If you are a cotton grower, you've likely heard commodity brokers and marketing advisors recommend that you hedge your counter-cyclical payments with futures options. A recent study by economists at Mississippi State University is questioning that blanket recommendation.
“One way to think about the cotton counter-cyclical payment is that it's like a free put option with a strike price at 66 cents, but its value does not continue to increase as prices fall below the loan rate,” says Keith Coble, an agricultural economist at Mississippi State University in Starkville, Miss.
Under the 2002 Farm Security and Rural Investment Act, counter-cyclical payments are decoupled from production, but are still dependent on price. Because they are directly tied to the market year average price, counter-cyclical payments are not guaranteed.
Put more simply, counter-cyclical payments are equal to the target price for a crop minus the direct payment minus the maximum of either the loan rate or market year average price.
For example, your cotton counter-cyclical payment is 13.73 cents when the market year average price is equal to or less than 52 cents, and your payment is zero when the market year average price is equal to or greater than 65.73 cents.
Coble calls counter-cyclical payments “a natural hedge.” That assumes, of course, that whatever crop you are receiving a counter-cyclical payment for is actually being grown on your farm.
Coble and his fellow economists, John Anderson, and Corey Miller at Mississippi State University, recently developed economic models to determine whether it is worthwhile for growers to buy call options during the growing season to offset the chance they could lose their counter-cyclical payments if cotton prices increase. They repeated their analysis for various potential price levels.
A key issue they found in their analysis was that it mattered if you have planted cotton on the base acres or another crop. “If you have a growing program crop on the base there is relatively little value to hedging the counter-cyclical payment because of the natural hedge,” Coble says. “On the other hand, if you have planted the base to another crop, there is more likely value in hedging the counter cyclical payment.”
For example, if soybeans are planted on cotton base, then a cotton price increase that causes a decline in the counter-cyclical payment may not be offset by gains in the soybean market.
What they also found, Coble says, is that the usefulness of hedging the counter-cyclical payment is highly dependent on expected price, with hedging percentages highest when expected price is slightly below the loan rate for that crop. If prices are well below the loan rate, then the crop price has to move significantly to reach a level where the counter-cyclical payment declines. On the other hand, if cotton prices are near or above 65.73 cents, the expected counter-cyclical payment will be relatively small.
Estimating the counter-cyclical payment is complicated by the fact that the total value of the payment remains unknown until after the end of the marketing year, well over a year after planting. The marketing year for cotton is August through July, with the peak marketing season occurring from November through January. The prices during this peak marketing period have the most influence on the marketing year average price, and therefore factor heavily in hedging strategies. On average, about half of the market year cotton marketings are completed between harvest and the end of December.
“Growers need to keep in mind that these results hold prior to marketing the crop. Once, the cotton crop is sold there is no longer a gain in the market to offset declines in the counter-cyclical payment,” says Coble.