Since 2006, the volatility of market prices has shifted significantly higher for most agricultural commodities. More recently, key agricultural commodity prices across the United States peaked, buoyed by growing global demand. For example, corn, a major crop in the 15-state AgriBank District, reached prices of $6.50 to $7.00 per bushel in 2012-2013 — nearly twice the 10-year average of $3.51. However, following bumper crops in 2013, lower prices for corn, as well as soybeans and other commodities, are expected to substantially reduce the profitability of crop producers in 2014. Such market volatility underscores the need for crop producers to minimize price risk— with hedging strategies offering an effective solution.- CROP PRICES DECLINE. Key crop prices have moderated while most input prices have held steady or increased — likely to result in tighter profit margins for crop producers.
- HEDGING AFFORDS PROTECTION. Locking in a crop price through hedging can guarantee some level of profit — and protect producers if prices decline.
- SWAPS OFFER FLEXIBILITY. Less traditional price risk management tools such as swaps, which are similar to futures, may provide crop producers more flexibility.
Hedging primer: An effective strategy to manage price risk
Prices for corn, soybeans and other crops have moderated from recent highs, while supplies are abundant. Some inputs, such as fertilizer, have experienced price reductions. Meanwhile, prices for fuel and other inputs have held steady or increased. The result: Crop producers could face tighter profit margins than in recent years. A hedging strategy designed to lock in prices can help protect producers from volatile markets.
Crop producers are in business to raise corn, soybeans or other commodities and sell them at a profit. Many variables affect profitability, including production costs, growing conditions and the uncertainty of future crop prices. Some years may be profitable, others may not.
Will crop prices rise or fall? No one can predict for certain — but prices inevitably will change along with changes in supply and demand. Producers have various marketing tools at their disposal to protect themselves from the financial risk of price volatility. One effective tool is hedging, which enables producers to hedge a price for a crop before or after harvest. Hedging in a price that guarantees some level of profit — or at least a break-even point — protects producers if prices decline. Producers won’t benefit from any gain if prices rise after they hedge in a price — but the goal for financially prudent producers who use hedging is to protect against downside price risk for a future cash sale (or upside price risk for a future cash purchase of an input), not enhance margins.
Defining a hedge requires understanding the two separate but related markets for farm products: the local cash market and the futures market.
LOCAL CASH MARKET — the physical market such as an elevator, ethanol plant, processor or terminal where a farmer sells an actual crop or other product
FUTURES MARKET — any exchange on which futures and options contracts are traded for future delivery of a commodity at a specific date, grade, place, price and quantity
Producer hedging of a produced commodity involves selling commodity futures contracts as a temporary substitute for selling in the local cash market, since the commodity will ultimately be sold in the cash market. The producer may also hedge future purchases of input commodities (such as a feedlot that feeds cattle) by buying futures as a temporary substitute for the future cash purchase.
The term basis refers to the difference between the local cash market price and the futures market price. For example, a bid of $4.00 per bushel for corn in the local cash market may be derived from a futures market price of $4.20 and a basis of 20 cents under the futures.
Sound marketing plans address price risk management
The greatest benefit of a marketing plan is to minimize emotional involvement. A well-planned strategy can help accomplish short-run measurable objectives and long-run business goals.
Following are five necessary components of producer marketing plans:
- WELL-DEFINED GOALS AND OBJECTIVES — must be reasonably attainable given the current production and financial characteristics of the farming operation
- THE PRODUCTION INFORMATION FOR THE PARTICULAR ENTERPRISE — the producer should know both the fixed and variable costs of production, which are necessary to establish pricing targets within the marketing plan. Also, for hedging an uncertain future production level (such as before harvest of a planted crop), it is important to know the historical yield and the level/type of crop insurance that is put in place in order to determine the size of the hedge position.
- A GENERAL DISCUSSION OF THE FUTURE COMMODITY PRICE OUTLOOK THAT TAKES INTO CONSIDERATION ALTERNATIVE SCENARIOS, NOT JUST MARKET FORECASTS — should include (at a minimum) the baseline, worst-case and best-case forecasts based on possible directions of the market
- A MARKETING TOOLBOX THAT CONTAINS THE STRATEGIES APPROPRIATE TO THE PRODUCER AND THE OPERATION — include only those tools where the level of risk is appropriate to the financial risk-carrying capacity of the business and to the comfort level of the owner or management team
- AN IMPLEMENTATION PLAN THAT PROVIDES THE ROADMAP TO REACHING THE GOALS AND OBJECTIVES OF THE MARKETING PLAN — should contain enough flexibility to adjust to changing market conditions, as well as take into account the typical production cycle of the commodity and any seasonality that may be present
This glossary provides a list of terms related to hedging.
Information in this post was provided by AgriBank. AgriBank is FCS Financial’s funding source. It is one of the largest banks within the national Farm Credit System, with more than $80 billion in total assets. Under the Farm Credit System’s cooperative structure, AgriBank is owned by 17 affiliated Farm Credit Associations. The AgriBank District covers America’s Midwest, a 15-state area from Wyoming to Ohio and Minnesota to Arkansas. More than half of the nation’s cropland is located within the AgriBank District, providing the Bank and its Association owners with exceptional expertise in production agriculture. For more information, visit www.AgriBank.com.
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