Cannabis market participants are increasingly seeking more certainty across all elements of business risk. Price risk management is one of these key elements. In Part 1 of this article, our content partner Cannabis Benchmarks introduced the concepts of market price risk, volatility, hedging, and the distinctions between cash (or spot) and forward markets. In the second part of this series, we outline some tools and methods buyers and sellers of cannabis can use to hedge, thereby reducing their exposure to market price risk.

Similarities to Other Commodities Markets

While there are many unique challenges within the cannabis industry, there are more similarities to other established markets than people may first consider. Trading of agricultural products has occurred for centuries, with one of the first standardized forward agreements struck during the 17^th century in Japanese rice markets. Today, thousands of physical commodities are transacted globally and, for a great many of these, interest in the benefits of hedging price risk has driven the development of markets for hedging instruments.

Physical agricultural markets have confronted many of the same issues as cannabis participants including, but not limited to:

• fluctuating supply and demand
• regulatory intervention
• storage challenges
• defaults on payments.

These challenges can be addressed in part by hedging or transferring risk through the use of a closely related instrument like a forward contract. The first forward contracts occurred in the U.S. grains market in the 1800s; by 1848 the Chicago Board of Trade was created to standardize contracting terms and centralize trading.

Forward contracts can include variations across some quality and commercial elements. When all elements of a forward contract are standardized, they are known as Futures contracts and are traded on an exchange. The image below illustrates the basic structure of Physical contracts versus Futures contracts.

Generally, commodities traded in such markets are broken down into several distinct categories, such as Energy, Metals, and Agriculture (which can be further divided into livestock, grains & oilseeds, dairy, and softs). There are many contracts for Currencies and Financials that are also considered within the general commodity schema.

Volume of Financial Transactions

Where financial instruments and markets have developed to support physical commodities markets, it is the clear norm that the financial contracts show a higher trading volume than the physical contracts, and that the physical contracts volumes are greater than the actual production. In other words, the physical goods are bought and sold several times between production and consumption.

Sources: USDA, National Agricultural Statistics Service, and Cannabis Benchmarks®

The latter phenomenon should be somewhat intuitive. For example: there are multiple physical transactions that bring a single bushel of wheat from the seed vendor to the farmer to the trucker to the elevator to the marketer to the barge captain to the miller to the baker. In this example, there are already eight physical agents making transactions on a single bushel (8X production) and that wheat has not yet reached a food packager, wholesaler, retailer, or restaurant. Where the transportation and logistics chains are longer, these multiples can be even higher.

Just as the physical transactions are a multiple of the production volume, the financial transactions are typically a multiple of the physical transaction volumes, as we have conservatively estimated in the table above. The underlying futures market structure – in other words, which sector participants or other actors are buying or selling these instruments – is complex and unique to each industry. In most cases, market participation almost certainly goes beyond the supply chain and includes players in the financial sector. These participants might use futures to protect loans, tax revenues, or credit agreements, or simply to speculate on movements in wholesale prices over time.

Coming up next…

Stay tuned for Part 3 of this series, where we will provide concrete examples of how cannabis operators can use price risk management strategies to protect value.

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