Investors holding long positions in FCStone Group, Inc. (FCSX) were met with an unpleasant surprise yesterday morning as the stock traded as much as 20% lower on extremely high volume. A report from William Blair and Company issued over the weekend sheds a bit of light on the situation. The note is actually in relation to a presentation given by Pete Anderson, FCStone’s CEO on June 18th.
William Blair points out that while the current volatility in agricultural commodities has a positive effect on the need for producers and consumers of these commodities to hedge their exposure, the cost of hedging is becoming prohibitive and making it especially difficult for farmers to maintain hedges on production.
Because of the increased volatility in commodity prices, margin requirements have been increased. The higher margins are simply a mechanism to protect counterparties in a trade so that each knows that the other has set aside funds to fulfill their obligation when the transaction (such as a futures or forward agreement) is completed. The margin requirements are enforced by a clearinghouse which serves as an intermediary between parties.
Now imagine if you are a grain farmer with an expected harvest of 100,000 bushels of wheat. There is a certain amount of cost involved in planting, fertilizing, watering, and harvesting the crop. At a certain final sales price, this process becomes profitable and yields enough cash flow to begin the same process for the next crop.
If the future price of wheat (as measured in the futures markets) is above this break-even profit point, a farmer would be wise to lock in a portion of his production by selling futures contracts against some of the wheat he will deliver. If the price continues to climb, it behooves the producer to continue to lock in higher prices by selling more futures contracts, up to the amount of production he will be bringing to market when the crop matures.
In order to sell a futures contract, the farmer must put up a nominal amount of money as collateral. This collateral (or margin) must be adjusted if the price moves against the farmer (higher in this particular case). Now in today’s market, the prices of wheat have been moving sharply higher, which raises the typical amount of collateral necessary, while at the same time, losses on selling a futures contract will likely be mounting.
Long-term, this is not a big deal for the farmer, because his crop will be able to be sold at a higher price with a profit that is equal to or above the losses sustained in the hedging technique (or the farmer could simply deliver the crop to whoever is holding the other side of the trade). But in the meantime, the margin required in order to hold the position open continues to increase.
It is likely because of these dynamics that producers are finding it difficult to use FCStone’s services even though their need is still just as great. The current credit crisis makes funding these obligations even more difficult. A recent announcement of a merger between Bunge Limited (BG) and Corn Products International, Inc. (CPO) has led to greater investor attention to this issue.
Now it is not clear that the William Blair report is the sole data point behind the selling in FCSX. In fact, it looks much more like a large holder of the stock is simply unwinding his position very hastily. However, the fundamentals behind the company point to a growing need for the services provided both domestically as well as internationally. And, temporary margin requirements may put a crimp on the amount of business the company can win for the current quarter.
Disclosure: Author does not have a position in FCSX.