Roger G. Ginder Economics Department Iowa State University. October 26, 2000

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1 Potential Liquidity Problems in the Elevator Sector Arising From Commingled Starlink Grain and Policies to Address Them Roger G. Ginder Economics Department Iowa State University October 26, 2000 Liquidity in the grain-elevator sector depends upon the near-perfect functioning of the commodity market for grains. Grain inventories can be converted to cash at the market price on any business day of the year. Commodity markets and conventional grade definitions permit inventories to be sold through space with adjustments for transport costs and through time with adjustments for the costs of holding inventory. These features of the market arise in no small part because well-established and widely accepted commodity definitions of product characteristics permit the substitution of one inventory for another of like grade and quality for wide variety of uses. Inventories in one place may also be substituted for inventory in another place or at another time. The consequences of the partial approval of Starlink for one use and the subsequent commingling of Starlink with a large fraction of the non- Starlink corn produced will make it extremely difficult if not impossible for the commodity markets to function properly in the coming year. These features of the grain markets also underpin the value of negotiable warehouse receipts issued from federal or state-licensed warehouses for grain deposited there. Licensed facilities can issue warehouse receipts that are acceptable to lenders and others as collateral for loans. The receipts from a licensed facility are generally negotiable and the lender can take possession of grain used as collateral for the loan in the event of default by the borrower. The state or federal agency issuing licenses periodically inspects the licensed elevators or storage facilities. These inspections are designed to ensure that the quantity and grade of grain evidenced by all of the receipts written is in inventory. Any deficiencies must be covered by either company-owned grain or from the purchase of the necessary quantity and quality of grain required to cover the receipts issued. Farmers wishing to store grain in an elevator can request such a negotiable receipt and use it as collateral for borrowing. An elevator can issue warehouse receipts to itself for grain it has purchased from farmers or others and is holding for future sale. After issuing a negotiable warehouse receipt to itself, the elevator may use that receipt as collateral to borrow the money required to

2 finance that inventory until it is sold. The elevator s lender will typically loan a high percentage of the value of the receipt. Lenders are willing to do this because the commodity grain markets function smoothly. These markets permit a grain inventory to be liquidated easily and at very low cost compared with most other kinds of collateral. This method of financing is widely used in the grain industry and few elevators have enough capital to operate without it. The Starlink situation creates some potentially serious problems with the use of warehouse receipts to create liquidity in the grain elevator and processing sector. At the core of the warehouse receipt concept is the ability to substitute one lot of grain for another lot of like quantity and grade. Receipts for U.S. #2 yellow corn for example imply that stored grain meets the grade standards established for U.S. #2 corn and that the corn is merchantable for all normal commercial uses and purposes. There are several primary use categories for U.S.#2 yellow corn: 1) animal feed, 2) food products for human consumption, 3) industrial products, 4) export to other countries. The U.S. #2 yellow grade designation permits one inventory to be substituted for another inventory of the same grade without regard to end use. Limitations on the use of Starlink grain in human food channels should prevent its designation as U.S. #2 yellow corn. It is no longer the same commodity as U.S.#2 salable for all uses. Failure to recognize that grain salable only in the livestock market is not the same commodity as grain salable to all major markets is a flaw in the system that could cause great economic difficulties. This definition also ensures that a depositor in a grain warehouse can permit grain to be commingled in the elevator and at a later time withdraw the same quantity of grain meeting the same standards. Grain deposited in an elevator under warehouse receipt represents an obligation on the part of the warehouse to deliver like quantity and grade when the depositor demands it. Starlink was registered under the express condition that it would be kept separate and that it would not enter food channels. Commingling Starlink with non-starlink U.S. #2 yellow corn results in the entire commingled inventory assuming those limitations. Depositors who delivered corn without Starlink will receive grain with a more limited market and almost certainly a lower value when they withdraw the commingled Starlink product. To date this has not been recognized in U.S grade standards. The current elevator problem arises from the fact that elevators were unable to distinguish Starlink or grain cross-pollinated with Starlink from other hybrids delivered. Physical inspection of the samples taken when grain is delivered yielded no visible differences. Producer lists generally were not provided to indicate that acreages of Starlink had been planted in the elevator s trade area. In most cases there was no information provided to elevators that there was a compelling need to be on the alert for Starlink. In virtually all cases, elevators were unaware the U.S. #2 yellow corn in their bins was being commingled with Starlink and would not meet the U.S.#2 standard. Some elevators

3 had designated a segregated feed mill location for delivery of grain produced directly from Starlink seed. However even these elevators were unaware that cross-pollinated grain or improperly channeled Starlink was entering their other facilities where grain suitable for all commercial uses was stored. In some cases warehouse receipts for U.S. #2 were issued to depositors by the elevator without any knowledge that the actual grain in the bins would not meet this grade standard due to Starlink contamination. Those elevators are now in the position of assuming the responsibility for providing holders of those receipts with grain that meets the U.S. #2 grade. Although the grain the elevator holds in inventory may meet that standard according to current USDA grade definitions, the depositor will not be able to use that grain for all uses and may take a substantial discount. This will result in a financial loss equal to the cost of locating, acquiring, and transporting the Starlink free grain to either the depositor or the elevator if it attempts to satisfy those receipts with grain suitable for all uses. As serious as this might be, it pales in comparison to the problems elevators might face if there is a significant price gap between inventories with Starlink and inventories without it. If the quantity of grain testing positive for Starlink is relatively large and is brought to market as livestock feed in an accelerated time frame, it is likely that the market for this grain will be depressed. And elevators have strong incentives to bring inventory that has been commingled to market as soon as possible. Unless the elevator anticipates significant price appreciation for this corn in the future, there is little incentive to incur the storage and interest costs of holding it. Recent announcements by the Chicago Board of Trade (CBOT) and Federal Warehouse Regulators that they will not differentiate between grain containing Starlink and grain without it will be of little significance or help in addressing the problems elevators face. It is not a question of the how the futures contract is defined. Nor is it a question of how warehouse receipts are written. Ultimately it is a question of how the users of grain treat corn without Starlink compared with the corn with Starlink. Even though USDA definitions of U.S. #2 yellow, definitions on the CBOT, or Federal or State warehouse receipts make no distinction, the end-use markets will. So long as FDA demands that products containing Starlink be recalled and important foreign buyers refuse to purchase corn containing Starlink, there will be two distinct markets from an economic value perspective. And despite all efforts to the contrary, these two markets are beginning to behave differently. Feeders who sense the shift in bargaining power when two major alternative uses are foreclosed are discounting Starlink-commingled shipments. Elevators with commingled inventory will find that it is difficult to conduct business in a normal fashion if they must hold large Starlink inventory through a long period of depressed feeder-market prices. Contract commitments that have been made with processors who will not accept commingled grain will have to be fulfilled or bought out. Railroad freight contract commitments that have been made for shipment to processors or

4 export will have to be fulfilled or bought out. These steps will require cash to accomplish and will place pressure on elevators to liquidate inventory. While borrowing may be an option for some elevators, the commingled Starlink stocks with uncertain future values will be much less valuable as collateral. Because any warehouse receipt written will not be for U.S. #2 corn suitable for all uses, normal liquidity will not exist and lenders can be expected to behave accordingly. Lenders routinely lend up to 80-90% of value for U.S. #2 yellow corn but the collateral value of commingled corn with an uncertain market is likely to be heavily discounted. This will further magnify the already-serious liquidity problems facing the affected elevators. It isn t possible to accurately estimate at the level of Starlink commingled with elevator inventories. Elevators may not know for sure themselves. Elevators typically learn they have it when a positive test occurs in a shipment. Very small quantities of commingled Starlink can cause a positive test in shipments. This uncertainty will create additional risk management problems for elevators as they merchandise their inventories. Merchandisers can no longer simply select the best market for the grain in the future, sell for delivery at that time and hedge the sale in the futures market. The problem arises because the limitations on Starlink utilization create an entirely separate commodity from the one the futures markets has traditionally traded or the one that negotiable warehouse receipts for U.S. #2 yellow corn have traditionally evidenced. Hedging grain using standard futures market techniques in this situation is unpredictable at best. If it is assumed that the commingled Starlink grain will trade at a discount to U.S.#2 yellow without Starlink, hedging commingled grain could actually increase risk exposure when an elevator attempts to hedge it. There is little or no evidence that the market for commingled grain will even move in concert with U.S. #2 yellow that is suitable for all uses. The problem has not arisen before, so there is no experience to indicate that the two markets would move together. If there is a very large supply of commingled grain and there is a strong demand from processors and exporters for the remainder of the crop that is not commingled, the markets could actually diverge. Such a divergence would mean that the elevator would be required to increase its margin deposits on futures contracts as the price for the non-commingled grain increases. At the same time, the value of its commingled inventory would be decreasing. The net result would be a loss of value in the futures market when the hedge is lifted as well as a loss in the cash market when the physical grain is sold. In the absence of a floor on the price of the commingled stocks the two markets could move in opposite directions. In the absence of a mechanism that forces the two markets to move in the same direction the two markets could diverge with one increasing while the other remains static at the floor. The development of two markets after the grain has been commingled is almost certain to create financially disastrous results for elevators that have unknowingly acquired a commingled Starlink inventory. Among the most serious problems is the inability to generate income by purchasing and storing inventory for sale later in the marketing year.

5 Other problems such as higher costs of operation, difficulties in generating or obtaining the necessary cash to meet warehouse receipt obligations, difficulties in performing on grain and transport contracts, reduced collateral value of inventory, and difficulties in conducting prudent risk-management actions are a virtual certainty for these firms. Taken together these conditions place even the most solvent elevator in such a precarious position that its survival is seriously threatened. The low margins and modest capitalization levels in this sector simply cannot sustain such an unlikely and unexpected assault. POLICIES TO ADDRESS THESE PROBLEMS Three policy initiatives would be useful in minimizing the current problems in the grainhandling and processing sector arising from the partial approval of the Starlink. Two would help to reduce the operational problems associated with marketing lots of grain from elevators in areas where Starlink was produced. A third would address the liquidity and risk-management problems facing elevators as a result of the dual market system that has already begun to develop. Origin testing of shipments for nonfeed uses -Design and implementation of origintesting program that is acceptable to processors and exporters would help to identify lots containing Starlink earlier in the channel. This is especially important where rail shipments are involved and significant added cost results from the rejection of shipments at destination points. Establishment of non-zero tolerances for Starlink Where there is scientific evidence to support it, there should be non-zero tolerances established. Zero tolerance is an extremely difficult standard to meet where biological processes are involved. In some respects it is even misleading to claim zero content since the determination is done by sampling. Two loads of grain with equal but very low Starlink content could sample differently strictly by chance yielding absolutely no benefit in keeping Starlink out of food products. Even very low levels of 1% or 2% tolerance would be helpful in reducing the fraction of the crop that is affected. Ultimately the question of tolerance is one that end users must answer, but every attempt should be made to establish maximum acceptable levels based on sound science. Establishment of a price floor for commingled product --- The limited uses for the inventories of grain containing Starlink create a need for risk management options. This is especially true if the amount of grain that must be moved into the livestock sector is large and/or there are some feeders who do not participate in these channeling efforts. Elevators with large commingled inventories will need some kind of price floor in order to borrow money and hold inventory that is not easily hedged. Thus some kind of CCC loan program where the elevator could forfeit commingled grain would be extremely important in maintaining liquidity and managing the presently unknown level of price risk associated with Starlink.