Grain buyers and cotton buyers are sending a clear message to producers: “We are no longer willing to hedge price risk like we used to. If you want to lock in prices that show up early, you will have to do it yourself.”
Back in the old days — last summer, for example — a soybean or corn producer could have locked in a profitable price on three, possibly four different crops; the 2008 crop in the field, the 2009 crop to be planted the next spring, the 2010 crop that will be planted the spring after that and even in some cases the 2011 crop.
The futures market was posting a daily price for all four crops. All you had to do to secure that price was call an elevator that would sell futures in order to establish a “hedge to arrive” contract. Most were willing to do that for a producer, at least out to 2010.
It's now gotten a little more complicated. If you want to lock in profitable 2010 or 2011 prices today, your only alternative is to do it yourself. Most cash buyers have come to the conclusion that hedging price risk for producers early in the marketing season is no longer worth the trouble.
Farmers who want access to the entire marketing season available to them will have to do what the elevators used to do, hedge with futures. The alternative is to stay at risk and hope the good prices are still available once the buyers finally decide to book crop.
Not many businesses will reward an owner who continually takes unnecessary risks over time. Many producers understand that taking a three- to four-year marketing season down to a few months is not an efficient way to manage marketing risk. They worry about the possible consequences of letting profitable prices turn into unprofitable prices, especially in today's volatile environment.
Those who take the next step and look at the advantages and the disadvantages of taking matters into their own hands may be surprised with what they find.
The primary risk of using futures to lock in a price is the same risk you take with a “hedge to arrive” contract. It is a production risk.
If the futures market trades above your hedged price and you do not have a corresponding amount of crop to deliver to the cash market, you will suffer a loss. That is true whether the contract is held at the elevator or in your brokerage account. Most producers know how to keep that risk under control.
The risk that gets the most attention when talking about hedging with futures has to do with interest and cash flow. If prices go up and stay up, you will have to tie up capital over a period of time. That capital will eventually be recovered, adjusting for basis, when you sell a corresponding amount of your production in the cash market. Depending on how high prices go and how long they stay up, the net result could be an interest expense.
With interest rates low, the cost of money is not a major consideration. More troubling for some is the risk of tying up needed capital. This is where your lender could play an important role.
Assuming you are able to finance the futures hedge position either personally or with the help of a lender, several significant advantages present themselves.
- You have access to the entire marketing season, which more than doubles your pricing opportunities each season.
- Not being locked in to a particular buyer, you would be in position to apply leverage when it comes time to negotiate a basis. This is especially true if you have on-farm storage.
- You would not have to lock in basis the same time you lock in your futures price. Most often early bookings bring a wide basis. You would in effect put on your own “hedge to arrive” contract.
- You do not run the risk of your buyer going out of business and not honoring your booking contract.
- If prices fall, you have access to your unrealized futures profits. This could eliminate some interest expense in other aspects of your business.
- If you hedge before planting season and prices fall, you have the ability to easily change plans and plant a different crop. You would be able to capture all of your futures profits.
Bottom line… If you are interested in limiting your marketing risks, improving your marketing efficiency and you have access to capital, take another look at futures. As with any tool, it is important that you understand how to use it properly. There is a risk of loss when trading commodity futures and options and may not be suitable for everyone.