The literature on commodity producers' earnings stabilization policies through hedging and stockpiling rules has traditionally focused on the welfare justification for stabilization rather than how to stabilize earnings most effectively. The hedging rules proposed to date typically neglect that stockpiling and financial constraints generate asymmetries in price and quantity distributions, and that most commodity producers operate economies with few opportunities to diversify risk by investing in other assets.

In Discussion Paper No. 481, Research Fellow Andrew Hughes Hallett and Prathap Ramanujam build on their earlier work in which they designed hedging and stockpiling rules for any market, regardless of the price distribution, to relax the three significant remaining restrictions: their rules apply only to producers taken as a group; they take no account of operating costs; and they are designed to minimize the variability of gross revenues.

Hughes Hallett and Ramanujam consider individual producers facing different supply conditions. They compare revenues under hedging and stockpiling strategies net of storage and transactions costs, subject to three remaining restrictions: the action to stabilize revenues does not affect the behaviour of market agents and traders; stockpiling rules are still intended to maintain the long-run equilibrium price; and the stabilization of earnings remains the policy objective. They apply these techniques to the five most volatile markets in the UN's list of 29 `core commodities', to show that the optimal stabilization rules vary more within than among markets, which may lead to disagreement over the choice or extent of intervention strategy. Losses from choosing the `wrong' strategy appear to be small, however, so an intervention strategy should be undertaken, even if the distribution of its benefits remains a problem. Taking storage and transactions costs into account, on the other hand, may severely reduce earnings stability in markets with significant price volatility and high unit values and/or strong price elasticities. Producers in such markets will tend to switch to hedging strategies to avoid the costs of depleting their stocks entirely.

Hughes Hallett and Ramanujam note that the stabilization strategy chosen by one producer need not be optimal for others nor for the market as a whole unless all face identical supply conditions, so conflicts may arise about the choice of hedging or buffer-stock interventions and how vigorous any stabilization operations should be. Strong disagreement will make the operation of any earnings stabilization scheme harder, especially if one producer's stabilization rule, or a market stabilization rule, destabilizes another producer's earnings. The potential for disagreement is less severe for hedging than for buffer-stock schemes, and explicit cooperation between private producers is more helpful than centralized planning.

Market Solutions to the Problem of Stabilising Commodity Earnings
Andrew Hughes Hallett and Prathap Ramanujam

Discussion Paper No. 481, November 1990 (IT)