The growing season is a tough time to make marketing decisions. Prices are volatile as traders react to every change in the forecast, and our most recent summer has added additional uncertainty with trade wars on multiple fronts. Every selling decision is a choice: lock in a price, which removes the downside risk but also forfeits any further upside opportunity, or not lock in a price, which leaves one exposed to an adverse price move. Though, when a price is not locked, farmers can capture additional price increases. Typically, these decisions are made under the reality that we don’t know what the future will bring.
Farmers face the additional challenge of navigating these selling decisions while also weighing their production risk. Pricing grain near the peak of a summer weather rally can be a costly decision if a yield wreck means bushels aren’t there to fulfill the obligation. This could potentially result in high buyout costs.
Most farmers are comfortable pricing a portion of their crop ahead of harvest, between 20 – 40 percent, depending on the region, specific crop, point in the growing season and risk appetite of the farmer. However, deciding whether or not to price more grain, and how that compares to the corresponding production risk, is more difficult when looking to lock in values on even more of the crop. For example, what if the market makes a short-term spike due to fund short covering (or a temporary weather scare), but also where the longer term outlook is negative. Should one price more grain and hope the bushels will be there in the fall? Wait for more production certainty but potentially miss a vital pricing opportunity along the way? What if we price grain only to later find out something has changed in the outlook and there is further upside ahead?
Fortunately, some tools can help growers navigate this dilemma. Hedging, mainly through the use of put options, gives farmers the opportunity to lock in a minimum price, while at the same time, leaving the upside opportunity open, and do so without having any risk of a buyout if the crop comes up short.
Put options act as a form of price insurance. With traditional insurance, a premium is paid up front and the insurance is used only when needed. Comparatively, with put options, an initial premium is paid to secure a minimum future price and the insurance is used if prices trade lower.
One criticism of put options is that the premium can be expensive. This needs to be weighed carefully with price levels that are being protected as well as the outlook for that market. However, attractive opportunities occasionally come up for growers to lock in a minimum value, retain the upside price potential, and do so while not having to stress about production risk (something that was relevant this past summer during the peak of the drought.) For example, over the last six months, there have been occasions where farmers could lock in an $11.00/bu minimum cash price for canola, which includes the full cost of the put option. Does a ‘worst case scenario’ of $11.00/bu look attractive today given the rising crop size expectations for canola in Western Canada and the turmoil in world soybean markets, knowing that you can also grab any upside if the market does rally? For any farm that achieved a decent yield, this price would result in a pretty reasonable minimum return.
Markets are difficult, and a common adage is that market prices move to the levels that screw the highest number of traders. However, farmers aren’t traders – they are marketers and risk managers of the crops they work so hard to grow and harvest. And now, there are tools that allow you to lock in prices while keeping the upside open. So it is possible to have your cake and eat it, too.