Cannabis Price Risk Management: Part 3 – Putting Theory into Practice

As the cannabis industry evolves, operators and investors are implementing price risk management strategies and processes to limit business risk.  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 Part 2 of this series, we outlined tools and methods buyers and sellers of cannabis can use to hedge, thereby reducing their exposure to market price risk. In this final installment, we will put those tools and methods to work in real-life examples of how contractual tools can mitigate market price risk reduce uncertainty in an organization’s cash flows.

Cannabis Grower Forward Sale

Building on the insights from Part 2 of this article series, the following is a detailed example of how an OTC hedge would be employed, the actual payouts in two cases are shown below. In it, we can explore the cash flow implications for a grower who may decide to remain unhedged or who may hedge 50% of future production of, for example, 100 pounds. The example considers two market scenarios – a weakening cash price and a strengthening cash price.

By hedging, in example B, the range of potential December cash flows decreases.  Unhedged, the range is $100,000 to $150,000 ($50,000 or 50% uncertainty); when hedged the range drops to $112,500 to $137,500 ($25,000 or 25% uncertainty).

In the real economy, decisions about how much to hedge, and over what time periods, are made very carefully and only after significant price and volatility analysis. While the economics are straightforward, the rationale for and execution of the hedge are ultimately matters of “hedging policy.” One of the most common fallacies is that a decision to remain unhedged is a conservative method of managing risk, when in reality this policy simply retains all of the market price risk.

Cannabis Retailer Hedge Using a Swap

Similar to the example above, which showed a grower’s forward sale, the table below demonstrates a hedge from the perspective of a participant such as a retailer that is buying cannabis using a common OTC agreement called a “swap.” In this case, we examine only the impact of a hedge for 50% of future requirements (i.e. 100 pounds) in a strengthening cash market.

A swap is one of the simplest tools that allows a third-party (not a physical buyer or seller) to participate in the transaction. Physical commodity market participants use swaps, which are purely financial (contractual) instruments, to manage price risk exposure because swaps have low transaction costs and the pool of potential counterparties is normally quite large. The most basic type of swap is a “fixed for floating” swap, in which one party pays a fixed price and the other party pays a floating (benchmark) price. Because the two counterparties pay each other, the instrument is called a swap.

Of course, the two parties do not actually pay each other because that would be a needless complication and waste of transaction effort and cost. The swap is settled by having the party that owes the most pay the difference: If A owes $6,000 to B and B owes $5,000 to A, then A just pays B $1,000. In the example below, the retailer is planning to purchase cannabis in the future at floating (spot) price and hedges some of its exposure by entering into a swap in which the dispensary will pay a fixed price.

This swap position will benefit the retailer if the spot price is above the chosen fixed price at the expiration of the swap. Commensurately, the swap will also be a cost to the retailer if the spot price benchmark is below the chosen fixed price at expiration. As a result, the swap “locks in” the net price the retailer will pay in December, for the quantity covered by the swap.

In this case, some other market participant – such as a grower, broker, or speculator – agreed to a seven-month swap with the retailer for 50 pounds of cannabis with a fixed price of $1,250 per pound. At expiration, the benchmark spot price was $1,500, and thus above $1,250, so that counterparty will pay the retailer the difference between those.  The retailer still buys the physical cannabis at the benchmark price (100 pounds x $1,500 per pound = $150,000) but the swap pays off (50 pounds x [$1,500 – $1,250] = $12,500) yielding a total cost of $137,500.

The net result is identical to the forward sale example, although the cash flow here is negative since the retailer will ultimately purchase the cannabis in the cash market on December 1 (remembering the swap contract is settled financially).

Note that for any specific commodity, the price in the cash market is usually less than its price in the forward market. This is because there are carrying costs, such as storage and insurance, involved in holding a commodity until it can be delivered at some point in the future. However, this is only a general rule and many other factors can come into play to impact this dynamic. The difference between the cash price and forward or futures price is called basis and can vary by season and contract.

It should be noted that the swap in the above example is considered a financial hedge and there are limitations to using such hedging for physical products. Standardization of swaps can be a drawback for those participants requiring an exact hedge for physical delivery, as the swap contract specifications may not allow for quantity fluctuations, different delivery points, and delivery days.

Summary of Cannabis Price Risk Management

Although the development of the cannabis industry in the U.S. remains hindered by federal prohibition, it is still possible to develop the basic tools for hedging. The use of a Benchmark Price Index and generally agreed contract specifications can be an important method to manage cannabis price risk.

As outlined, participants can agree upon a standard and a specification such as specifying flower in a certain geography where transactional prices are reported by an independent third party such as Cannabis Benchmarks.  The parties would agree upon a fixed quantity and price and enter into a swap using a contractual agreement that used standard terms and conditions. In other commodity markets, such contract standardization has been created by participant pools, cooperatives, federal entities, and international organizations.  Given the projected volume of transactions and currently planned centralization of distribution, the first actively traded hedging markets for cannabis could conceivably occur in California within a year.

While the potential exists today for hedging cannabis both physically and financially, it is contingent upon the industry to come together and create the framework and standards for this potential to be realized.

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