Commodity market situation - 2008
Editor’s note: This article is from the archives of the MSU Crop Advisory Team Alerts. Check the label of any pesticide referenced to ensure your use is included.
2008 has already shown significant volatility in the commodity markets. A fallout of this market has been the hesitance or inability of grain merchandisers to continue to forward contract grains. Rapidly advancing markets in January and February have forced many grain purchasers to continually shell out large sums of dollars to meet margin demands on their brokerage accounts servicing forward contracted grains at the CBOT. This means that many producers who want to lock in grain prices will have to work with brokerage firms directly. This may be out of the comfort zone for many producers.
Hedging is the purchase or sale of a futures contract as a temporary substitute for a cash market transaction to be made at a later date. Usually it involves opposite positions in the cash grain market and futures market at the same time. The cash market position refers to the farm’s commitment to deliver grain to the market during the contract month. As long as producers are working with a true hedge situation, producing a crop to offset their position in the futures market, the cost of marketing their grain this way should be limited to brokerage fees and potentially the interest cost of borrowing money to maintain the required balance of margin money on their accounts. On a corn contract, you can expect to have $2,000 on deposit when you open an account. The standard grain futures contract is for 5,000 bushels. Mini-sized contracts that cover 1,000 bushels are available for smaller producers. Keep in mind that it may cost nearly as much in brokerage fees to work with mini-contracts as it does to work with the traditional contract.
Margin calls are sometimes hard to understand for producers not involved in the futures market. The margin refers to the amount of “earnest money” that is required to be on deposit for the trading account. This is usually 10 percent of the value of the contract. With the price of commodities rapidly increasing, producers or elevators that hedged or positioned themselves with sold futures contracts at well below the current market value must post enough money in their accounts to meet the increase in value, or the exchange will be obligated to close your position and require payment in full for the contract. Margin accounts must maintain the correct balance at the end of each trading session, so having adequate money at the brokerage to service this requirement is of the utmost importance. This may mean that producers may have to obtain a line of credit to service these requirements in order to hedge their crop.
In order to use the futures market to provide a true hedge, you have to be able to produce the amount of grain that is contracted in the futures market. The value of the grain, (board price plus basis [usually negative] at your deliver point) is the offset to futures position. The same kind of production risk that you would have with a forward contract will be in place with your futures contract. This tool can be used to lock in the futures position for a portion of the crop, but should not be used to market all of your expected production. In addition, the basis portion of the crop price is still at risk because you do not know for sure what basis will be at the time of delivery. Some elevators will allow you to lock in the basis. With the sold future position and a locked in basis, you have the same net result as a forward contract except that you need to have the cash available to handle the margin account. You may end up having income or expenses from your margin account. Limiting sales to 40-50 percent of your average crop can help make sure that you can meet your financial obligations. Crop insurance or irrigation can help mitigate some of these risks.
Southwest region farm management educator Roger Betz reminds us that the key ingredient in making good marketing decisions is to have an understanding of your needed revenues per acre to meet cash flow demands and to maintain financial net worth. At today’s prices, most producers can meet the economic cost of production. However, it is important to recognize that cost of production, cash flow and maintaining net worth are three very different values. With knowledge and understanding of these values for your farm, good marketing decisions can be made in this volatile pricing situation.
Hedging with a futures contract is not the only tool available for helping to price grains. MSU southeast regional farm management educator Dennis Stein suggests some producers may want to consider the use of a PUT option. By using a PUT option to insure a minimum price, you can set a floor price for a given number of bushels of grain. An option is a contract between two parties that conveys to the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a PUT) a specific commodity at a specific price within a specific time period for a premium. The premium, which is the cost, is made up of a combination of the market’s price movement risk and a time value. When you buy a PUT option, you pay the premium (like car insurance) with every hope that you will never need to collect on the policy, in this case, that the price of the grain stays above the PUT options strike price. The premium cost is a fixed amount that you invest to have your position in the market and to cover the price risk.
If you have not used this marketing tool in the past now may be the time to learn more about this market risk management tool. As a rule of thumb, options are best used in times where you are not able to determine the direction that the commodity market is taking and wish to protect against a major negative move in the market. Options tend to be a poor choice if prices do not change much.