The relationship between the cash value of a commodity and its counterpart in the futures market can be complicated. Depending upon the product and market being traded, strategies to capitalize upon the correlation may be equally complex or relatively simple.
Producer Hedging Practices
Participants in the markets of storable agricultural commodities find a standardized futures exchange especially useful for “hedging” financial risk. Perishable items — such as corn, soybeans, wheat, and rice — are examples of products that are actively swapped for cash while being openly traded on futures markets. In these cases, the trade of futures contracts serves as a vital tool for risk management and as a catalyst for speculation.
The modern futures marketplace gives producers and processors the ability to efficiently mitigate risk through hedging the value of their products. From the viewpoint of the producer, traditional hedging is accomplished through being long in the cash market while taking an opposing position in the futures market.
As an illustration, let’s say a wheat farmer wishes to seek protection for next year’s crop of winter wheat:
- In August, the crop is planted with a projected yield of 10,000 bushels. Harvest will be May-July of next year. As of the crop’s planting, the farmer is effectively long the wheat cash market.
- To mitigate pricing risk, the farmer sells two contracts of next July’s Chicago Soft Red Winter (SRW) wheat futures. The farmer is effectively short the wheat futures market.
After the hedge is put on, the only market-related risk assumed by the farmer is attributed to wheat’s “basis.” Basis is the difference between a product’s price in the cash market and its price in the futures market at a specific time. In the event that the cash price of wheat decreases faster than the futures price does, the effectiveness of the hedge is compromised. However, if the price of wheat increases at a faster rate than the futures price, a net gain is realized. While basis risk can be considerable, it pales in comparison to price risk.
Aside from limiting price risk, a primary advantage of hedging is that crop producers are able to sell their product at anytime, to anyone. In the event that a local buyer is willing to pay a premium in the cash market, the futures position is easily closed, and the profits are tallied.
Advantages of Commodity Storage
Stockpiling commodities can be a profitable undertaking for producers possessing the resources required for product storage and transport. Physically holding a commodity presents the opportunity of gain due to beneficial changes in the product’s basis, positive tax implications, and profiting from positive “carry.”
Carry is the difference in the price of a commodity between two separate delivery months. There are two types of carry:
- Positive: Positive carry occurs when the price at delivery in upcoming months is higher than a commodity’s delivery in preceding months. It represents the premium available to parties that are able to store a product until some time in the future. Higher prices for the future delivery of a product indicate that potential buyers are satisfied with current supply levels.
- Inverse: Inverse carry occurs when there is a shortage, or perceived shortage, of a particular commodity. In contrast to positive carry, the price of a product for future delivery is lower than its current price. This provides incentive for immediate marketing of the product.
Positive carry can be a big part of a producer-side trading strategy. For instance, crop producers often view positive carry as a means to realize a substantial profit. While the ultimate goal of crop production is to raise and deliver a product to market at the best available price, being paid a premium to store a product may be too good to pass up.
Given the following scenario, a wheat grower may want to implement a hold strategy for the coming harvest:
- It is June and harvest of winter wheat is in full swing
- Pricing for July Chicago SRW wheat futures is lagging, an indicator of potential underperformance in the cash market at delivery
- Chicago SRW futures contracts for September, December, and March of next year are trading at $.05, $.10, and $.20 per bushel premiums
Remember that profiting from a carry strategy is dependent upon commodity pricing at local cash markets. Often, transport to various regional markets is necessary to realize optimal profitability.
Awareness Is Key
The markets are challenging, dynamic, ever-evolving arenas. However, producers have access to many resources that make engaging the markets on beneficial terms possible. If needed, a reputable futures firm can provide valuable experience, market-related knowledge and guidance to producers.
Ultimately, producers must accept the responsibility to stay aware of current market conditions and make informed trading decisions. By performing the necessary due diligence, and seeking guidance when necessary, producers can benefit by engaging the marketplace and hedging financial risk.