Through our experience from working with more than a few grain farmers, we are always dealing with the producer dilemma of choosing whether they should hedge or make a cash sale. As similar as the two choices appear to be, they are NOT one in the same. Each action will eliminate downside price risk, but with different results. When faced with these options, it is important to identify the factors driving the decision making process. So, first thing we need to establish are the variables that will be affecting our decision.
With grain, the variables are pretty straight forward. They are the basis (cash price minus futures price) and futures price itself. More specifically, is the basis and/or futures price relatively low or high compared to where we think they will be in the future? For this article, the variables will be classified as either rising or falling. In more normal markets, the cash prices tend to dictate the futures prices. However, since managed funds are creating deeper waters and stronger currents in the deferred contracts, money flow has partly taken over as a driver for futures prices. This has left normally certain markets with unique set ups that producers aren’t used to.
An additional factor will be whether or not the producer has on-farm storage. Many farmers have been leery of USDA data released lately. Because of the perceived contradiction between the cash market and information provider (USDA), producers have been hesitant to part with their grain. They feel it’s a better investment in their future to hold the grain and wait for the best cash price they can instead of “trading” it for cash just because they feel it is time to reduce risk. If they are going to keep their grain on the farm, then they need to look to the board as a way to reduce said risk. A farmer with 20 K bushels of corn in the bin has no less risk than the speculator with 4 futures contracts on his books. Operating under any other assumption is ignoring the big business their farm has become.
With that in mind, let’s look at the playbook for the different scenarios we will see:
Falling Basis/Falling Futures price — This is the toughest set of variables the producer will be presented with. This is a market we have not seen much recently in beans or corn; however, the wheat market has provided a little of this setup lately with a weak basis and a weakening futures price. For this kind of market, I would recommend holding the grain as long as possible and waiting for a move higher in your local cash price. If the producer doesn’t have storage or is inclined to sell, then a re-ownership strategy on the board via futures purchase or bull call spread would be in order. With the markets near seasonal and annual lows, producers should be holding and waiting to sell cash on a move up in either basis or futures.
Rising Basis/Falling Futures price — This type of market is seen when the futures are in a sell off mode, but the basis is not. The old crop corn markets have been showing these characteristics as of late, with the futures price being semi depressed by fund selling, the prospect of big supplies coming on line, and the cash price reflecting tight supplies and a record basis. In other words, something doesn’t jive. In markets like these, I recommend HTA type sales via selling calls on the board, collars (sell a call, buy a put) or selling outright futures. Essentially, when a market falls and the basis rises, one wants to eliminate the general market price risk and leave the basis free to float. When one sells the futures, they lock in everything except basis. If a producer believes their basis will improve and doesn’t want overall price risk, he can just sell the futures, which will leave him only exposed to the local cash forces from wherever they sell cash product. This is popular in a market that is selling off because the futures account will make profits from falling prices, and the cash side of the business will still be able to profit from relative cash appreciation.
Rising Basis/Rising Futures price — For this scenario, producers should look to make cash sales via forward contracting or a cash contract. If the basis is high along with the futures (as seen in the current soybean market), then producers should forgo hedging and get the best cash price they can. Another strategy would be a back spread (buying 2 puts and selling 1 in the money put. This can provide the producer with protection to the downside with the ability to profit from an upside move. Another choice for producers in this scenario so they can hold on to the grain, they should look for a “basis contract” through an elevator or ethanol plant that will lock in their basis. If you can’t find a basis contract locally, you can synthetically create a basis hedge by selling the front month futures and buying the next available month.
An example can be seen in the current old crop soybean market. Due to production problems in South America, soybeans have gotten a lift in the futures markets, along with the cash markets. The basis has rallied in a time of the year when it is traditionally a little softer, and with the help of massive fund open interest, has seen the futures price rally almost 3.00 in a short period of time. A put purchase or sale of a futures contract would establish a good hedge but would do nothing for the basis. If one is insistent on holding on to the grain, I would recommend a collar, combined with a basis hedge. If the basis retreats, we should see the first/second month spread work in favor of the second month.
Falling Basis/Rising Futures price — REOWN!! This is the type of market where producers will want to reown the board. Eliminate that basis risk and just make hay on the board. When cash commodities sell off relative to the futures, one needs to get out of their cash position and onto the board. I encourage farmers who sell grain at a weak cash price in an environment where outside markets could push futures higher to execute ownership strategies via futures purchases or outright calls/call spreads. Re-owning the board eliminates the profits that producers would receive from selling their cash grain at higher prices with offset gains in their futures account.
I believe the market showing the most characteristics of this would be the new crop corn market. As more supply becomes more readily available, the local processors will be asking to pay less than they are today relative to the futures. We also want to re-own if the futures prices are looking to rally but you NEED to sell your cash corn. Don’t fall in love with your grain. Sell it in the cash, rebuy it on the board and regrow some more.
For more information on how to apply hedging strategies to your production, please contact us at 800.800.3840.
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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.