Forward prices in the merino wool market

There is a view in the wool industry that forward pricing is a good thing in terms of price risk, with the implication that it is also good for profitability, which farmers have neglected. Participation in forward markets has declined, with some in the industry thinking education is an antidote to this decline, without really debating whether hedging is actually useful to extensive wool growers. Forward pricing in the right circumstances can be useful, but it is not innately so as it is a net cost.

Figure 1 shows a weekly price series for the eastern 19 MPG (in nominal Australian cents per clean kg terms) from late 1998 to early 2024. A second line is added to the graph to show the forward 19-micron quote at the same time (that is, the forward price for wool in 12 months’ time). Usually, the 12-month forward price follows the 19 MPG fairly closely, generally staying lower in markets with high prices such as 2000-2001, 2008, 2011, and 2017-2018. The difference in percentage terms between the auction 19 MPG and the 12-month forward price is shown by the bars in the graph (right-hand axis) – the forward curve.

The forward price is closely linked to the auction price as that is the logical starting point for developing a forward price. Forward prices give their view on the market not through price (which is driven by the auction price) but in the relativity of their price to the auction level; it is above or below the auction price and by how much. In the example used here, the 19-micron price, the 12-month forward price has generally been quoted at a discount to the auction market, but not always.

Note that in markets with high price levels, the 12-month forward discount tends to be 10-15% or more, signalling a strong view that the high auction prices are cyclical and unlikely to persist into the future. That means the better times to hedge forward (high auction levels) are also the hardest from a psychological perspective as the forward prices will be well discounted (by 10-20%). At the other end of the range, forward prices that are close to auction levels or above (at premiums) are in times when the market sees minimal risk of prices falling. Such a market view is only the combined opinion of participants in the forward market and precludes anticipation of abnormal events such as the pandemic in 2020.

What does this mean in practice? Figure 2 looks at the result of hedging 19 micron wool in November of each year from 1998 to 2023, for delivery/settlement 12 months forward. Monthly average prices are used. The auction 19 MPG is shown, as well as the 12-month forward quote at the time. The bars show the hedge result 12 months later in nominal Australian cents per clean kg. Figure 3 repeats the process for 19-micron wool forward sold 12 months in May.

Table 1 provides a breakdown of the hedge results from Figures 2 and 3 for the full 25 years and also for the last decade alone. It shows the median result, plus the range in quartiles and the average result. On average, hedging 12 months forward every year costs money. Hedging is not a profit centre. This means there has to be, on average, another benefit to hedging to make it worthwhile. Will it reduce price volatility? As the graphs show, the forward price is based on the auction price, so it will not address price volatility, though it will trim income in the higher price years (not a good result). To make hedging attractive to wool growers, either non-price benefits need to be present to offset the net cost, such as access to capital, or the buy side of the market needs to build in premiums to the pricing.