September 5, 2019
Editor’s note: Knowledge is power. That’s why we’re starting Advanced Marketing Class, our new series that explores the most important skills you need to understand in grain marketing. Look for Advanced Marketing Class online and in each issue.
As a producer, you have number of different ways to price grain – forward contracts, options, and a variety of hybrid contracts offered by many local elevators. My preferred pricing tool is the futures contract. Allow me to explain.
To “hedge” with futures is to buy or sell a futures contract as a temporary substitute for an intended later transaction in the cash market. At planting time, if you sell December corn futures to price new crop corn, you have no intention of sending corn to facilities located on the Illinois River (per the CBOT contract). Your intention is to deliver corn to a local market at harvest and “lift” the hedge—i.e., buy back futures contracts.
Selling futures (aka a short hedge) protects the value of bushels held in storage, or protects the value of a commodity growing in the field. Here is a simple formula to calculate your price if you choose to hedge with the sale of futures contracts:
futures price (when sold) + expected basis – brokerage fees = expected price
Bear in mind that for most Corn Belt grain producers, basis is negative (cash prices are less than futures). Adding the basis, for most grain producers, is adding a negative number. The formula generates an expected price, based on expected basis. The final price is determined by the actual basis.
Why would any producer want a brokerage account and exposure to margin calls? Futures contracts have two distinct advantages over a forward contract: (1) a higher average price, and (2) you are not locked into delivery.
Why a higher average price using futures contracts? When posting bids for grain months in advance of delivery, local elevators often offer a less-than-favorable basis. By selling futures, you can separate and defer the basis decision. Selling futures allows you to separate the delivery decision.
If you have on-farm storage facilities and access to a truck, selling futures gives you free-agent status with regards to final delivery. You’re not just waiting for a better basis from the local elevator - you can track the basis 30 miles south at an ethanol plant, or 15 miles east at a hog operation.
Roll the hedge
Then again, by selling futures you don’t have to deliver at all. Forward contracts end in delivery, while selling futures does not need to end in delivery. If carrying charges are large, you can “roll the hedge” forward by buying back your original futures sale and selling a deferred contract.
Futures contracts have some nice advantages - what is the disadvantage? The margin account! Using futures to price grain requires a margin account with a broker and the need to provide margin money as the market fluctuates. This challenge is both operational and psychological.
The operational challenge is making sure you have the funds to meet margin calls as the market fluctuates. The lenders I speak with are aware of this challenge. In general, they are committed to meeting your margin needs on two conditions: (1) you have a marketing plan that explains what you are trying to achieve with a futures position and, (2) the margin account is not used for speculative purposes.
The psychological challenge behind margin accounts is trickier. A loss in the margin account is always seen as bad, while a gain is usually seen as good. But for the true hedger, margin calls can be seen as a positive. For producers who hedge - sell futures contracts to price grain - the need for more margin money is simply a reminder that market prices are trending higher, and that your initial sales were too early and too cheap. However, any unpriced grain is more valuable, as is next year’s crop. Grain producers benefit from higher prices.
Futures positions and margin accounts can be managed. Just remember to use futures contracts as a hedging tool, and not to speculate on the market. Pricing grain with futures contracts give you the ability to separate the basis decision and offers the ultimate in delivery flexibility.
Together, this is powerful stuff that can help you find the edge in marketing.
Edward Usset is a Grain Market Economist at the University of Minnesota, and author of the book “Grain Marketing is Simple (it’s just not easy).” You can reach him at [email protected]
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