Don’t understand the new generation marketing contracts being offered by CHS, ADM, Cargill and others?

You are not alone.

The emergence of complex grain marketing contracts, both over-the-counter products (e.g. accumulator contracts), and combinations of futures and vanilla options (e.g. price plus contracts), has complicated the management of farm portfolio risk, says Lisa Elliot, South Dakota State University Extension commodity marketing specialist

These new complex grain marketing contracts are often given unique names and are unique in the way they manage risk.

She and Matthew Elliot, SDSU Extension agribusiness specialist, prepared the chart accompanying this article comparing and explaining seasonal averaging contracts, premium contracts, minimum price contracts and accumulator contracts.

Contract guide
In addition, they offer the following guide to the contacts:

• Averaging contracts are typically just an average of the daily futures closes over a given time period to determine a contract price. One can accomplish the same result as averaging contracts by hedging a set amount of bushels equally during a specified period.

• There are also averaging contracts that include downside price protection. These contracts are similar to buying a put and then selling a set amount of bushels each day, usually an equal amount.

• Premium contracts typically provide a premium to the futures price that is being offered today if in the future the producer is willing to sell more bushels if the futures price is higher than a target price that is set. Premium contracts usually only commit a set amount of bushels in the future sale, and if the price on a future date is below a target price then a sale of additional bushels is not required. Premium contracts are similar to selling an out of the money call and selling a futures contract.

• Minimum price contracts typically lock in a basis and a floor but allow for some upside potential. This type of contract is similar to a basis contract to lock in basis, but also buying a put to ensure a minimum futures price.

• Another type of minimum price contract exists with limited upside potential but usually a higher minimum price. This would be similar to a basis contract plus buying a put and selling a call, or what is typically called a collar. The selling of the call returns a premium that can be used to help reduce the costs of buying the put.

• Accumulator contracts offer premiums on a non-guaranteed amount of bushels. In accumulator contracts, the bushels are committed and sold at a premium rate if the market does not fall below a threshold called a knockout barrier. Accumulator contracts also require a greater rate of bushels to be sold if the price rises above what is called the strike price or “double up.” The amount of bushels sold in an accumulator contract depends on the number of days the futures price remains above the knockout barrier and above or below the strike price. Accumulator contracts would be similar to buying an in the money vanilla put and selling out of the money vanilla calls. However, accumulator contracts are different in that the amount of bushels sold is dependent on the time and price path of the futures contract during the duration of the contract period. This difference typically allows higher premiums to be achieved but may involve less risk reduction.

• There are also accumulator contracts where a guaranteed amount of minimum bushels are to be sold. Bushels are committed and sold at a premium rate if the market does not fall below the knockout barrier threshold over the contact period. If the knockout barrier is breached, then the remaining bushels of the guaranteed amount of bushels are sold at the floor price.

Pros and cons
There are positives and negatives to using elevator contracts versus performing the trades yourself, the Elliotts point out:

Positives. You can be provided an upfront payment for an agreed sale to the firm. Moreover, you would not have to maintain maintenance and margin in a futures/options trading account. Further, elevators can sometimes provide you with unique risk management opportunities that would only be available by firms that offer over-the-counter products. Finally, contracting with elevators can give you the opportunity to lock-in basis.

Negatives. The downside of utilizing contracts through elevators would be that they often result in committing your commodity delivery to a specific firm. Thus, opportunities to deliver to different locations that may offer better basis pricing at a future date are lost. In addition, an elevator may charge a greater fee on the contract than what you would have to pay in trading fees on your own. Finally, by contracting with an elevator, you expose yourself to the specific financial risk of that firm, such as default risk. Thus, it is important to know the financial health of an elevator you are considering contracting bushels to account for potential counter-party risk.

Trading on your own will typically require you to have a line of credit to manage maintenance and margin calls. However, interest costs may be less than having an elevator perform the trades where a set fee is included. Trading on your own may also give you greater flexibility when to execute trades and the type of risk management strategies to utilize. When you perform your own trades through a brokerage service, you do not limit your ability to deliver to a specific elevator in the future. This allows you to adjust delivery locations, depending on pricing and other potential benefits.

Source: SDSU