Brian Wittal offers some warnings and suggestions for dealing with grade risk when you sign sales contracts
In the last issue of Grainews I discussed a perfect grain marketing contract from a farmer’s perspective.
Having thought about this a little more the past two weeks I think we may need to change the term “perfect” to “fair and equitable.”
With that change in mind we can work on coming up with terms for the contract that will fairly address both the buyers’ and sellers’ concerns, and the risks that both parties face when entering into a grain marketing contract.
In the last column I touched on delivery period assurances. Now, let’s move on to grade risk, price spreads and discounts.
For this discussion we will assume that the contract base grade is a No. 1 CWRS.
Within a contract there may be a clause that references the grades that the buyer is willing to accept on the contract. Always read any contract carefully so that you know what you are agreeing to as far as terms and specs.
With CWRS wheat, buyers may be willing to accept No. 1, No. 2 or No. 3 but not No. 4 or Canada feed wheat. This adds additional risk for farmers. If you end up with only No. 4 or Canada feed wheat after a lousy harvest, you can’t deliver it against your contract. This leaves you having to find a new market for your poorer quality wheat plus having to either buy out your contract, find someone else to fill it for you, or surrender it to the company. If the contract price is better than the current market price, you may not have a problem, but if the market price is lower, you may have to buy out the contract, and pay a contract cancelation administration fee.
Companies may restrict the grades they will accept so that they can meet the specs for the sales they’ve made for milling quality wheat. If they take delivery of a No.4 or Canada feed wheat, their buyer will most likely not accept the lower quality. Then the company must try to find other grain that is acceptable to their buyer. And, if they take delivery of your poorer quality grain that they can’t ship to their end customer, they’re tying up space in their facilities. This can cause them real problems down the road when they need space for future shipments.
For farmers concerned that they may not grow the grade specified in the contract, one way to reduce this risk is to make an agreement with the buyer that the company will accept your grain if it ends up being a lower quality, and that you will accept a price for that lower quality based on current market price spreads at time of delivery.
This would allow you to deliver against your contract and eliminate your risk of potentially having to buy back the contract.
An agreement to use current price spreads at time of delivery sets a fair market value for lower quality wheat as compared to a higher quality.
Grade spreads:an example
Let’s say you deliver feed wheat and the market difference between feed wheat and No. 1 CWRS at the time of delivery is $100 per tonne. The Company would deduct $100/t from your contract price to determine what they’ll pay you for the feed wheat. This allows the company to turn around and sell the feed wheat into the market without losing any money.
You can move and sell your wheat, and the grain company can resell it without tying up facility space. This arrangement is fair for both parties, with minimal risk and or hassles.
Price spreads will change throughout the year depending on the volume and grade of grains available in the marketplace.
If for example the price spread from a No. 1 CWRS to a No. 3 CWRS is, on average, about $30/t, and then after a poor harvest there is twice as much No. 3 CWRS available you can expect the price spread to widen between the two grades. Exactly how much the spread might widen is hard to say. Many factors would come into play.
The volume and quality of the world wheat crop is a key factor, as it influences the world price for wheat. The grain companies have to determine at what price they could sell No. 3 CWRS as compared to the world price, and then set an appropriate discount off of the No. 1 CWRS price that will allow them to make sales and move the massive volume of No. 3 CWRS.
With the large volume of No. 3 CWRS wheat harvested, there is proportionally less No. 1 wheat available. The discount needs to be wide enough to ensure that the available No. 1 wheat sells at a premium price above the No. 3 CWRS.
Companies will blend the No. 1 and No. 3 CWRS to make a No. 2 that is hopefully more desirable to buyers than No. 3 but cheaper than the No. 1. The price spread needs to be appropriate so that they can blend the grades and sell more grain.
Throughout the year, as things change in the world wheat markets, these spreads will adjust to keep our grain prices competitive in the world market.
Locking in price spreads
It would be too risky for a company to lock in price spreads for you one, two or six months in advance unless they had a committed sale already made. In that case, they could offer you guaranteed price spreads based off of the value of their actual sales.
Prior to harvest this is still a risk for the companies — they don’t know what grade of grain they’ll receive until it is harvested. If world market prices or average qualities change in the meantime, they are at risk of losing money if spreads widen above what they have locked in with farmers who haven’t delivered yet.
All of these factors need to be considered when setting price spreads so that grain companies can obtain the best prices and sell and ship the maximum volume of grain.
These reasons should help you understand why a grain company, for the most part, will not lock in the price spreads until they are ready to cut you the cheque for the grain you have delivered.
A short discussion on discounts
“Discount” refers to a reduction in price due mainly to factors like the moisture level of the grain, the weight of the grain or the amount of foreign material in the grain.
There is a tough and/or damp discount that will be deducted from your price if your grain is above a certain moisture level.
A common practice in the feed barley market is to discount the price of your contract if the weight of the barley is not at or above 48 pounds per bushel. Some end users will even pay a premium if the weight is over 50 pounds.
You can also see a discount if other grains are mixed in with your grain, or if there are stones or ergot or other degrading factors that devalue the grain to an end user.
These discounts can be different with every grain and on every contract based on what the company needs. Read your contract carefully and/or negotiate the discounts before signing. †