Berry Opens Grain Market Toolbox

12/21/2013 7:00 AM
By Philip Gruber Staff Writer

CHRISTIANA, Pa. — Grain farmers are used to speaking the jargon of machinery, pesticides and seed varieties. Grain marketing takes them into yet another world, the specialized realm of financial instruments, which has its own sometimes confusing terms.

Penn State Extension marketing educator John Berry helped grain growers understand the various procedures for selling grain during the monthly grain marketing meeting on Dec. 11 at Dutch-Way Restaurant in Christiana.

Before trying to choose a tool, farmers should calculate both their break-even and maximum prices, Berry said.

Knowing the minimum helps farmers know the price at which they will start turning a profit, and farmers need to know how high they can realistically expect their price to go so they do not hold out too long for a price that is unlikely to come.

Berry gave the corn maximum as the harvest price plus $2.30. For soybeans, it is the harvest price plus $4.50.

Cash Forward Contract

There are three fixed-price tools. The first is the fairly familiar cash forward contract. This happens when a farmer calls the elevator and says, “I want to bring a load of corn on June the first. What’s your price?” Berry said.

This option takes a lot of uncertainty out of pricing. The farmer knows his exact price because basis, which indicates whether a market wants grain now or later, is fixed. Farmers can sell grain in any amount, not just the 5,000-bushel increments required for some more complex tools.

Though forward contracts are fairly straightforward, they do have some inherent risks. The contract ends in delivery, so the farmer has to deliver even if he does not have a load. Often a farmer will have to buy out the contract if he cannot deliver.

Being required to produce crops that are not yet planted is unnerving for some farmers, Berry said.

Forward contracts also carry institutional risk, meaning the farmer loses out if the buyer goes out of business before the agreed delivery date.

Farmers may not always see the kind of basis they would like because the agreement is so far in the future.

Grain buyers are “not willing to commit until they know their needs,” Berry said.

Futures Contract

Futures, also called hedge contracts, are similar to forward contracts, but futures are handled by a broker, typically on the Chicago Mercantile Exchange.

“In a down market, you’re the smartest person in the world” to sign a futures contract, Berry said.

The price a farmer locks in with a futures price equals the futures price when sold plus the expected harvest basis minus brokerage fees.

Futures contracts require partial payments, called margin money, that help compensate for market fluctuations during the life of the contract.

Often, the margin money is expected right away, which can leave farmers scrambling to find the money if the requirement catches them off guard.

“It’s potentially unlimited how much money you have to send to Chicago,” Berry said.

Berry calculated a corn futures price for the group. The futures price at the close of trading that day was $4.67. Berry added zero for the expected harvest basis, minus 2 cents a bushel in brokerage fees. The result was $4.65 per bushel.

“That’s the price I locked in if I sold a hedge contract today,” Berry said.

A futures contract sets up a sort of competition between the contracted grain and the rest of a farmer’s grain.

If basis erodes by the time of delivery, a farmer will get better than the current market price for his grain, though the grain he does not have in the futures contract will lose value.

If, however, basis improves after signing the contract, the farmer will be able to take advantage of the upturn with the portion of his grain that’s on the cash market, but not with the contracted grain.

Futures can be rolled into a storage hedge, in which the grain is put into the bin unpriced. That strategy allows farmers to take advantage of an improved carry after harvest. It is “totally a paper trade,” so it is easier to buy out, Berry said.

Hedge-to-Arrive Contract

Hedge-to-arrive contracts are similar to futures contracts, but they are made with a local elevator, not a Chicago broker. These contracts do not tie up money in margin accounts like futures do and rarely need to be in 5,000-bushel units.

Hedge-to-arrive contracts usually do not fix the basis component of the price, allowing farmers to take advantage of a future increase.

These contracts typically involve a fee of several cents per bushel, and they pose institutional risk like forward contracts. Hedge-to-arrives also have the risk that basis will not go up before the delivery date.

One farmer asked why the elevator would raise the basis during the life of a hedge-to-arrive contract if he already knew the grain was coming. Berry agreed that that was an interesting question.

“You have to use the tools you’re comfortable with,” Berry said.

Call Option

While the first three tools are attempts to settle on a price for future grain, there are also tools that allow farmers to pay to establish a minimum price for their product.

Some local elevators may offer a way to set a minimum price, but the two most common tools are call and put options handled by a broker.

A call option converts a fixed-price tool into a minimum-price tool. The minimum price is calculated by subtracting the call premium and brokerage fee from the forward contract price.

In Berry’s example using his most recent numbers, $4.60 corn had 38 cents as the call premium, and 2 cents went to the broker. That guaranteed the price floor at $4.20 per bushel.

Unlike a futures contract, the farmer will not have to put more money into the contract for margin calls after buying the option. Unlike a forward contract, the call option allows a farmer to take advantage of a higher price after making the agreement.

“A call to me is very like insurance,” Berry said. It is about protecting what you have more than it is about profiting.

“Are we trying to make money on our health insurance?” Berry asked. He would rather lose his insurance premium than have to use the coverage for a health problem.

In the same way, a call option offers protection if the grain price falls. It is great if the cash price jumps — that helps the farmer get a good price for the grain that is not covered by the call option — but if the price falls, the call minimizes the farmer’s pain.

Put Option

Farmers can also sell put options. Those are calculated by adding the put strike price to the expected basis and subtracting the put premium and brokerage fee.

A strike price is the amount the buyer will pay on delivery. It is higher than the price a farmer protects because of the fees associated with the put.

The market offers a range of strike prices depending on how close the price is to the expected price at time of delivery.

If a farmer chooses to protect a higher price, he will spend more on the premium.

Berry calculated a put option with a strike price at the money, meaning the strike price is close to the expected price at the time of delivery.

The corn strike price was $4.70, expected basis was zero, the put premium took off 40 cents, and the broker took 2 cents. The protected price was therefore $4.28.

In future meetings, Berry and the discussion group participants will review the prices they calculated at the December meetings.

The Christiana grain marketing gathering, one of four Berry leads in eastern Pennsylvania, starts at 6 p.m. the second Wednesday each month during the winter at Dutch-Way.


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