In this article, you will learn what hedging is, why you should be hedging sorghum, and how it’s done.
Congratulations, assuming you harvested a crop over the last 5 years, you should have experienced a financial windfall from the price rally in sorghum and the other grain markets. The rallies we have seen in grains since 2005 have provided the US producer with profit margins not seen in years. This is good because higher prices mean more money for producers. This is bad because big profit margins encourage more farming, which is bad for price in the medium term. I’m sure you have read the latest reports calling for a substantial price correction in all grain markets over the next 12 to 24 months, should the 2013 growing season be a fruitful one. As the winds change, producers are encouraged to change their behavior. What has worked marketing crops the past few years may not work in 2013. If the new crop has good growing conditions, the current fundamental setup will look completely different in 9 months than it does right now.
Because of this fundamental supply change, those who lost and sold early/hedged in 2012 will win this year, as the amount of supply coming online at the end of the season will dwarf current demand, erasing much of the advantages producers have enjoyed over the last 8 growing seasons.
So, what is a guy/gal to do? How do I establish a plan? Is there even a place to hedge sorghum? If those are some of your questions, you are reading the right guide.
Let’s start from the beginning with some frequently asked questions:
What is a hedge? A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by a producer or end user of a commodity. Hedges can be good or bad. Ask those who hedged in 2012 their opinions on the practice. They will differ from those who hedged in 2004. Hedging risk is a process, it is a behavior. It is NOT a one-time act aimed at creating wealth.
Why would I want to consider this? Many farmers have an internal battle whether or not to participate in a risk management program. The main reason why you should look to participate is that prices have a lot of room to fall. As a business owner, you probably understand the importance of protecting profit margins. High prices and out-of-this-world profit margins have changed the perception of farming. It went from something that only folks in the country did for money, to something everyone/anyone with a lot of investment capital needs to be involved in. This is good and bad for the producer. It’s good because your products and skills are in demand. It’s bad because more and more big money players in agri-business are scaling up production and buying up more land. Just like in any business, the big sharks will feed on the weak, and in this case, they will first go after those who cannot afford to farm 4.00 corn.
I am not completely sure end prices for agriculture products will stay high. I am 100% positive inputs will stay high, at least for the medium term. What I am trying to point out is that 5.00 corn/milo is not making farmers happy anymore. Two years ago, 5.00 corn was making farmers do backflips. Now I speak with farmers everyday who get hives thinking about selling anything under 5.50! Profit margins are beginning to be squeezed, so the savvy hedger/producer will need to manage prices to ensure they can survive the next few years if prices fall back into a more historically acceptable range, and at this point those ranges are below the cost of production for most producers. THAT, my friends, is the reason hedging should be considered by every producer.
There are many factors each individual producer will need to weigh, such as cash flow, storage capacity, local basis, etc. One of the most appealing aspects to using futures or options to hedge is that you are not committing your grain to anyone. YOU are in control of your product while it is in the field/bin, rather than an elevator or end user. Thus, you can cover price risk while not getting oversold or committing the product when there is a chance you may not be able to grow it.
How can I hedge sorghum if there is no futures market available? This is a common question for many sorghum producers, as there is no futures market available for milo/sorghum. But, there is a market that has almost mirrored the sorghum market (from a price standpoint) over the last 25 years: CORN! Before I get too in-depth into this, I think it’s important we establish why we use the corn markets.
If you have ever called your local elevator or coop, you know that Sorghum basis is calculated using corn futures. This is because milo is a direct substitute for those who feed or use corn in their end product. Because of this, it makes sense to use corn futures to hedge your production. Not only are the uses similar, but more importantly the prices are similar. Take a look at the two charts below, one is sorghum and the other is corn, can you tell which is which?
The top chart is corn and the bottom chart is sorghum. Although the charts are not 100% correlated, they are darn close. If a major price move is made in corn, then I think it’s safe to say we will see the same price action in the cash price of sorghum. For this reason, I feel sorghum producers can confidently and effectively use the corn markets to hedge their production.
Now that we have answered a few questions about sorghum hedging, let’s talk about what is driving price over the short/medium term. Because the price of sorghum is heavily correlated with the price of corn, it makes sense to establish the bearish/bullish fundamentals driving the corn markets. Even though you aren’t putting corn in the ground and won’t be selling it at the end of the season, you need to know what is going on in corn. The news and price movements of the corn market will drive your decision more than the fundamentals of the sorghum markets will.
I believe the issues discussed below will pull and push on the markets over the 2013 growing season. I think a lot of the issues cross over into the milo markets as well. Here is the fundamental set up for corn:
- The projected tightness in the current year’s balance sheet should be providing price rationing, not short term sell offs. If the trade starts to focus on what we have, not what we will have, the market should gain some traction.
- Potential inflation, coming from higher priced goods, will improve margins and make inputs more attractive if new crop prices would weaken. This must happen if prices are going to stay in this new trading range (between 5 and 8 dollars) over the long term. Remember, if the end user can’t make money using the products you provide, they will stop doing business altogether. End users like Cargill and Tyson are not the US Postal service. They won’t run their business in the red.
- Continued dryness in the Western Corn Belt. Right now no one seems to care. They will this summer if the weather patterns do not change. This will affect milo basis more than it will corn basis, as most of the sorghum production is in the hardest hit areas of the drought.
- Strong seasonal cash basis for feed (corn, milo, bean meal) will develop as the year goes on; the US has almost no corn on hand. The next three months are as crucial a time for the US corn markets as they have been in a long time.
- Open interest is at near term lows. If a bullish story would develop, the fuel is there for prices to rally.
- Late US and Chinese plantings. The early chapters of the 2013 corn story are not positive thus far. China has been delayed as has the United States. We have been hearing rumors of China increasing imports almost two fold should their growing season be slow. This is good for Sorghum, as it will follow corn.
- US Corn exports have been putrid (Is it because we have nothing to export?).
- Strong South American production, especially in Brazil, will provide a cushion should we have another hot, dry summer. This condition did not exist last year.
- Falling wheat prices, creating cheaper feed alternatives. I have been telling clients for weeks that wheat will lead corn down or up.
- Record large US 2013 plantings. The USDA is currently estimating over 97 million acres planted for 2013. This is almost 20% more than we did just 5 years ago. The current USDA yield estimate is 158 bushels per acre. Production of this size will erase our current carryout problem and should deflate prices in the short term as demand looks to be rebuilt through better livestock and ethanol profit margins.
- The USDA is also expecting an additional 7 million acres to be dedicated to sorghum this year as well. That is almost 30% more acreage than 5 years ago. As water becomes more of a problem in the Western growing areas, I expect milo to maintain its planted acre share against corn.
I hope this article has been a help and provided some food for thought about why this is something ALL producers of every commodity should have in their repertoire. The bottom line is that you can take the downside risk out of the market. You can actively manage your profit margins. It’s easy for producers to do well when prices rally like they have, but when the music stops, it is only the best farm managers who are still having fun. To be that manager, you need to be participating in the markets.
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