With the increased level of U.S. cotton plantings, the market is set up for an uncertain production outcome. Now that the Dec’17 ICE cotton contract is the most actively traded, production uncertainty is the main source of volatility for futures prices. Production influences like rainfall, temperature, crop condition, and yield potential are the specific influences.
The USDA’s first benchmark production forecast back in May was 19.1 million bales U.S. all cotton. That projection was based on above average yields and below average abandonment. But that production potential will only be realized if we have timely rains during the summer, and then good maturation weather in the early fall. If that happens, the expectation of surplus supplies could easily push futures prices below 60 cents by harvest time.
Similarly, the expectation of a large crop would likely result in more typical Texas cash price offerings, e.g., 6 cents to 8 cents under Dec’17 instead of the much stronger basis that growers saw during the previous nine months. Under a big crop scenario, Texas growers could be facing harvest time cash prices near the loan rate.
On the other hand, with a large increase in Texas acreage, there is always the possibility that unexpectedly harsh growing conditions will cause a widespread downshift in production expectations, leading to higher prices. We saw that briefly during July 2016, when the futures market rose 12 cents, only to retreat 9 cents in August.
This summer will likely have a few weather scares, leading to upward price volatility. Frequently these weather market rallies come and go as the market adjusts to new expectations, especially when the initial headlines of a heat wave or hurricane turn out to be not so bad. In other words, higher prices will likely be fleeting.
How can a grower plan for such alternatives? The first step is the premise that the price outcome is ultimately uncertain. Then we need a contingency plan of action that a grower/hedger can take in various possible, but ultimately uncertain, market situations in the future.
A marketing plan can include many strategies, probably in combination with each other. These could include basic tactics like forward contracting, selling at harvest, marketing pools, and the USDA loan program. Hedging with futures and options can complement or substitute for these basic tactics.
REDUCE DOWNSIDE RISK
Besides identifying the specific tactics, a marketing plan should include targeted price levels (based on your production costs) and calendar dates when you will take a given action. A marketing plan could even include rules about when you will exit hedged positions, e.g., by a certain date, or after achieving a given level of profit.
Regardless of the tactic, the goal should be to reduce downside price risk while allowing for the possibility of higher prices. The accompanying chart outlines several ways of doing this.
One way is to buy put options to provide a flexible floor against falling cash prices, while allowing for upside potential while the crop remains unsold until harvest. Another way of doing this would be to sell a futures contract and buy an at-the-money call option. Both of these strategies assume that growers would have cotton bales to sell in the harvest-time cash market (that is what gives you the upside potential).
Many growers, especially dryland growers, face too much production risk to assume a crop at harvest time. In that case, the two hedging strategies described above could be applied, covering a level of production at or just below the grower’s APH yield*Revenue Policy coverage level. Both of these strategies still face basis risk.
A third way of implementing a flexible floor is to match cash contracts (either forward or at harvest) with at-the-money call options. The cash contract sets the floor protection (and eliminates basis risk), and the call option allows for upside price potential. Of course, forward cash contracts can impose yield and quality risk on growers, as well as all the legal obligations in the agreement.
For additional thoughts on these and other cotton marketing topics, please visit my weekly on-line newsletter at http://agrilife.org/cottonmarketing/