Price Volatility Brings Marketing Opportunities, With Risks
Most of the marketing news recently has focused on the accuracy of USDA reporting. Although this topic merits conversation, the debate doesn’t help you market grain. The amount of uncertainty about national production and your own farm yield has put farmers in a tough place. Should you be selling growing crop now, or waiting?
According to the July 28 USDA Crop Progress report, 58% of U.S. corn is silking, well behind the 2014-18 average of 83%. This delayed crop progress has positively impacted the price of corn but makes farmers nervous about how much grain they are actually going to produce and even more nervous using cash contracts to price it.
If you feel prices will increase, but you’re unsure of your production, leaving your growing crop unpriced is a valid survival strategy. Waiting to price your crop until later in the season will allow you more time to assess your anticipated production, at which time you may be more comfortable with cash contracts.
However, if you do not believe that current price levels can be sustained, futures markets contracts can assist you in capturing current prices. Futures markets allow for flexibility if production is less than contracted bushels as futures contracts allow the user to “roll” the uncontracted bushels forward to next year’s harvest.
Let’s assume that at some point this summer, a farmer believes that prices will peak and gradually fall as harvest approaches. The farmer could short the market by selling a futures contract. A short hedge would provide protection against financial loss from a decline in market prices while simultaneously exposing the farmer to additional financial risk from buying back contracted bushels that were not produced. Let’s walk through a couple of examples.
Example 1. On June 17, a farmer places a short hedge by selling a December 2019 corn futures contract at $4.55 per bushel. At harvest, the price for the futures contract is $4.27 per bushel. Buying the futures contract back while delivering the grain, the farmer would obtain $0.28 per bushel less any brokerage fees.
Example 2. On June 17, a farmer places a short hedge by selling a December 2019 corn futures contract at $4.55 per bushel. At harvest, the price for the futures contract is $4.90 per bushel but the farmer does not have enough bushels to fulfill the last futures contract. If the farmer bought the futures contract back, they would owe $0.35 per bushel ($4.90-$4.55) for the 5,000-bushel contract. This cost can be alleviated by rolling the December 2019 futures contract to December 2020. This strategy may be a benefit if December 2020 is trading at a premium to December 2019 or a cost if December 2020 is trading at a discount to December 2019.
Currently, December 2020 futures is trading at a discount to December 2019 of around $0.10 per bushel. Rolling today from December 2019 to December 2020 would reduce the futures price by $0.10 to $4.45 per bushel. To “roll” this hedge at harvest the farmer would buy back the December 2019 contract at $4.90 per bushel while simultaneously selling December 2020 at $4.80 per bushel. Effective futures price is $4.45 ($4.80-$0.35). This is a valid strategy because a) the farmer does not suffer the financial cost during harvest of 2019; b) this would be the first sale of 2020, which applies to a small amount of 2020 expected production at a decent price.
These are two examples of many possibilities. Actual costs will likely be greater than those presented here. If the producer borrowed money to make margin calls, then they would have to account for the interest expense. Brokerage fees apply to trades. While we deviate from actual costs, we do this to keep the analysis clean so readers can understand the flexibility associated with futures hedging.
You need to know how to respond to adverse market events to be comfortably involved in hedging. Not being comfortable with possible outcomes places extra and unwanted stress on the farm.
There are a few considerations that must be taken into account when deciding to use a hedging strategy.
- What are the fees associated with buying and selling futures market contracts? There are fees associated with hedging. Make sure you are aware of these fees and how they apply prior to placing a hedge.
- How many contracts are you going to price? Unlike cash contracts, futures contracts are set at 5,000 bushels per contract. Although you are not committing to delivery, it is not recommended that you contract more bushels than you expect to produce. Contracting more than you will produce will put you into a speculative position and at more risk for financial loss. Rolling futures contracts can help you alleviate this financial pain.
- What are your price targets? Like with cash contracts, it is important to have price targets when it comes to hedging. If you are shorting the market, at what prices are you going to sell each contract? It is recommended that you do not price every contract at the same level. More importantly, do you have an “exit plan” if the market moves against you? Having these price targets written beforehand will assist you in not getting caught up in the emotions of buying and selling futures contracts.
- How are you going to fund a brokerage account? A brokerage account is an investment account used to fund the hedge. For every penny the market moves against you, $50 is removed from the account for each contract. If your account becomes deficit, you will have to make margin calls, that is, put more money into your brokerage account. If you are using borrowed money to fund this account, you must also consider the interest expense of the barrowed money when determining your profit or loss from the hedge.
Over the next 30 to 45 days, the market will begin to understand its true production. Be ready for a changing market with a written marketing plan. A major milestone in directing the grain market will be the August 12 crop report. Grain marketing involves fully embracing the opportunity associated with price risk. The alternative is less attractive—a stated price for your commodity that does not change.