Typically, my time spent writing this blog will involve explaining our perception of the corn and soybean balance sheets, spotting actionable patterns in the market, or proposing methods to consider for managing farm profitability. But nothing is typical about the market we are currently dealing with and there are other risks to consider beyond prices dropping. These risks could be far worse than a drop in price and they involve the market going higher.
The word on the street is that a large market participant lost $90 million this week due to their exposure in the spread between May and July corn. Let’s walk through this together.
Imagine for a second you are short May corn futures, which a commercial entity is required by law to be, if they are holding physical bushels. Now imagine that short position represents 225 million bushels, or 45,000 contracts. If the commercial is going to maintain physical ownership of those bushels past the expiration of the May contract, the short position needs to move to July. In a well-supplied environment, the commercial entity will generally take advantage of carry in the market and exit the short May position while simultaneously selling the July contract at a higher price. Carrying product in this environment pays handsomely.
We are not in a well-supplied environment and things didn’t work out as planned. On the day May options expired, May corn futures settled 23 cents above July futures; first notice day was a week away. Now moving your short position to July at a 23-cent inverse is not an easy pill to swallow, but in the next few sessions the spread ran another 40 cents higher before the roll was done. Ouch!
While the talk on the street will always be about the biggest example of what happened, I’m a believer that if I see one cockroach, there are more lurking. My point in saying this is that you need to be aware of the counter-party risk involved in selling and delivering grain. Is your local co-op or grain elevator another smaller example of what we just walked through?
Spread risk isn’t just on the commercial side, though. You may or may not be familiar with a product called accumulators. Generally speaking, the product will allow producers to slowly accumulate sales at a price above the market when the product is agreed upon. The “catch” is that if the market goes down after agreeing, prices might reach your “knockout” in which case you will no longer accumulate any more sales above the market.
There’s another “catch,” and this one is the one that really hurts. Accumulators have another feature; if futures values are above a certain price level on a certain day, the producer owes double the amount of agreed upon bushels. Let’s imagine together again and say that during the summer of 2020, in the low-price environment, a producer used an accumulator product based on July ’21 futures to accumulate sales above the market, thinking that an extra 15 cents could make all the difference in the world to their farm’s profitability. “If I could get $4 for corn, I can turn a profit this year.”
Fast forward to now and the producer doesn’t have those bushels. Oops!
Now the producer must deliver bushels they don’t have. The elevator manager is really nice though and will let the producer “roll” the sale of those bushels to another delivery period. “If the bushels aren’t there to deliver against July, you can just roll the sale to new crop.”
Great idea! But wait, when can those sales get rolled to new crop? Those doubled up bushels aren’t officially doubled up until July option expiration. Could the producer without the bushels to deliver get burned in the same fashion as the large commercial entity we walked though earlier? The answer is very much so a resounding YES
At some point along the way that producer felt like they were taking advantage of ever-increasing prices and sold the rest of their old crop thinking the market would stop going higher. Who knows at what point the producer realized they didn’t have the bushels to deliver against their July accumulator, but since fall the July ’21 contract has gained as much as $1.20 on Dec ’21.
This is very important, and you need to understand this. Until June 25th, when July options expire, the producer is at the mercy of the July/Dec corn spread. When the sale is rolled from July to December, the amount he spread is trading at is taken off the December sale price. Let’s say the accumulator “double-up” was at $4. If that July sale is rolled to December at today’s settlement of $1.095 over, the December sale is now $2.905. What if July continues to gain on December over the next two months? What if July went $2 over December and it turns into a $2 December sale? What if it’s worse? What if the producer has no idea this exposure even exists…?
As always, feel free to contact me directly at 815-665-0463 or anyone on the AgMarket.Net team at 844-4AGMRKT. We’re here to help.