As commodities prices rally, producers of goods should be taking a hard look at marketing plans that will hedge downside price risk. When the U.S. initiated credit swap lines with Europe back in mid-December, commodities rallied across the board. Producers have had the bull in their corner; but with uncertainty in these markets being far from over, marketers should be looking into ways to lock in prices at these levels by using hedging strategies on the board. For producers who are new to hedging, there are a few things they should keep in mind before beginning.
In the agriculture world, hedging can be a dirty word. Everyone knows somebody who was involved with futures or options and lost money. When I hear stories about losing money, I always wonder what went wrong. Was it a misunderstanding between the producer and the advisor? Was there not enough cash to hold the hedges? Did the producer not coordinate his position adjustments on both the cash side and futures/options side? Most of the time, it’s a combination of those reasons combined with a lack of expectation setting that should be provided by the advisor.
Here are a few points to keep in mind before embarking on any marketing plan:
- Farmers or producers are inherently LONG the grain they choose to farm or produce. If a producer is planning to farm 50,000 bushels of corn, then they are the equivalent of being long 10 contracts of corn (1 contract = 5000 bushels). The feeling a farmer has being exposed to 10 contracts of price risk probably doesn’t feel the same as the speculator who bought or sold 10 contracts on his own, but the risks are equal. A big difference is the farmer doesn’t receive a daily statement from his bank telling him what his crop is worth every day. They aren’t bludgeoned with account statements or calls from FCM’s looking for them to meet a margin call.
- Most successful marketers don’t price their entire production at one time. They hedge incrementally throughout the year, rewarding the rallies that will inevitably come. Doing so helps eliminate seller’s remorse.
- The futures account and the account where the producer banks cash sales should be thought of as one in the same. They move together like a see-saw. The funds in the cash account may have to go to the brokerage account to support the futures/options positions, but that means that the farmer will be selling their product at higher prices. If they can’t meet a margin call or get credit to meet that margin call, then they should avoid marginable positions.
- If you lift a hedge in your futures account, make the corresponding cash sale on the physical side to offset the removal of hedges. The biggest mistake I see is when a farmer will exit a hedge and hold on to the product. This is a recipe for disaster. If a farmer is in a hedge, the futures account may take a loss, but that should be offset by the gains on the cash side. By lifting a hedge and not selling the product, the hedger could lose on the futures side and the cash side. This is the most common mistake we come across when analyzing a producer’s past experiences.
- The more a hedger pays up front for the hedge, the less they will have to worry about margin calls should the market move against their positions. Those who only buy puts never have to worry about a margin call. Those who do collars and sell options will need to keep an eye on the margin and liquidity levels in their accounts. It’s important to be able to keep the account liquid so the hedges can be kept in place, if the hedger decides to exit the hedges because their short calls would be under pressure, they need to sell their production.
- Consult your banker before starting. A hedging plan should be something they recommend as well. Commercial bankers get uncomfortable when their customers sell production at prices under cost. They will encourage any producer to do whatever it takes to avoid that.
- Never get over sold. Don’t sell production you don’t have – or won’t have. Most of the horror stories we hear from producers who have experienced bad hedging make this mistake.
There are several points to consider before hedging. Speak to a good advisor who can explain in layman’s terms how hedges work and what will happen to both the cash account and futures account if prices go a certain direction. There’s no better place to start than giving a Daniels Trading advisor a call at +1.800.800.3840. We promise to listen first and talk straight.
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Kevin Van Trump has made it his goal to help provide those in the Agricultural Business with the latest and most comprehensive news, information, commentary, and marketing strategies in the industry. He hopes this information helps you make better marketing decisions and keeps you more informed about current price direction and overall market dynamics.
