Farm product prices change because of changes in supply and demand. During the growing season, because of production concerns, attractive pricing opportunities often arise before farmers have grown the crops. Forward pricing to take advantage of those relatively high prices may be done directly by using a deferred delivery contract or, for commodities with a futures market, by hedging.
For commodities with a futures market, there are two markets whose prices tend to move together: the cash (or physical) market and the commodity futures market. The difference between the prices in each market is called basis.
Hedging: the definition
The commodity futures market is a market where the right (and obligation) to deliver or receive delivery by some future date at a specific price is bought and sold. The contract price represents a forward price of the commodity at a certain delivery point in the future. “Hedging” is the act of taking opposite positions in the cash and futures markets to reduce your risk of a price change.
Think of it this way. A farmer who seeds a crop must buy the seed, fuel, fertilizer, herbicide and all the other inputs. In essence, the farmer buys the crop by buying the inputs. If, during the growing season, the farmer hedges the crop by selling futures contracts, he has sold that crop for a price at some point in the future. This creates the hedge — holding opposite positions in the cash market (buying the crop) and the futures market (selling the futures contract).
With the sell hedge in place, a drop in the futures price will make the crop in the ground worth less. But your sell or “short” futures position will be worth more. Losses in one market will be offset by gains in the other.
Futures Hedging: an example
In January 2011, after considering his costs of production, expected yield, market outlook and cash flow needs, Jim, a canola grower reviewed the available canola contract prices for October 2011. He decided that a target price of $13/bushel for part of his expected crop was realistic.
In checking cash buyer bids for October delivery, Jim calculated that the difference between the October delivery cash bid and the November 2011 futures price was -$40 per tonne. Jim judged this basis of $40/tonne under the November futures to be too weak to lock in. He decided he might see a basis of $18/tonne under the November futures at some time before November, so he set that basis level as a target in his marketing plan. Jim decided to use his commodity futures account to lock in the futures price of some of his expected canola production. The he could shop around for his target basis level.
To achieve a cash price of $13/bushel (about $574/tonne rounded up), and considering his target basis of $18/tonne, Jim’s target November futures price was $592/tonne ($574/tonne + $18/tonne).
Jim placed an open order with his commodity futures broker to sell five contracts (100 tonnes) of November 2011 canola futures at $592/tonne. This 100 tonnes represented 20 per cent of his expected production.
Several times last spring, the November canola futures price exceeded $592/tonne, so Jim’s futures hedge was “filled.” He then had a sell futures position for 100 tonnes of November canola futures at a price of $592/tonne.
Jim’s broker required him to have $2,500 in his commodity futures account to secure that 100 tonne futures position. So, when his canola was growing in the field, Jim had 100 tonnes of his crop priced with his sell futures position. On that 100 tonnes of canola, he reduced his price risk to that of basis. Specifically, his price risk on that 100 tonnes is that the basis may weaken. The basis is not locked in until Jim signs a contract to deliver his actual canola.
On October 21, Jim delivered 100 tonnes of canola to a buyer for $504/tonne, the highest cash price he found in the local market. That this is the highest cash price in the market implies that it’s also the best basis available. The November futures price that day was $522/tonne, so the basis was $18/tonne under the November futures ($522/tonne – $504/tonne), equal to Jim’s target basis. (Of course, Jim also considered trucking costs and his experience with that buyer before he made this decision.)
Having sold his physical canola, Jim no longer needed his canola futures hedge for that 100 tonnes, so he removed his “sell” position by contacting his commodity futures broker and buying back five November canola futures contracts. This buyback (offset) of his November futures sell position was done at $522/tonne (the current futures price at the time).
In the futures market: Jim sold 5 contracts at $592/tonne, then bought them later at $522/tonne. This resulted in a gain of $70/tonne. Since he had 5 contracts, each made up of 20 tonnes, this is a net gain of $7,000 ($70/tonne x 20 tonnes/contract x 5 contracts), less brokerage fees.
On the farm, Jim had a price target of $574/tonne for his canola. Instead, he sold it for $504/tonne — $70/tonne less than he’d hoped to receive ($7,000 for his 100 tonnes).
This is called a “perfect” hedge because the final return ($504/tonne cash sale + $70/tonne futures profit) matched Jim’s original target price of $574/tonne (excluding the small commission cost of futures hedging.)
In the case of a crop reduction during the growing season, all or part of the futures hedge could have been easily reversed.
Had the canola futures price risen instead of falling, Jim would have been in the same financial position. He would have lost money on his futures account (selling low and buying high), but sold his physical canola for a higher price.
Hedging with the futures market enables farmers to lock in the major part of their prices before delivery. This retains farmer flexibility — you can still decide which buyer to deliver to and when to deliver. †