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Corn+Soybean Digest

Lock In Prices

Learning how to grow a new crop is difficult. Learning how to market it can be an even bigger challenge.

New cotton growers in northwest Texas are taking on those tasks. And they have quickly learned that, as with corn or other fall-harvested crops, locking in a good price early will pay off this fall and into 2006.

“I'm looking to make 60-62¢/lb. on my cotton,” says Keith Watson, a Dumas, TX, grower just into his fourth cotton crop. “I have some minimum price forward contracts at 561/2¢ with the Allenburg marketing co-op and I hope for about a 5¢ advance on top of that.”

Along with those contracts, Watson also locked in a basis contract with Cargill through his local gin. He locked in a 61/2¢ under basis, then hopes to set them when December '05 futures hit 60¢. “With the basis contracts, I can also collect the LDP (loan deficiency payment),” he says.

John Robinson, Texas A&M cotton marketing economist, says growers were probably wise to consider using forward contracts, simple put options or other options strategies to lock in a good price early on. Similar pricing opportunities this fall might also be to their advantage, he says, noting that world demand from huge cotton importers like China and other countries can often change overnight, meaning growers should keep a close eye on cotton prices.

“As always, the answer (to what growers do in marketing) will depend on the grower's production costs, risk preferences and other financial concerns,” says Robinson, who was appointed to his position early this year after the retirement of long-time A&M cotton marketing specialist and now consultant Carl Anderson.

“But I think it's a very reasonable thing to consider (locking in a price near 60¢), since I can see this year unfold in several ways that could give us lower, similar or higher prices. Using options gives you the best of all positions in an ultimately uncertain situation, such as setting a floor and allowing for upside price potential.”

If and when December futures rise above 60¢, Robinson suggests implementing some form of options based strategy to lock in a higher floor price. He adds that even puts in the high 50s can also protect growers against major price declines. He points out several types of strategies that can be used, all of which include using combinations of buying and selling options to secure a good price without spending too much on options premiums.

“The put spread is one way to offset the premium associated with purchasing the 55¢ put,” he says. “It retains the advantage of options in setting a price floor (a put strike price less the premium, less the basis) while allowing for you to take advantage of higher cash prices.”

A December put option at the level or near where futures are trading can often cost more than 3¢/lb. “So the idea of a put spread is to also sell a December put option at about 10¢ below the strike price of the one you bought,” says Robinson. “This will hopefully gain you about 1/2¢ and make the original put purchase more affordable. It also provides downside protection which bottoms out at the strike price of the put that you sold.”

Robinson's Web site, looks at four or more strategies, based on recent futures prices and options premiums. He and O.A. Cleveland, renowned Mississippi cotton marketing specialist with, warn growers to consider strategies to protect their counter-cyclical payment (CCP) in the event prices shoot up due to weather or other crop problems worldwide.

“Growers shouldn't expect the CCP to hold at the maximum permitted by law this season,” says Cleveland. “In fact, market conditions are ripe for the CCP to be reduced by 4¢ this season. One way to protect the maximum payment is to purchase the December 60¢ call (in the 1.8-2¢ range) and sell two December 70¢ calls.”

The net premium paid would be less than 1¢. “Of course, the grower's risk would be above 70¢, basis December futures,” says Cleveland. “Yet with world carryover expected to climb to 48-49 million bales and U.S. carryover to climb above 8 million bales by July 30, 2006, the risk is minimal.”

Robinson says growers should first focus on the downside price protection. “After that, I also think it's reasonable to consider using call options to protect government payments like LDP and CCP that could possibly depreciate as prices rise,” he says.

“It's a matter of being posed to purchase those call options at the right time, and for an inexpensive premium, like 2¢ or less. I'm not sure I'd call this hedging. If you've got a cotton crop, it's already naturally hedged by rising prices. Nevertheless, this type of risk management can protect potential assets.”

Watson has worked with corn futures and options in the past. But cotton required some additional advice. “I switched from corn to cotton because I can grow cotton with 12-14 in. of irrigation water, compared to 30-35 in. for corn,” says Watson, who is among a number of regional growers who contracted their '05 crops through the new Moore County Gin. The gin was built this year to handle new cotton acres in northwest Texas.

Gin manager Leighton Stovall, who came to Dumas from an area where cotton was king near Lubbock, TX, assists growers by offering basis contracts and putting them in contact with marketing co-ops.

“The minimum price contracts the growers looked at in the spring were for about 6.4¢ over the government base loan of 51.6¢,” says Stovall, whose gin is among several new ones on the northwest Texas/southwest Kansas region. “That puts growers at the 58¢ level (no matter how low the price goes). About 25% of our expected acres were contracted in the spring.”

Unlike with corn or soybeans, new cotton growers are learning that the quality of each bale can be different. Higher quality cotton can provide an extra few cents per pound.

“You just don't go to the gin and get a straight price,” says Stovall. “Our growers are seeing the benefits of producing cotton that has a higher grade.”

Higher prices in 2006? The International Cotton Advisory Committee (ICAC) thinks so. It says world production is expected to decline by 10% in 2005-2006 and will likely fall slightly below world consumption. Net imports by China are forecast to increase “from an estimated 1.45 million tons this season to 2.8 million tons in 2005/06,” ICAC says.

ICAC believes prices could average 66¢/lb. in 2005/06, 13¢ above the 53¢ average price expected for the current season.

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