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

Massive Demand Growth

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.

Markets Must Find Balance Between FOOD FUEL

Rebalancing Includes 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 Inputs Sector Farm Level Response Demand Structure Consumer Impacts Linkage Adjustments

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

Government Support-Bear Strategy 1.Price early (spring) 2.LDP at harvest 3.Store 4.Earn carry in the market Government Support LineOpportunity

Market Opportunity-Bull Strategy 1.Price later (wait for a big event) 2.No government programs 3.Consider selling at harvest-replace with long futures/calls 4.Smaller returns for storage Government Support Line Opportunity

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

Introduction to the mechanics of futures markets (CMS Disk 1, Unit 2, module 3a)

What are Commodity Futures Contracts?

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.

Two Distinct Markets! Futures Market Cash Market

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

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.

Example: No. 2 Soybean Futures SizeTick Size Daily Limit Contract Months Last Trading Day 5,000 bu¼¢ /bu50¢ /buJan, Mar, May, Jul, Aug, Sep, Nov The business day prior to the 15 th of the month

Contracts Change Value as Prices Change March 20: 5,000 bu of July corn $2.50 = $12,500 March 25: 5,000 bu of July corn $2.60 = $13, cent change in price = $500 change in one contract Change in Value for: Buyer = +$500 Seller = -$500

Margin Margin can be thought of as a performance bond—a 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.

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.

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 broker’s business practice. If margin calls are not met, the position can be liquidated.

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

Margin Key Concept If you trade futures contracts, you must be prepared to meet margin calls!

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

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

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

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.

Futures Prices as Forecast The corn futures market is suggesting that prices will move higher into July. This gives a stronger incentive to store. CornSoybeans March Futures$2.50$8.25 July Futures$2.75$7.75 On the other hand, soybean futures suggest prices will fall. So, consider selling now rather than continuing to store.

Futures Prices as Forecast 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. CornSoybeans Dec/Nov Futures$2.40$6.10 March Futures$2.55$6.30 May Futures$2.65$6.30 July Futures$2.60$6.35 How Long Should You Store?

Futures Prices as Forecast Say it’s fall and you have to make a decision about how many acres of wheat to plant for next year and… Next year’s 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

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.

Discussion Topic Let’s look at futures prices and discuss what information it’s providing about the future for: Corn Soybeans Crude Oil Unleaded gasoline Interest rates

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

Price Risk Prices are volatile – today’s price (at planting) is not likely to be tomorrow’s price (at harvest). Hedging!)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.

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

How to Hedge with Futures hedging today laterWhen hedging, the futures market position taken today is a temporary substitute for a transaction that will occur later in the cash market. End Result—Losses in the cash market are offset by gains in the futures market.

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

What is Basis? Cash Price - Futures Price BASIS

Establishing Prices on a Growing Crop 1.(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. 2.When you are ready to sell your cash crop at the elevator you would lift the hedge or liquidate it by a.Selling cash grain to the elevator, and b.Buying back or liquidating the futures contract

3.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 Establishing Prices on Growing Crop (continued) 4.A hedge diagram is used to illustrate positions for the cash and futures markets.

Establishing Price CashFuturesBasis May 20 Expect cash value to be $2.50/bu Sell 5,000 bu of Dec corn $2.70 Expect Basis to be 20 cents under futures Oct 20 Sell corn at elevator for $2.00/bu Buy back Dec $2.20/bu Basis is 20 cents under futures Summary Sold $2.00Gain in futures is +$0.50 Net Price Received = $2.50/bu (before any futures commission or hedging costs) 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. Begin Here

What If Prices Moved Upward? CashFuturesBasis May 20 Expect cash value to be $2.50/bu Sell 5,000 bu of Dec corn $2.70 Expect Basis to be 20 cents under futures Oct 20 Sell corn at elevator for $3.20/bu Buy back Dec $3.40/bu Basis is 20 cents under futures Summary Sold ______________ Loss in futures is ? _____________ Net Price Received = _______________/bu (before any futures commission or hedging costs)

The Answer: CashFuturesBasis May 20 Expect cash value to be $2.50/bu Sell 5,000 bu of Dec corn $2.70 Expect Basis to be 20 cents under futures Oct 20 Sell corn at elevator for $3.20/bu Buy back Dec $3.40/bu Basis is 20 cents under futures Summary Sold $3.20Loss in futures is -$0.70 Net Price Received = $2.50/bu (before any futures commission or hedging costs) 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.

Example of Basis Speculation CashFuturesBasis May 20 Expect cash value to be $2.50/bu Sell 5,000 bu of Dec corn $2.70 Expect Basis to be 20 cents under futures Oct 20 Sell corn at elevator for $2.08/bu Buy back Dec $2.20/bu Basis is 12 cents under futures Summary Sold $2.08Gain in futures is +$0.50 Net Price Received = $2.58/bu (before any futures commission or hedging costs) 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. What’s Different?

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.

Price vs. Basis

Establishing Price: Current Example CashFuturesBasis Jan 8, 2007 Expect cash value to be $3.44/bu Sell 5,000 bu of Dec07 corn $3.64 Expect Basis to be 20 cents under futures??? Oct 20, 2007 Sell corn at elevator for $3.00/bu Buy back Dec $3.20/bu Basis is 20 cents under futures Summary Sold $3.00Gain in futures is +$0.44 Net Price Received = $3.44/bu (before any futures commission or hedging costs) 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.

Establishing Price: Current Example CashFuturesBasis Jan 8, 2007 Expect cash value to be $6.95/bu Sell 5,000 bu of Nov07 soybean $7.25 Expect Basis to be 30 cents under futures??? Oct 20, 2007 Sell beans at elevator for $7.10/bu Buy back Nov $7.40/bu Basis is 30 cents under futures Summary Sold $7.10Loss in futures is -$0.15 Net Price Received = $6.95/bu (before any futures commission or hedging costs) 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.

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

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

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

A Harvest Decision Producer Alternatives: –sell at harvest, –store until April (unpriced), –store until April (forward contract), or –store until April (futures hedge).

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

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

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

Storage Decision Harvest Bid = $3.30 Forward Contract= $3.65 What if we use a storage hedge? What if we store unpriced?

Storage: Futures Information CONTRACT MONTHPRICE/BU. July 2007$3.78 September 2007$3.66 December 2007$3.60 March 2008$3.69 May 2008$3.75 Inverse Carry

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 DateCash MarketFutures MarketBasis Initiate Hedge Expects $3.65/bu net Sell May $3.75/bu Expected to be $0.10 under Lift HedgeSell $3.20/bu Buy May $3.25/bu Basis is $0.05under

Pricing Basis: Storage Decision ActionAdvantageDisadvantage Harvest $$ Now! Simple No more risk No storage costs No Upside: Cannot Capture Futures Carry or Basis Appreciation Forward Price Lock-in Price No Basis Risk No Upside No Basis Appreciation Futures Hedge Basis Appreciation Flexible-Choose elevator Basis Risk No Upside Storage Speculation All Upside PotentialAll Downside Potential

Long (Buying) Hedge DateCash MarketFutures MarketBasis Jan 22, 2007 Expects $3.85/bu net purchase Buy 20,000 May $3.75/bu Expected to be $0.10 over May 1, 2007 Buy $3.30/bu Sell May $3.25/bu Basis is $0.05 over Hedge Summary Cash Price = $3.30 Futures Loss = +$0.50 Net Price = $3.80 Situation: Livestock feeder needs to purchase today (Jan 22) 20,000 bushel of corn for May 1 st delivery. Expected purchase basis is 10 cents over May futures. Net price of $3.80 was $.05 better than expected because the basis was $.05 more favorable

Readings for Jan 29 th on Options In Agricultural Futures and Options: A Hedger’s Self-Study Guide –p –p –Useful glossary of terms p

Assignments 1.Hedging Exercise completed 2.Basis Exercise 3.Go to then double click “Charts & Quotes”, then double click on “Corn” then double click on “May07” What direction are May corn futures headed? 4.Go to 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 chartwww.incorn.org