You’re still selling your 2012 crop, but it’s already time to start making decisions about your pricing strategies for 2013
Winter is a good time to make marketing decisions. Not just for the crop you already have in the bin, but for the crops you’re planning to seed in the coming spring. This is the time to consider your alternatives and decide how much risk you want to take.
For “cash grains” that do not have actively traded futures contracts (commodities like peas, durum, barley, flax and lentils), your price risk alternatives are very limited.
The best risk protection option I’ve seen is a production contract that includes an Act of God clause. For example, some of these contracts will allow you to price up to 20 bushels per acre. If you sign one of these contracts and end up short production at harvest to cover your commitment, the Act of God clause will kick in. Once your loss situation is verified, you won’t be obligated to deliver the tonnes you don’t have.
Other than these contracts, your options are limited. To avoid production risk, you could wait until you have the grain in the bin at harvest before you sell any. This leaves you with the risk of missing higher markets earlier on and having to settle for lower prices at harvest time.
Another option is to take on less pricing risk so that if and when the markets are high enough that you can sign a deferred delivery contract and lock in a profit per acre (based on your production costs) for a percentage of your estimated production. By locking in only a small portion of your planned production (perhaps five to 15 per cent), you can lock in a profit on some production without taking on a big delivery risk early in the year. As the growing year progresses you can price further increments of your production as you’re comfortable, or wait until harvest to ensure you grow the tonnes before pricing any more.
Depending on your crop mix, you can spread out your overall pricing risk by minimizing your pre-pricing of cash grains and focusing more on price protecting and pre-selling your “futures grains” (grains like wheat, canola, corn and soybeans, for which there are actively traded futures contracts).
These futures contracts allow you to use hedging strategies by either selling futures or buying put options contracts to protect a price for your grain on paper without having to commit to having to deliver any grain to any particular company.
Prior to being able to use futures and or options contracts you will have to set up a commodity trading account through a brokerage firm or an online e-trading account that will give you access to commodities trading. This will take some time and involves a fair bit of paper work especially if you are doing it under a corporate name, so plan ahead.
Using futures contracts in a hedging strategy requires a full understanding of how a hedge works. You will also have to make a financial commitment to ensure your hedge remains active until you’re ready to physically sell your grain and unwind the hedge.
Because of these complexities I would strongly suggest you consider using options contracts instead of futures contracts to protect a price for your grain early in the crop year cycle.
Buying a put option allows you to lock in a floor futures price. You pay a flat premium up front for the option contract — there is no fluctuation risk as there is with a hedge strategy using futures contracts. However, options premiums move with the markets. Depending on the time of year and the amount of volatility in the market, you could be laying out a lot of cash to put an options strategy in place.
Current put option premiums for November 2013 canola are in the range of $40 to $60 per ton, depending on the strike price you choose. It is not cheap to purchase options this far in advance of harvest.
It is best to use a blend of pre-selling along with options contracts to balance out your pricing risk and without breaking the bank. You could be using options strategies a year in advance of harvest if the markets so dictate, which means you will need to have cash available to do that when the time is right. This means setting some funds aside for trading or creating a line of credit at your bank that you can tap into at a moment’s notice, as markets change fast.
As you will need to pre-price grain at some time so you can deliver it and get cash to pay bills, here’s a strategy to help reduce your delivery risk — the risk of not growing enough tones to fulfill your contract, and having to buy out your obligation. When you’re pre-pricing futures grains with a grain company, you can use call options to protect yourself against this risk by.
When you lock in tonnes for fall delivery to a grain company, you can buy a call option for the same tonnage at the same futures value, with a strike price equal to your selling price. Currently, November 2013 call option premiums range from $20 to $35 per tonne.
Call options provide value to you in a rising market. In the unfortunate event that you’re not able to brow the tonnes you need to meet your delivery contract, you’ll need to buy out your contract. If, at the time of the buyout, the futures prices are lower than the prices you’ve contracts, you may be able to find a neighbour who would take over the contract and deliver against it. Or, the company will probably be willing to cancel the contract with no charges as they can buy tonnes to replace yours in the current market at a cheaper value.
However, if futures values are higher than your contracted futures at delivery time, you’ll have to pay the difference to the company so they can buy replacement tonnes in the market to meet your contract obligations. This is where a call option becomes valuable. The futures have risen — the increase in the value of your call option will offset the cost of your buyout with the grain company. (Although, you may still have to pay a basis adjustment and or a contract administration fee.)
There are grain companies that are combining options with pricing contracts in an effort to provide farmers more flexibility. If you don’t have a trading account this will be the only way you can use an options contract as part of your pricing risk strategy. Options attached to contracts don’t come free so make sure you are aware of the cost of the options portion of your contract — compare this to the cost of buying an option on your own. If the costs seem competitive, this may be a good choice for you to consider.
Until next time, turn on your computers and calculate your costs of production so you can start setting pricing goals and strategies for next year! †