June 28, 2012

5 Min Read


Drought conditions could hit Indiana farmers in the pocketbook in more ways than one, Purdue Extension Agricultural Economist Christ Hurt says. Not only could water-starved corn and soybean crops produce smaller yields and cut into farmers' revenues, but they also could force some growers who signed future delivery contracts with grain buyers to buy back some bushels they are unable to supply, Hurt says.

"We've been hearing of producers calling their grain managers and talking with them about the possibilities of dealing with these yield reductions," Hurt says. "Right now it's hard to say what will happen because nobody knows where grain prices are going to go."

With some parts of Indiana now nearing a month without significant rainfall and the critical pollination phase of corn either already started or about to begin, large crop losses appear likely for some farmers. Those losses would be especially painful for farmers who sold a large percentage of their anticipated corn crop this spring in forward cash contracts.

In forward contracts, producers promise to deliver a specified amount of grain to buyers well before their crops are harvested. In turn, farmers are guaranteed a set price for their grain, even if grain prices fall below that set price before their deliveries are made.

Farmers face a double whammy if the drought persists, Hurt says. On one hand, they could fail to produce enough crop to meet their contractual obligations. On the other, they could lose additional revenue if prices rise above their locked-in rate.

Hurt gives the example of a farmer who agreed to sell corn at $5/bu. based on an anticipated production of 150 bu./acre, for $750 in revenue/acre. If drought reduced the farmer's production to 120 bu. and pushed cash prices to $6/bu., the farmer would deliver that smaller crop at the price agreed upon but then have to pay the buyer for the 30 bu./acre the farmer was unable to supply. That undeliverable charge would be $30/acre, based on the $1/bu. more than the contract price the grain is now worth.

"That 120 bu. delivered would only generate $600 for the farmer," Hurt says. "Then, after the farmer paid the $30 on the non-delivered grain, they would have only $570 of revenue/acre, or $180/acre less revenue than they had originally planned."


Short-crop season options

Farmers with forward-sold grain have three options to address a short-crop season, Hurt says.

"First, if they have a local buyer – a grain elevator, processor or local livestock operation – they can buy back some of those bushels that have been forward-sold," he says. "Probably for most producers at this point they're going to have to pay some difference for those bushels lost, but they would avoid further potential losses if prices move even higher.

"A second common strategy would be to buy futures to offset some of the price impacts. Buying futures still means they would be committed to deliver the cash position, so that doesn't get them out of the need to physically deliver. But it does get them some recovery against even higher prices. If prices go higher they could gain on their futures position and those gains could help offset losses on their cash-forward contract."

Hurt says a third strategy is to buy call options - contracts that give farmers the right, but not the obligation, to buy a fixed number of bushels for a specific price by a specific date.

"The farmer would have to pay a premium for those rights but would have price protection against rising prices," Hurt says. "Options strategies do not deal with the need to deliver physical bushels; they simply are used as a way to potentially generate positive returns if prices rise. These positive returns can then be used to offset some of the negative consequences of the bushels that cannot be delivered at higher prices."

Hurt urges farmers who are concerned that they have sold more bushels than they might produce to contact their grain buyers and discuss delivery alternatives.

Not all the news is bad. In drought years, farmers can still see their revenues increase through what economists call the "natural hedge."

"It's this concept that when a major production state has reduced yields due to something like drought conditions, prices generally go higher than yields go down," Hurt says. "So if yield losses for an entire region or a state were 10% but prices go up by, say, 15% or 20%, actual revenues in a drought year can be higher than in a year when you have normal yields."

For example, Indiana's average corn yield in 2011 was down 7% from the previous year, but prices were 16% higher, meaning farmer revenues per acre were higher than in 2010. Hurt says if yield losses are widespread enough this year, higher prices would help compensate farmers for some of their lost crop.

There is another glimmer of hope for farmers with grain left over from the 2011 crop season. The longer the drought continues the better the odds that their stored grain will increase in value, Hurt says.

With July corn futures moving prices to about $6.60-6.70/bu., old-crop cash corn should push past $7/bu., Hurt says. "If we go above $6.75 or $6.80 on July futures, then I think we've got a real shot at retesting the all-time highs at around $8."

Hurt says he talked to one farmer who has 88,000 bu. of old-crop corn in storage. "That's over half a million dollars worth of corn," he says.

Old-crop soybeans could hit $15/bu. and jump to about $16.50 should weather patterns remain unchanged, Hurt says.

"We have a very bullish situation ahead if the drought continues," he says. "We could have quite an explosive market. But that could all change if we get rain."

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