The 2003 cotton counter–cyclical payment is expected to be a little more than 3 cents per pound. That estimate comes from the University of Illinois, farmdoc.uiuc.edu. If it turns out to be correct, it will be a far cry from the 13.73 cents those with a cotton base received for the 2002 payment. It is also substantially less than they could have received, had they taken some precautions last spring.
Is it possible for a farmer to protect CC payments and if so, what is the best way to get it done? Those questions were hotly debated last winter as we moved into the second year of a brand new farm bill. With the benefit of hindsight and with the 2004 counter-cyclical marketing season still in front of us, this would be a good time to take another look at the issues.
Some leaders in the cotton industry were of the opinion last spring that the only thing a land owner/producer needed to do to protect their 2003 CCP was to plant 85 percent of their base and then make sure that the price they received for their cotton was at least as high as the APR (average price received) number the government will use to determine the payment. They reasoned correctly that if the producer was able to match the APR (which by no means is a given) they would then be assured of receiving at least the target price of 72.40. They then went on to say that any additional marketing positions such as the purchase of call options would be unnecessary and would in fact be labeled a speculation.
A few of us in the marketing advisory business took a different view. We agreed that planting the program acres and then marketing cotton at a price that at least matched the national APR number would return no less than the target price. We did not agree that purchasing call options last season was an unnecessary speculative position. Instead we saw it as a prudent risk management strategy. So who turned out to be right?
Obviously, since cotton prices went up at harvest, the purchase of calls last winter and spring looks like a good idea. Those clients who followed our advice and bought calls are certainly glad they did. But what if prices had gone down, and the calls our clients bought turned out to be worthless? Would we still be of the same opinion? As a marketing consultant concerned with helping my clients manage risk, my answer is yes!
We see it as an insurance question. The CCP represents a valuable asset when commodity prices are low as they were last spring. Yet as we saw, the value of that asset is subject to substantial risk should prices trade higher. Call options appreciate in value in a rising market, the very price scenario that takes away CCP money. That makes them the logical tool to provide protection.
What if prices had gone down last harvest instead of up? In our case, had the market fallen below the strike price of our calls during the heart of the CCP marketing season (September – February), the calls our clients bought would likely have expired with no value. Those same low prices however, would have resulted in a low APR number which, in turn, would have enabled our clients to receive the major portion of the potential 13.73 cents in CCP money less the cost of the protection. They would have in effect bought “fire insurance” on a building that did not burn down.
Do call options provide perfect protection? No, because the actual sales numbers and percentages used to calculate the final government APR are not known until the end of the marketing period. The timing of the purchase and sale of the calls does require some finesse. Do call options provide enough protection to be of benefit? We think in certain situations they do and our experience last season bears that out.
Here is a brief run down of the cotton CCP strategy we presented to our clients last winter:
Our basic plan was to establish some cost parameters and, then, if the opportunity presented itself, protect 40 percent of program production (85 percent of base * program yield) with December calls and the other 60 percent with March calls. We would then cash in the calls throughout the CCP marketing season (August – July) on a schedule based on historical sales data. We also suggested that in the event we were able to cash in the calls and recover the equivalent of the entire 13.73 cents, we would do so. This strategy was presented to our clients last winter.
Here is how the recommended call strategy played out:
- Dec. 12, 2002; Bought Dec 60-cent calls @ 2.00 cents, covering 40 percent.
- June 02, 2003; Bought Mar 60-cent calls @ 2.50 cents, covering 60 percent.
- Sept. 05, 2003; Sold one-half of the Dec calls at 2.00 cents.
- Oct. 16, 2003; Sold the balance of the Dec calls at 14.10 cents.
- Oct. 30, 2003; Sold the Mar calls @ 22.40 cents.
- Net Results: 14.36 cents per pound credit.
- Estimated CCP: 3.24 cents per pound
Will we have the opportunity to protect the 2004 counter-cyclical payment? That remains to be seen. As with any insurance question, you must be able to justify the cost of the protection when compared to the level of coverage. At this point, the cost appears to be too high although that could certainly change before the CCP marketing season rolls around.
Should we go with the same call strategy we used in 2003? Not necessarily. We are working with higher market prices this year, which means we likely will have to look at more complicated strategies.
In our opinion, protecting a valuable asset when you get the chance is always a good idea. We think that applies to your CCP whether you plant your base or not.
Steven H. Scott is an agricultural marketing consultant with Scott & Associates in Little Rock, Ark. Contact him at 1-800-206-2474 or: