Grain Marketing in the BioFuels Era: Session 1: January 22

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Grain Marketing in the BioFuels EraSession 1
January 22
Ethanol
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Massive Demand Growth
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Nearly Unlimited Fuel Usage
U.S. Gasoline use is about 140 billion gallons
per year. All our corn crop would only provide
14 of the energy in gasoline.
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Markets Must Find Balance Between
FOOD
FUEL
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Rebalancing Includes
Inputs Sector

• Input supplies usage
• Acreage in production
• Specialization in certain crops
• Technology used
• Crops grown
• Crop prices
• Domestic vs. Export Markets
• The way livestock are fed
• Consumer demand for food products

Farm Level Response
Demand Structure
Consumer Impacts
Linkage Adjustments
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How BioFuels Era Impacts Prices and Marketing

• Level of crop prices rise
• Relationship of crop prices change
• Volatility of crop prices increases
• Government programs Limited importance
• Risk Exposure-- of Exposure grow
• Cyclical Uncertainties as Boom/Bust Odds Grow
• Coordination of linkage between growers and end
  users

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• Government Support-Bear Strategy
• Price early (spring)
• LDP at harvest
• Store
• Earn carry in the market

Government Support Line
Opportunity
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• Market Opportunity-Bull Strategy
• Price later (wait for a big event)
• No government programs
• Consider selling at harvest-replace with long
  futures/calls
• Smaller returns for storage

Opportunity
Government Support Line
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Your Course Includes Each Monday Night Jan 22,
Jan 29, Feb 5, Feb 12

• About 1/3 of course is
• BioFuels Era Marketing and Outlook
• Changes in market relationships

• About 2/3 of the course will be
• Learning about marketing decisions
• Futures, Options, Basis
• Storage
• Pricing Alternatives
• Seasonality
• Price Forecasting
• Strategies and planning

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Introduction to the mechanics of futures markets

• (CMS Disk 1, Unit 2, module 3a)

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What are Commodity Futures Contracts?
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Futures Contracts

• Definition A commodity futures contract is a
  legal instrument calling for the holder of the
  contract to deliver or to accept delivery of a
  commodity on or by some future date.

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Two Distinct Markets!
Cash Market
Futures Market
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Futures Contract Jargon

• Sell Short means the contract holder has a legal
  obligation to make delivery of the commodity.
• Buy Long means the contract holder has a legal
  obligation to accept delivery.
• Round Turn is the completion of a sell and buy
  back or of a buy and then sell set of
  transactions

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Futures Contracts

• Commitment to Accept or to Make delivery of a
  commodity with the following specifications
• Grade
• Quantity
• Delivery Location
• Delivery Time
• Each commodity contract is standardized with
  these four items determined.the only variable to
  discover is price.

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Example No. 2 Soybean Futures
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Contracts Change Value as Prices Change
March 20 5,000 bu of July corn futures _at_ 2.50
12,500 March 25 5,000 bu of July corn futures
_at_ 2.60 13,000 10 cent change in price 500
change in one contract Change in Value
for Buyer 500 Seller -500
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Margin

• Margin can be thought of as a performance bonda
  deposit of cash that shows each trader
  acknowledges their responsibility when trading on
  the exchange. Two types of margin are
• Initial Margin and Maintenance Margin.

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Initial Margin

• Initial Margin is the amount the trader must
  deposit to enter a futures contract. The initial
  margin is kept in the margin account.
• The exchange sets initial margin based on
  volatility of the market.
• Historically, initial margin seldom exceeds 5 of
  the face value of the contract.
• Brokerage firms can choose to charge more than
  the minimum level of margin.

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Maintenance Margin

• Maintenance Margin is the minimum level at which
  the account must be maintained. It becomes a
  threshold for the margin call when the position
  is losing money.
• The margin call is a request for additional money
  to restore the margin account to its initial
  level. In general, margin calls are initiated
  when the margin account is about 2/3 of its
  original value.
• Margin calls must be handled in 24 to 72 hours,
  depending on the brokers business practice. If
  margin calls are not met, the position can be
  liquidated.

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Futures Positions Require Margin Money
Margin means you do not have to pay the full
value of your futures position.JUST a MARGIN
Controls a LARGE amount of Commodity Value
A small amount of Your
20,000
4 corn example
1,000
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Margin Key Concept

• If you trade futures contracts, you must be
  prepared to meet margin calls!

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Using Futures Contracts
(CMS Disk 1, Unit 2, module 4a)
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Objectives

• Understand the many uses of futures contracts
• Define the concept of hedging
• Show how futures contracts can be used to
  establish prices for a growing crop
• Show how futures can be used to establish a
  favorable storage return

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How Do Farmers Use Futures in Their Marketing?

• To forecast prices
• To establish prices of growing crops or livestock
• To establish feed prices or other input prices
• To gain a return to storage
• To speculate on paper rather than with inventory

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Futures Prices as a Forecast
Buyers and sellers formulate an ask and bid price
based on their expectations of supply and demand.
When an ask or bid price is accepted, the market
has reached an agreement about the future value
of the commodity. In essence, the futures price
is a market determined forecast.
However, while futures prices may be a good
estimate of future prices today, do not assume
that prices will be at the same level when the
contract matures. Remember, new information will
cause prices to change.
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Futures Prices as Forecast
The corn futures market is suggesting that prices
will move higher into July. This gives a
stronger incentive to store.
On the other hand, soybean futures suggest prices
will fall. So, consider selling now rather than
continuing to store.
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Futures Prices as Forecast
How Long Should You Store?
The final answer is more complicated, but the
futures market shows corn storage might make
sense to May. On the other hand, soybean
futures suggest prices may not increase much
after March.
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Futures Prices as Forecast
Say its fall and you have to make a decision
about how many acres of wheat to plant for next
year and
Next years futures prices are July wheat
futures 3.70 November soybean
futures 6.30 December corn futures 3.25
Of course, which crops to plant next year is a
complex decision, but futures markets are hinting
that both wheat and corn are expected to be more
favorable compared to soybeans.
Note These months are the most common to use
when considering new crop
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Key Points

• Futures prices are determined by buyers and
  sellers armed with information.
• Futures prices are forecasts made by the market.
• Futures prices can be a useful (but not perfect)
  decision tool.

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Discussion Topic

• Lets look at futures prices and discuss what
  information its providing about the future for
• Corn
• Soybeans
• Crude Oil
• Unleaded gasoline
• Interest rates

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Futures Hedging Establishing Forward Prices
Hedging

• Short (Selling) Hedge
• 1. Forward Pricing a Growing Crop
• 2. Establishing favorable returns to storage
• Long (Buying) Hedge
• 1. Establishing price on corn feed needs for a
  livestock business

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Price Risk

• Prices are volatile todays price (at
  planting) is not likely to be tomorrows price
  (at harvest).
• Futures market positions will allow us to balance
  the losses for cash commodities with futures
  contract gains. (Hedging!)
• But, the futures market position will also limit
  our ability to take advantage of higher futures
  prices.

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Hedging

• The goal of hedging is to reduce risk associated
  with the cash market through the use of futures
  market transactions
• Hedges are used to
• Establish the price for a crop
• Establish the cost of an input like corn feeding
  needs
• Protect the value of inventory like stored crops
• Hedging may be accomplished with futures
  contracts or futures options contracts

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How to Hedge with Futures

• When hedging, the futures market position taken
  today is a temporary substitute for a transaction
  that will occur later in the cash market.
• End ResultLosses in the cash market are offset
  by gains in the futures market.

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Why Hedging Works

• The cash and futures markets are different but
  closely related markets
• The cash and futures prices typically move
  together

Prices
Futures
Cash
Time
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What is Basis?

• Cash Price
• - Futures Price
• BASIS

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Establishing Prices on a Growing Crop

• (Decision Time) When hedging with futures, you
  would sell a new crop futures contract. This
  takes the place of a cash sale to be transacted
  in later months.

• When you are ready to sell your cash crop at the
  elevator you would lift the hedge or liquidate it
  by
• Selling cash grain to the elevator, and
• Buying back or liquidating the futures contract

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Establishing Prices on Growing Crop (continued)

• The price you receive for your grain is
  therefore
• The cash price for the grain at the elevator
• Plus or minus
• The gain or the loss on the futures contract

• A hedge diagram is used to illustrate positions
  for the cash and futures markets.

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Establishing Price
Begin Here
They reached their goal of pricing 5,000 bu of
corn at 2.50/bu. The decline in the cash price
was exactly offset by a decline in futures.
Net Price Received 2.50/bu (before any futures
commission or hedging costs)
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What If Prices Moved Upward?
Net Price Received _______________/bu (before
any futures commission or hedging costs)
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The Answer
They reached their goal of pricing 5,000 bu of
corn at 2.50/bu. The increase in the cash price
was exactly offset by a increase in futures.
Net Price Received 2.50/bu (before any futures
commission or hedging costs)
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Example of Basis Speculation
Whats Different?
They exceed their goal of pricing 5,000 bu of
corn at 2.50/bu and net 2.58. WHY? Because on
Oct. 20, the cash price was 12 under, rather than
the expected 20 under.
Net Price Received 2.58/bu (before any futures
commission or hedging costs)
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Hedging and Basis Risk

• Basis influences the effectiveness of the hedge
• Hedging is effective in reducing price risk
  because changes in basis, over time, are much
  smaller and more predictable than changes in
  price.
• Basis risk is less than price risk.

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Price vs. Basis
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Establishing Price Current Example
They reached their goal of pricing 5,000 bu of
corn at 3.44/bu. The decline in the cash price
was exactly offset by a decline in futures.
Net Price Received 3.44/bu (before any futures
commission or hedging costs)
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Establishing Price Current Example
They reached their goal of pricing 5,000 bu of
soybeans at 6.95/bu. The decline in the cash
price was exactly offset by a decline in futures.
Net Price Received 6.95/bu (before any futures
commission or hedging costs)
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Hedges Lock In the FUTURES Price

• Actual price will depend on actual final basis
  when hedge is liquidated and converted into a
  cash position
• In session 3 we will discuss basis in more detail

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Storage Hedge
(CMS Disk 1, Unit 2, module 4b)
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Objectives

• Examine Post Harvest Marketing Decisions
• Understand the Components of Storage Costs
• Examine a Post Harvest Marketing Alternative
  (Selling Futures Storage Hedge)
• Understand the Advantages Disadvantages of the
  Storage Hedge

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A Harvest Decision

• Producer Alternatives
• sell at harvest,
• store until April (unpriced),
• store until April (forward contract), or
• store until April (futures hedge).

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Current Elevator Bids
Harvest (Nov 07) Bid 3.30 April 08 Bid 3.65

• Should we forward contract for April delivery?
• What is the mathematical difference between the
  harvest price and the April Bid?

Realized Price April Bid Storage Costs
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Using Basis Storage Pricing

• Quick Hit Storage Costs
• On-Farm vs. Commercial
• Variable Storage Costs (per bushel)
• Direct Costs Utilities, Pesticide, Shrink,
  etc.
• Interest Expense or Opportunity Cost
• Annual interest rate
• Harvest Cash Price/12
• Hedge Months

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Example Elevator Bids
Harvest Bid 3.30 April 08 Bid 3.65 Should
we forward contract for April delivery? Storage
Costs Direct Charges 0.05 Opportunity
Cost 0.10 Realized Price April Bid
Storage Costs
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Storage Decision

• Harvest Bid 3.30
• Forward Contract 3.65
• What if we use a storage hedge?
• What if we store unpriced?

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Storage Futures Information
Inverse
Carry
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Storage Hedge
Hedge Summary Cash Price 3.20 Futures
Gain 0.50 Net Price 3.70
Storage Summary Corn Price Gain
0.40 Cost of Storage -0.15 Net Return to
Storage 0.25
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Pricing Basis Storage Decision
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Long (Buying) Hedge
Situation Livestock feeder needs to purchase
today (Jan 22) 20,000 bushel of corn for May 1st
delivery. Expected purchase basis is 10 cents
over May futures.
Hedge Summary Cash Price 3.30 Futures
Loss 0.50 Net Price 3.80
Net price of 3.80 was .05 better than expected
because the basis was .05 more favorable
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Readings for Jan 29th on Options

• In Agricultural Futures and Options A Hedgers
  Self-Study Guide
• p. 21-32
• p. 49-58
• Useful glossary of terms p. 63-64

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Assignments

• Hedging Exercise completed
• Basis Exercise
• Go to www.gptc.com , then double click Charts
  Quotes, then double click on Corn then double
  click on May07 What direction are May corn
  futures headed?
• Go to www.incorn.org , then to Local Cash Grain
  Bids, put in zip code, ask for up to 5 markets
  in your local area. Once bids come up try
  clicking on the number for your corn basis and
  you should get a basis chart