 450

Valu

es i

n 1

0^

-3

Distribution for Prix producteur final / A+B+C (B57)

Mean = 220,4832

X <= 176.515%

X <= 284.0395%

0

0,002

0,004

0,006

0,008

0,01

0,012

0,014

0,016

0,018

0,02

100 200 300 400

Current situation

Impact of the model

Example of simulation :

Smoothing simulationExtreme Situations = Schocks and Crisis

300 500 700 900

1 100 1 300 1 500

Réel

Lissé

Plancher

Simulation du lissage + "méplat" + aideSituations extrêmes = Choc et Crise

300 500

700 900

1 100

1 300 1 500

2006

2009

2012

2015

2018

2021

2024

2027

2030

Réel

Lissé

Lissé + tunnel

Plancher

CriseShock

RESULTS OF MONTE CARLO SIMULATION

• Robust model under current hypothesis (Monte Carlo simulation)

• Risk decrease for WCA cotton chains– 35-40 % decrease of the coeff. of variation of the producer price– 30-35 % decrease in standard deviation of the producer price

• Value at Risk (5%) improvement  : 20-25 %

• Use of Layer C : 3 to 5 % for an average of 37 MM F.CFA (Burkina Faso – 700.000 ha), 1 or 2 times every 30 years (37 or 74 MM F.CFA)

MODEL ADVANTAGES

• Effective risk reduction for WCA cotton chains

• VaR(5%) improvement

• Non-distorting mechanism

• « clear principles » and parametrization to reach local objectives

• Non manipulable therefore « sustainable »

• Linked to « market » through the use of market signals (exponential smoothing) and instruments (futures-forward, options)

• Cultural acceptability in merging « buffer funds » and « market instruments » therefore « locally acceptable » … in addition to parametrization

MODEL LIMITS

• Jumps are not considered (FCFA devaluation, strong production cost changes – i.e. GMO – strong cotton area increase) … therefore additional « governance » mechanisms are required to handle jumps consequences

• Requirement of a national agreement for sharing the world cotton value and risk in between ginners and producers (formula margin and productivity targets)

• Unknown derivative market liquidity, inducing transaction costs on the knockout option through market intermediaries (banks, international trading firms, specialized intermediaries)

• Requirement of an agreement between the local Cotton Chain (Interprofession) and the Government for « Layer C management »

… IMPLEMENTATION ISSUES

• Need to move from current national situations (objective and also constraint of pilot tests)

• Set theoretical and practical layers limits (A, B and C)

• Premium issue (perceived cost/benefit, how much, flexible/fixed)

• A need for normative costs (ginners)

• Adaptation to national ginners structure (one or several ginners)

• Institutional, legal, initial endowments issues

THANKS FOR YOUR ATTENTION

ITF CRM annual meeting, Pretoria, May 16, 2006

Besoin d’un « plan marketing » et d’un suivi

Plan MKG :

Fondement du suivi

Compatibilité des aides par rapport à l’O.M.C.

• Notion de choc et de crise

• Amélioration possible de la règle de « catastrophe naturelle » telle que rédigée en annexe 2 – paragraphe 7 de l’accord de Marrakech

Revenu coton - Période 2006-32

0

100

200

300

400

500

2006

2009

2012

2015

2018

2021

2024

2027

2030

Revenu brut

Revenu "structuré"

- Autor. OMC

- Aide prévue

10 % confidence

0,00

200,00

400,00

600,00

800,00

1000,00

1200,00

1400,00

2001 2002 2003 2004 2005