It is an argument that certainly sounds logical. If prices go up, the dollars you lose in CC payment will come back when you sell your cotton. Unfortunately, in the case of cotton, it is not that simple.
Take this scenario. At the time you are making your planting decisions, December cotton futures are trading in the high 50s. You know if cotton prices continue to trade no higher than the mid 50s during the government’s 12-month marketing season, which begins next August, you will likely receive your full 13.73 cents in CC payments. You also know if prices go up your payments will be at risk. In order to protect those payments, you decide to plant your base.
During the growing season, market fundamentals change and prices do go up. December futures trade to 70 cents per pound. Your buyer calls and tells you he can give you a 10-cent equity contract if you sign up today. You know that 70 cents is an important price point in cotton and a 10-cent equity is the best contract you have seen in years. You decide to take him up on his offer, giving you an expected cash price of 62 cents.
The weather cooperates, and you end up making an average crop, spending about what you expected to spend. Once all of your cost and rebates are factored in, your breakeven turns out to be 60 cents a pound. Your 10-cent equity contract nets you a profit of 2 cents a pound.
Cotton futures continue to trade above 70 cents well past harvest. You begin to hear rumors later that winter that your 2003 counter-cyclical payments are in trouble. Sure enough, when the end of the 12-month marketing year rolls around July 31, the government announces there will be no 2003 CC payment for cotton.
So how did you do? As far as the cash market is concerned, you made 2 cents a pound selling your crop slightly above your breakeven. On the CC side of the equation, you received 13.73 cents a pound less than you expected at the time the crop was put in the ground. At that point, you may be asking yourself, what happened? Where is the 13.73? It certainly did not come back to you in profits.
You console yourself with the realization that you did receive 6.67 in Direct Payments, but those payments were coming to you anyway, no matter what crop you planted. You are left scratching your head wondering what happened to the rest of the money.
There are at least two problems I see with counting on your planted acres to protect your CC payments. One has to do with the way the CC payments are determined.
Here is how it works. The government will determine how much cotton is marketed and the average price farmers received for those sales each month during a twelve-month marketing year. (The marketing year begins right before harvest.) At the end of the twelve months, the government will add up the monthly totals and come up with a figure called the APR (Average Price Received) that will determine the CC payment.
Uncle Sam will then compare the final APR with the CCC Loan Rate and chose the higher of the two. If that number is below the Target Price, they will calculate the difference between that number and the Target Price. Considering the fact that the farmer will receive the Direct Payment, the government will determine if any additional money is needed in order to get the farmer up to the Target Price. That payment is called the Counter-Cyclical Payment.
This is what the CC formula looks like:
CC Payment Rate = (Target Price) – (Direct Payment) – (greater of: 12-month average price received (APR) or the Loan Rate).
The problem is one of timing. If a producer is planning on the cash price he or she receives for their crop to offset any loss in the CC payment, their cash price would have to match the governments’ APR number. That will be very hard to do considering the fact that the government will factor in thousands of sales made over a 12-month period to come up with their number. Even the marketing done by the big co-ops who price crops year-round based on their own agenda will likely not come close to the APR number.
There is another problem. If you are counting on your cash sales to match the APR, you will be very reluctant to price any of your crop before the government’s 12-month marketing year beginning in August. That takes over two-thirds of your marketing season off the table. Not a very efficient way to market cotton.
Your planted crop will offer limited CC protection at best. Fortunately, there is another alternative.
The final CC calculation the government will come up with is a function of price and time. We know if cash prices come in above a certain price (the loan rate) during the 12-month marketing season, your CC payments will be reduced. That fits very well with a marketing tool that is also a function of price and time…the options market.
Call options are based on a specific price point (strike) and are in play over a specified period of time. If the market goes up, they will increase in value at the very time your CC payments are losing value. You would have a hard time designing a better CC insurance policy.
The challenge comes in determining the proper strike price and figuring out how much you are willing to pay for the protection. As with any insurance policy, you do not want to pay more than is justified. Option prices change daily so you will want to have a plan worked out and be alert for opportunities. It will not be easy to lay in protection, but it can be done.
Because of the money involved, protecting your counter-cyclical payments when you get the chance makes good financial sense. Do not depend on your crop to get it done.
Steve Scott of Scott & Associates, Little Rock, Ark., can be reached at 800 206 2474 or on the Web atwww.scottagri.com