Is there a future for derivatives in SA’s wine industry?

Surplus wine in global markets is squeezing the profitability of many South African wine farmers. It has been proposed that a derivative instrument should be introduced for the wine industry to help stabilise bulk wine prices and create transparency for all industry role-players. In principle this would be similar to the futures market on which SA grain farmers can trade to hedge price risks.

Surplus wine in global markets is squeezing the profitability of many South African wine farmers. It has been proposed that a derivative instrument should be introduced for the wine industry to help stabilise bulk wine prices and create transparency for all industry role-players. In principle this would be similar to the futures market on which SA grain farmers can trade to hedge price risks. Glenneis Erasmus investigates how a derivative would operate for wine producers.

Approximately 15% of GLOBAL WINE PRODUCTION can be labelled as surplus wine. This surplus is having a decimating impact on wine prices – particularly red wine prices – across the world and many South African wine farmers are struggling to remain profitable.

he wine surplus can be attributed to huge expansions in production in California in the US and Australia, which has resulted in these countries being able to supply wine at relatively low prices. “This in addition to the strong rand has made it difficult for the South African industry to compete in the international market,” says Dr Willem Barnard, CEO of KWV.

The wine surplus is expected to continue for at least another few years. To make matters worse, South Africa’s primary markets have become dominated by price-conscious consumers with little brand loyalty. Barnard believes the weaker rand would make market conditions a little more bearable for the industry.

Wessel Lemmer, agricultural economist at Grain SA (previously at the Western Cape Department of Agriculture), suggests the introduction of a wine derivative for bulk red wine and white wine to help manage price risks for producers in South Africa. He says a wine derivative would help to stabilise bulk wine prices and promote transparency, providing the industry with more accurate market information.

How would this risk management instrument work? Say the wine derivative is based on the following two conditions: it is operated over an 18-month period, meaning that the market would cater for one production season and a further six months after the season; and, one contract equals 32 000 litres of wine. According to Lemmer, operating the contracts at smaller volumes would render the derivative unattractive to buyers. Based on available market information, a bulk red-wine producer might foresee the depreciation of wine prices over the next 18 months.

So he or she decides to hedge a part of the red wine plantation against the expected depreciation in market prices. If he sells 17 contracts (amounting to 554 400 litres of wine if one contract equals 32 000 litres) – at R6,46/litre for delivery 18 months later, then the producer would manage to make a profit of R1,26/litre on the JSE if the wine price decreased to R5,20/litre by the time of delivery. On the same day the producer can sell the physical wine (the 554 400 litres which represented the 17 contracts) at the dominant market price. This should be the same as the derivative price at R5,20/litre.

In effect, the producer will still realise the planned price of R6,46/litre when he or she adds the R1,26 profited per litre through the derivatives market to the price realised in the physical market.

Challenges of a wine derivatives market
Establishing a wine derivative is easier said than done. Currently no other country makes use of a wine derivative because wine is such a complex product, says Chris Sturgess, manager of the Agricultural Products Division at the JSE. Euronext launched Winefex Bordeaux – a futures contract based on premium quality Bordeaux red wines in September 2001 to help the industry hedge price risks. But the attempt was unsuccessful. Lemmer ascribes Winefex’s failure to the introduction of futures just before the 11 September attacks in the US. “The timing wasn’t right. The attacks had an impact on the whole market and people were too scared to invest in new enterprises,” he explains.

Investigations initiated by the Business Chamber and Business School of Bordeaux also later found that this type of instrument should be closer to the producer in the value chain. In other words, it would be better to trade bulk wine – a more undifferentiated product – than wines at the top range of the price segment, Lemmer explains.

The differentiated nature of wine could pose serious challenges for the creation of a wine derivative. “There are different cultivars – from Pinotage to different blends and different years of harvest. Then you need to consider the impact of terroir – macro- and microclimate – on the end product. How on earth will the industry develop a standardised product suitable for trade on the stock exchange?” asks Johan van Rooyen, CEO of the SA Wine Industry Council. Sturgess adds there should also be sufficient volumes of the standardised product and enough buyers of this product to sustain such a derivative.

Lemmer does not see this as a major problem. He proposes that the derivative be operated in two primary categories – one for white wines and one for red wines. “The Wines of Origin Scheme and Certification Board can act as a governance structure to ensure that the wine traded on the market satisfies a minimum quality standard.

Due to the complexity of wine quality, which increases the cost of measurement, the underlying instrument has to be based on an undifferentiated natural white wine or red wine,” Lemmer says. Supplying the market with a higher quality wine would be to a producer’s disadvantage. “If a farmer is already engaged in a contract, then he can buy in some lower quality wine for trading on the derivatives market and sell his or her higher quality wine on the open market,” Lemmer advises.

But Dr Ferdie Meyer, agricultural economist from the University of Pretoria and the Bureau for Food and Agricultural Policy, asks if there’s adequate demand and supply to support such a market. ”Having too few buyers might result in one large buyer manipulating the market to his or her favour,” he cautions.

Research by Lemmer has revealed that in 2004 in South Africa the trade value for white wine reached R830 million and for red wine R556 million. There were 114 buyers and 181 sellers in the white wine market, and 83 buyers and 172 sellers in the red wine market. Lemmer says this is more than enough to support a derivative instrument.

Trading period
Meyer points out that it would be trickier to operate a derivatives market for a perennial crop such as grapes, than for an annual crop, such as maize, wheat and soya, which are traded over a one-year period on the derivatives market.
 “The number of risks involved in trading increases in relation to the length of time the derivative market will be open for trading a specific commodity,” he explains.

Sturgess, however, doesn’t foresee a long trading period as a challenge. “Role-players will just have to decide on the length of the trade, which will be determined by the nature of the underlying product, and supply and demand,” he says. Sturgess says it would be possible to operate the wine derivative market over a one-year period as vineyards produce an annual yield once they are established. Lemmer, however, feels the trading period should be 18 months, thus providing for one production season and a further six months after the harvest. This would allow a producer to sell a contract in July 2007 for delivery in December 2008.

Price monitoring and research
Existing price indicators have shown that the volatility of white wine has been constant, clustering in the 20% to 30% range, but has recently fallen to lower levels due to reduced prices. In 2004 the price for white wine varied between the monthly average of R3,08/litre and R2,67/litre, while monthly sales volume varied between 18,5 million litres and 29,3 million litres.

For a long time the volatility in red wine stayed over 30%, but is now also tending downwards as a result of decreased prices attained for red wine. The price for red wine varied between R6,00/litre and R5,07/litre, while the sales volume varied between 4,3 million litres and 12 million litres. Lemmer thinks that this volatility sufficiently justifies the use of a derivative as a risk management tool in the wine industry.

Lemmer suggests that wine prices be monitored weekly by an independent institute for 12 months to 18 months and the price index then be published. Results should be shared with market analysts who should communicate their interpretations to the industry.

The objective support from government or research agencies and the dissemination of objective information to the industry will be of the utmost importance. According to Lemmer, the introduction of a derivative instrument would have to be supported by the whole industry for it to work.

Most bulk wine producers are currently in favour of further research into the use of such a mechanism, but premium quality wine producers are afraid that South African wines might become associated with low-quality wines should a wine derivative come into effect.

 “Many wine cellars and companies have been working very hard to establish a premium quality product in the market. The establishment of a wine derivative could lead to South African wines becoming associated with a commodity product and this could have a detrimental impact on the international image of our wines,” says Dr Barnard. For further information contact agricultural economist Wessel Lemmer on (056) 515 2145. |FW