AGRITHOUGHT REPORTS
April 2016
For producers, it's no surprise that crop prices have tumbled after a long bull run, largely due to ample global inventories and recent bumper harvests. However, the surprise may be in a recent Agriculture Department (USDA) forecast, which projects only a modest long-term rise in prices for major grain and oilseed crops. Due to that lack of optimism for another sharp market rise anytime soon, a well-considered marketing approach becomes that much more vital to the bottom line.
"In the current environment where we have large commodity stocks-to-use ratios, prudent risk management is increasingly important," said Pete Rudeen, AgriBank's vice president of Association relationship management. "For most producers, that means taking a look at everything in your marketing and hedging toolbox, and having a strategy in place for when opportunities present themselves this season."
In its Agricultural Projections to 2025 report issued in February, USDA noted that prices for corn, soybeans and wheat would continue to face downward pressure this year, with a strong U.S. dollar and weak income growth in developing nations hurting export demand (see chart). For the 2016-17 crop and marketing cycle, USDA forecast a cash farm price of $8.65 per bushel for soybeans, $4.40 for wheat and $3.60 for corn.1 While declining fuel and fertilizer prices may provide some relief this spring, producers will still need to take a hard look at their outlay for rent, seed and other expenses to justify operating loans and maintain cash flow.
In the longer view, USDA assumes that continued global population and income growth – combined with rising food or industrial uses for corn and biofuel uses for soybeans – will lead to steady or moderately higher prices. Over the next decade, USDA expects the cash price for soybeans to gradually hit $9.35 a bushel, with wheat rising to $4.95 during that same time frame. Meanwhile, corn prices are forecast to remain nearly flat, increasing to just $3.75 per bushel by 2025.2
Like any other business owners, producers grow their commodities with the goal of selling at a profit. However, in the current low-price environment, they need to maximize the use of various marketing tools to gain protection from the financial risks of price volatility. One effective tool is hedging, a strategy that may guarantee some level of profit – or at least a break-even point – in the event that prices decline. The goal for financially prudent managers is to use hedging to protect against downside price risk for a future cash sale (or upside price risk for a future cash purchase of an input such as feed).
Common hedging tools available to producers include:
Futures. Producers can protect against a decline in upcoming cash prices by placing a hedge in the form of a futures contract. These standardized contracts are traded on exchanges designated by the U.S. Commodity Futures Trading Commission (CFTC) for futures trading. A futures contract allows buyers and sellers to establish a price for delivery or receipt of the standardized commodity at a specific location and future time period. Because these contracts are standardized and essentially the same regarding terms of delivery for each commodity/month specified, they can be offset by making a transaction opposite to the initial transaction in the contract market. The financial gain or loss on the futures transaction is added to the gain/loss from the actual cash transaction in the local market to establish a net buying or selling price to the hedger.
However, futures hedges are subject to basis risk, which is the fluctuation between local cash prices and those quoted in the futures markets. Because the futures market is standardized and the cash market is not, the basis generally reflects the price/cost differences between the two markets in time (storage/seasonality), location (transportation), form (quality premiums and discounts), and market conditions (usually referred to as the random component). So, to put it succinctly, hedgers substitute basis for cash price risk and do so because basis is less volatile and easier to predict.
Options. Like futures, options are standardized contracts that trade on the futures exchanges. However, the two key differences with options include the ability to set a floor price (put option) on a future sale or a ceiling price (call option) on a future purchase and to participate in favorable price moves to the upside (put option) or downside (call option). In exchange for this flexibility, the hedger (buyer of the option) pays an up-front premium for a specific level of price coverage, based on a list of available strike prices.
Swaps. While swap agreements are very similar to futures contracts, they typically offer a higher level of customization and flexibility. These contracts are available either on the futures exchanges or in the over-the-counter (OTC) marketplace. A swap is simply a contract that calls for the exchange of cash flows between two parties, based upon a particular market price or index value. The most common kind of swap in commodities is the fixed-floating swap, where one party pays a predetermined fixed price and the other party pays a market-determined floating price. For hedging a future cash sale, a producer will take the market-determined float side of the swap. A swap functions much like a futures contract in terms of its price risk coverage; however, because it is generally offered through the over-the-counter (OTC) marketplace, it has more flexibility with regards to some of its terms such as contract size and method of settlement.
Cash forward contracts. Cash forward agreements are between the producer and a local buyer, such as an elevator, ethanol plant or other processor. The four general types of cash forward contracts are:
AgriHedge. This tool, introduced by AgriBank in 2013, can help a producer hedge price risk without the concern of daily margin calls. The AgriHedge product includes a loan through a local Farm Credit Association that supports a commodity swap provided by a third party. Once an AgriHedge account is set up, a producer may initiate a swap with an AgriBank-designated partner in order to lock in a fixed futures price for a crop (which does not require physical delivery of the commodity). Depending on how market prices move, a producer could either owe money or receive money at the end of the swap period. Farm Credit will cover any required daily margin calls during the life of the swap and will settle up with the producer at swap expiration. Throughout the process, the producer enjoys the confidence that a Farm Credit loan commitment is available to cover the entire hedging strategy. Interest does not accrue on this loan commitment unless funds are needed at swap expiration to pay the final margin requirement.3
While available hedging tools are important, a carefully constructed producer marketing plan is critical to success in this low-price, tight-margin environment. At a minimum, this plan must include a specific review of all fixed and variable production costs, crop pricing targets, and an analysis of how crop insurance and federal Agricultural Risk Coverage (ARC) or Price Loss Coverage (PLC) payments may affect cash flow and overall risk management. Once those elements are in place, the producer can sketch out a crop marketing roadmap that accounts for any potential issues, such as prevented plantings or weather threats, as well as opportunities, such as unexpected spikes in commodity pricing.
Jeff Houts, executive vice president of operations for FCS Financial in Jefferson City, Mo., said this year's expected drop in gross income will put a premium on cash flow. In the short term, that may require some producers to restructure capital payment requirements or tap equity in land or other assets to cover shortfalls in liquidity through the upcoming crop year. This is particularly necessary when producers evaluate their hedging options, since the use of those tools can directly affect cash flow requirements.
"In this cycle, producers need to understand the uncertainties and the market trends," Houts said. "However, I also believe they need to focus mainly on their operations, and the certainties they can create with a marketing plan. By really understanding their production costs, break-even numbers and financial goals, that plan will create a lot more opportunities for them to execute when the time comes."
Sources:
1"U.S. Agricultural Projections to 2025: U.S. Crops" (February 2016) United States Department of Agriculture
http://www.ers.usda.gov/media/2017433/oce-2016-1-c.pdf
2"U.S. Agricultural Projections to 2025: U.S. Crops" (February 2016) United States Department of Agriculture
http://www.ers.usda.gov/media/2017433/oce-2016-1-c.pdf
3Partnering for Today's Success and a Stronger Tomorrow (April 4, 2013) AgriBank 2012 Annual Report
http://info.agribank.com/Test/AgriBank_Full_Report_4.4.13.pdf
April 2016
For producers, it's no surprise that crop prices have tumbled after a long bull run, largely due to ample global inventories and recent bumper harvests. However, the surprise may be in a recent Agriculture Department (USDA) forecast, which projects only a modest long-term rise in prices for major grain and oilseed crops. Due to that lack of optimism for another sharp market rise anytime soon, a well-considered marketing approach becomes that much more vital to the bottom line.
"In the current environment where we have large commodity stocks-to-use ratios, prudent risk management is increasingly important," said Pete Rudeen, AgriBank's vice president of Association relationship management. "For most producers, that means taking a look at everything in your marketing and hedging toolbox, and having a strategy in place for when opportunities present themselves this season."
In its Agricultural Projections to 2025 report issued in February, USDA noted that prices for corn, soybeans and wheat would continue to face downward pressure this year, with a strong U.S. dollar and weak income growth in developing nations hurting export demand (see chart). For the 2016-17 crop and marketing cycle, USDA forecast a cash farm price of $8.65 per bushel for soybeans, $4.40 for wheat and $3.60 for corn.1 While declining fuel and fertilizer prices may provide some relief this spring, producers will still need to take a hard look at their outlay for rent, seed and other expenses to justify operating loans and maintain cash flow.
In the longer view, USDA assumes that continued global population and income growth – combined with rising food or industrial uses for corn and biofuel uses for soybeans – will lead to steady or moderately higher prices. Over the next decade, USDA expects the cash price for soybeans to gradually hit $9.35 a bushel, with wheat rising to $4.95 during that same time frame. Meanwhile, corn prices are forecast to remain nearly flat, increasing to just $3.75 per bushel by 2025.2
A Closer Look at the Hedging Toolbox
Like any other business owners, producers grow their commodities with the goal of selling at a profit. However, in the current low-price environment, they need to maximize the use of various marketing tools to gain protection from the financial risks of price volatility. One effective tool is hedging, a strategy that may guarantee some level of profit – or at least a break-even point – in the event that prices decline. The goal for financially prudent managers is to use hedging to protect against downside price risk for a future cash sale (or upside price risk for a future cash purchase of an input such as feed).
Common hedging tools available to producers include:
Futures. Producers can protect against a decline in upcoming cash prices by placing a hedge in the form of a futures contract. These standardized contracts are traded on exchanges designated by the U.S. Commodity Futures Trading Commission (CFTC) for futures trading. A futures contract allows buyers and sellers to establish a price for delivery or receipt of the standardized commodity at a specific location and future time period. Because these contracts are standardized and essentially the same regarding terms of delivery for each commodity/month specified, they can be offset by making a transaction opposite to the initial transaction in the contract market. The financial gain or loss on the futures transaction is added to the gain/loss from the actual cash transaction in the local market to establish a net buying or selling price to the hedger.
However, futures hedges are subject to basis risk, which is the fluctuation between local cash prices and those quoted in the futures markets. Because the futures market is standardized and the cash market is not, the basis generally reflects the price/cost differences between the two markets in time (storage/seasonality), location (transportation), form (quality premiums and discounts), and market conditions (usually referred to as the random component). So, to put it succinctly, hedgers substitute basis for cash price risk and do so because basis is less volatile and easier to predict.
Options. Like futures, options are standardized contracts that trade on the futures exchanges. However, the two key differences with options include the ability to set a floor price (put option) on a future sale or a ceiling price (call option) on a future purchase and to participate in favorable price moves to the upside (put option) or downside (call option). In exchange for this flexibility, the hedger (buyer of the option) pays an up-front premium for a specific level of price coverage, based on a list of available strike prices.
Swaps. While swap agreements are very similar to futures contracts, they typically offer a higher level of customization and flexibility. These contracts are available either on the futures exchanges or in the over-the-counter (OTC) marketplace. A swap is simply a contract that calls for the exchange of cash flows between two parties, based upon a particular market price or index value. The most common kind of swap in commodities is the fixed-floating swap, where one party pays a predetermined fixed price and the other party pays a market-determined floating price. For hedging a future cash sale, a producer will take the market-determined float side of the swap. A swap functions much like a futures contract in terms of its price risk coverage; however, because it is generally offered through the over-the-counter (OTC) marketplace, it has more flexibility with regards to some of its terms such as contract size and method of settlement.
Cash forward contracts. Cash forward agreements are between the producer and a local buyer, such as an elevator, ethanol plant or other processor. The four general types of cash forward contracts are:
- A fixed-price forward contract, under which the producer delivers the contracted quantity in the future for an agreed-upon fixed cash price payment
- A basis contract, under which the basis is fixed on a future delivery, but the futures price component remains open
- A hedged-to-arrive contract, under which the futures component of the selling price is fixed, and the producer has the ability to fix the basis component at a later date
- A minimum price contract, under which future delivery is specified at a minimum cash price, with a premium either paid directly by the producer or deducted from the sale price
AgriHedge. This tool, introduced by AgriBank in 2013, can help a producer hedge price risk without the concern of daily margin calls. The AgriHedge product includes a loan through a local Farm Credit Association that supports a commodity swap provided by a third party. Once an AgriHedge account is set up, a producer may initiate a swap with an AgriBank-designated partner in order to lock in a fixed futures price for a crop (which does not require physical delivery of the commodity). Depending on how market prices move, a producer could either owe money or receive money at the end of the swap period. Farm Credit will cover any required daily margin calls during the life of the swap and will settle up with the producer at swap expiration. Throughout the process, the producer enjoys the confidence that a Farm Credit loan commitment is available to cover the entire hedging strategy. Interest does not accrue on this loan commitment unless funds are needed at swap expiration to pay the final margin requirement.3
Focus on Operations, Be Alert for Opportunities
While available hedging tools are important, a carefully constructed producer marketing plan is critical to success in this low-price, tight-margin environment. At a minimum, this plan must include a specific review of all fixed and variable production costs, crop pricing targets, and an analysis of how crop insurance and federal Agricultural Risk Coverage (ARC) or Price Loss Coverage (PLC) payments may affect cash flow and overall risk management. Once those elements are in place, the producer can sketch out a crop marketing roadmap that accounts for any potential issues, such as prevented plantings or weather threats, as well as opportunities, such as unexpected spikes in commodity pricing.
Jeff Houts, executive vice president of operations for FCS Financial in Jefferson City, Mo., said this year's expected drop in gross income will put a premium on cash flow. In the short term, that may require some producers to restructure capital payment requirements or tap equity in land or other assets to cover shortfalls in liquidity through the upcoming crop year. This is particularly necessary when producers evaluate their hedging options, since the use of those tools can directly affect cash flow requirements.
"In this cycle, producers need to understand the uncertainties and the market trends," Houts said. "However, I also believe they need to focus mainly on their operations, and the certainties they can create with a marketing plan. By really understanding their production costs, break-even numbers and financial goals, that plan will create a lot more opportunities for them to execute when the time comes."
Sources:
1"U.S. Agricultural Projections to 2025: U.S. Crops" (February 2016) United States Department of Agriculture
http://www.ers.usda.gov/media/2017433/oce-2016-1-c.pdf
2"U.S. Agricultural Projections to 2025: U.S. Crops" (February 2016) United States Department of Agriculture
http://www.ers.usda.gov/media/2017433/oce-2016-1-c.pdf
3Partnering for Today's Success and a Stronger Tomorrow (April 4, 2013) AgriBank 2012 Annual Report
http://info.agribank.com/Test/AgriBank_Full_Report_4.4.13.pdf
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