Grain Marketing in the BioFuels Era:
Session 1: January 22
Ethanol
Massive Demand Growth
4.6
11.0
4.1
10.0
3.6
9.0
3.1
8.0
01/01/07
12/01/06
11/01/06
10/01/06
09/01/06
08/01/06
07/01/06
06/01/06
05/01/06
2.1
04/01/06
6.0
03/01/06
2.6
02/01/06
7.0
Billion Bushels
12.0
01/01/06
Billion Gallons
Ethanol Capacity: Exisitng + Under Construction:
Source: Renewable Fuels Association
Nearly Unlimited Fuel Usage
Estimates Renewable Fuels:
Lugar/Harkin 2010, 2020 & 2030
Estimated % Renewable
25%
20%
15%
10%
5%
0%
4 6 8 10
Year
20
U.S. Gasoline use is about 140 billion gallons per year.
All our corn crop would only provide 14% of the energy in gasoline.
30
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 Line
Opportunity
1.
2.
3.
4.
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
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: 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
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
Size
Tick
Size
Daily
Limit
Contract
Months
5,000 bu ¼¢ /bu 50¢ /bu Jan, Mar,
May, Jul,
Aug, Sep,
Nov
Last Trading Day
The business day
prior to the 15th of
the month
Contracts Change Value as Prices Change
March 20: 5,000 bu of July corn futures @ $2.50 = $12,500
March 25: 5,000 bu of July corn futures @ $2.60 = $13,000
10 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.
Futures Positions Require Margin
Money
Margin means you do not have to pay the full value
of your futures position….JUST a MARGIN
A small
amount of
Your $
$4 corn
example
$1,000
Controls a LARGE amount
of Commodity Value
$20,000
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
March Futures
July Futures
Corn
Soybeans
$2.50
$2.75
$8.25
$7.75
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.
Futures Prices as Forecast
Dec/Nov Futures
Corn
$2.40
Soybeans
$6.10
March Futures
$2.55
$6.30
May Futures
$2.65
$6.30
July Futures
$2.60
$6.35
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.
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
Note: These months are the
most common to use when
considering new crop
$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.
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).
• 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
• When 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
Establishing Prices on Growing
Crop (continued)
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
4. A hedge diagram is used to illustrate positions for
the cash and futures markets.
Establishing Price
Begin Here
Cash
Futures
Basis
May 20
Expect cash value
to be $2.50/bu
Sell 5,000 bu of Expect Basis to
Dec corn futures be 20 cents
@ $2.70
under futures
Oct 20
Sell corn at
elevator for
$2.00/bu
Buy back Dec
futures @
$2.20/bu
Summary
Sold cash @ $2.00 Gain in futures is
+$0.50
Net Price Received = $2.50/bu
(before any futures commission or hedging costs)
Basis is 20 cents
under futures
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.
What If Prices Moved Upward?
Cash
Futures
Basis
May 20
Expect cash value
to be $2.50/bu
Sell 5,000 bu of Expect Basis to
Dec corn futures be 20 cents
@ $2.70
under futures
Oct 20
Sell corn at
elevator for
$3.20/bu
Buy back Dec
futures @
$3.40/bu
Summary
Sold cash @
Loss in futures is
?
_____________
______________
Net Price Received = _______________/bu
(before any futures commission or hedging costs)
Basis is 20 cents
under futures
The Answer:
Cash
Futures
Basis
May 20
Expect cash value
to be $2.50/bu
Sell 5,000 bu of Expect Basis to
Dec corn futures be 20 cents
@ $2.70
under futures
Oct 20
Sell corn at
elevator for
$3.20/bu
Buy back Dec
futures @
$3.40/bu
Summary
Sold cash @ $3.20 Loss in futures is
-$0.70
Net Price Received = $2.50/bu
(before any futures commission or hedging costs)
Basis is 20 cents
under futures
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
Cash
Futures
Basis
May 20
Expect cash value
to be $2.50/bu
Sell 5,000 bu of Expect Basis to
Dec corn futures be 20 cents
@ $2.70
under futures
Oct 20
Sell corn at
elevator for
$2.08/bu
Buy back Dec
futures @
$2.20/bu
Summary
Sold cash @ $2.08 Gain in futures is
+$0.50
Net Price Received = $2.58/bu
(before any futures commission or hedging costs)
What’s
Different?
Basis is 12 cents
under futures
They exceed their goal of pricing
5,000 bu of corn at $2.50/bu and
net $2.58. WHY? Because on Oct.
20, the cash price was 12 under,
rather than the expected 20 under.
Hedging and Basis Risk
• Basis influences the effectiveness of the hedge
• Hedging is effective in reducing price risk because
changes in basis, over time, are much smaller and
more predictable than changes in price.
• Basis risk is less than price risk.
Price vs. Basis
2.5
Corn Price ($/bu)
2
1.5
1
0.5
0
-0.5
Sep
Oct
Nov Dec
Jan
Feb Mar Apr
May Jun
Time
Futures Price
Cash Price
Basis
Jul
Aug
Sep
Establishing Price: Current Example
Cash
Futures
Basis
Jan 8,
2007
Expect cash value
to be $3.44/bu
Sell 5,000 bu of
Dec07 corn
futures @ $3.64
Expect Basis to
be 20 cents
under futures???
Oct 20,
2007
Sell corn at
elevator for
$3.00/bu
Buy back Dec
futures @
$3.20/bu
Basis is 20 cents
under futures
Summary
Sold cash @ $3.00 Gain 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
Cash
Futures
Basis
Jan 8,
2007
Expect cash value
to be $6.95/bu
Sell 5,000 bu of
Nov07 soybean
futures @ $7.25
Expect Basis to
be 30 cents
under futures???
Oct 20,
2007
Sell beans at
elevator for
$7.10/bu
Buy back Nov
futures @
$7.40/bu
Basis is 30 cents
under futures
Summary
Sold cash @ $7.10 Loss 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
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
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
• Forward Contract
= $3.30
= $3.65
• What if we use a storage hedge?
• What if we store unpriced?
Storage: Futures Information
CONTRACT MONTH
PRICE/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
Date
Cash Market
Futures Market
Basis
Initiate
Hedge
Expects $3.65/bu
net
Sell May Futr @
$3.75/bu
Expected to be
$0.10 under
Lift Hedge
Sell cash @
$3.20/bu
Buy May Futr @
$3.25/bu
Basis is $0.05under
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
Pricing Basis: Storage Decision
Action
Advantage
$$ Now! Simple
Sell @ Harvest No more risk
No storage costs
Lock-in Price
Forward Price No Basis Risk
Disadvantage
No Upside: Cannot
Capture Futures Carry or
Basis Appreciation
No Upside
No Basis Appreciation
Basis Appreciation
Basis Risk
Futures Hedge
Flexible-Choose elevator No Upside
Storage
Speculation
All Upside Potential
All Downside Potential
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.
Date
Cash Market
Futures Market
Basis
Jan 22,
2007
Expects $3.85/bu
net purchase
Buy 20,000 May Futr
@ $3.75/bu
Expected to be
$0.10 over
May 1,
2007
Buy cash @
$3.30/bu
Sell May Futr @
$3.25/bu
Basis is $0.05 over
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
Readings for Jan
th
29
on Options
• In Agricultural Futures and Options: A
Hedger’s Self-Study Guide
– p. 21-32
– p. 49-58
– Useful glossary of terms p. 63-64
Assignments
1. Hedging Exercise completed
2. Basis Exercise
3. 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?
4. 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