grain marketing in the biofuels era: session 1: january 22 ethanol

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

Ethanol

Ethanol Capacity: Exisitng + Under Construction: Source: Renewable Fuels Association

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Massive Demand Growth

Nearly Unlimited Fuel UsageEstimates Renewable Fuels:

Lugar/Harkin 2010, 2020 & 2030

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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 Line Opportunity

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/calls4. 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 ShortSell Short: means the contract holder has a legal obligation to make delivery of the commodity.

Buy LongBuy Long: means the contract holder has a legal obligation to accept delivery.

Round TurnRound 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

Last Trading Day

5,000 bu ¼¢ /bu 50¢ /bu Jan, Mar, May, Jul, Aug, Sep, Nov

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 = +$500Seller = -$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.

Corn Soybeans

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.

Corn Soybeans

Dec/Nov Futures $2.40 $6.10

March Futures $2.55 $6.30

May Futures $2.65 $6.30

July Futures $2.60 $6.35How 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 $3.25Of 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 Crop2. 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!)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 cropEstablish the cost of an input like corn feeding needsProtect the value of inventory like stored crops

Hedging may be accomplished with futures contracts or futures options contracts

How to Hedge with Futures

• When hedginghedging, the futures market position taken todaytoday is a temporary substitute for a transaction that will occur laterlater 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

Cash Futures Basis

May 20 Expect cash value to be $2.50/bu

Sell 5,000 bu of Dec corn futures @ $2.70

Expect Basis to be 20 cents under futures

Oct 20 Sell corn at elevator for $2.00/bu

Buy back Dec futures @ $2.20/bu

Basis is 20 cents under futures

Summary Sold cash @ $2.00 Gain 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?Cash Futures Basis

May 20 Expect cash value to be $2.50/bu

Sell 5,000 bu of Dec corn futures @ $2.70

Expect Basis to be 20 cents under futures

Oct 20 Sell corn at elevator for $3.20/bu

Buy back Dec futures @ $3.40/bu

Basis is 20 cents under futures

Summary Sold cash @

______________

Loss in futures is ?

_____________

Net Price Received = _______________/bu(before any futures commission or hedging costs)

The Answer:

Cash Futures Basis

May 20 Expect cash value to be $2.50/bu

Sell 5,000 bu of Dec corn futures @ $2.70

Expect Basis to be 20 cents under futures

Oct 20 Sell corn at elevator for $3.20/bu

Buy back Dec futures @ $3.40/bu

Basis is 20 cents under futures

Summary Sold cash @ $3.20 Loss 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

Cash Futures Basis

May 20 Expect cash value to be $2.50/bu

Sell 5,000 bu of Dec corn futures @ $2.70

Expect Basis to be 20 cents under futures

Oct 20 Sell corn at elevator for $2.08/bu

Buy back Dec futures @ $2.20/bu

Basis is 12 cents under futures

Summary Sold cash @ $2.08 Gain 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

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Time

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Futures Price Cash Price Basis

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

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: $3.30April 08 Bid: $3.65

Using Basis: Storage Pricing

• Quick Hit: Storage CostsOn-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 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

Hedge SummaryCash Price = $3.20Futures Gain = +$0.50Net Price = $3.70

Storage SummaryCorn Price Gain = $0.40Cost of Storage = -$0.15Net Return to Storage = $0.25

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

Pricing Basis: Storage Decision

Action Advantage Disadvantage

Sell @ 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 HedgeBasis Appreciation

Flexible-Choose elevator

Basis Risk

No Upside

Storage Speculation

All Upside Potential All Downside Potential

Long (Buying) Hedge

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 SummaryCash Price = $3.30Futures Loss = +$0.50Net Price = $3.80

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.

Net price of $3.80 was $.05 better than expected because the basis was $.05 more favorable

Readings for Jan 29th 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 completed2. Basis Exercise3. 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