Securing a Margin in Volatile Markets
Market price volatility returned with a vengeance in mid-2010. Initially all was positive for cereal farmers as the May 2011 futures moved up from a low of 105/t in early June to peak (so far) at just over 210 in mid- February, and back again in April. Yet within a week in March, it moved from 178 to 167 and back to 194 in the space of five days trading. Pretty hairy stuff for the traders and merchants involved, and almost impossible for most farmers to follow and make sense of as markets moved minute by minute. Picking the moment to sell, to lock into a price, is, for the present, the most important decision for most farmers. Variety choices, fertliliser rates and fungicide differences have a measurable effect on yield and output, but, by comparison with making the correct marketing decisions, pale into insignificance. A 50/t movement is 450/ha on or off the bottom line.
Volatility by its very nature means periods of low prices, not just prolonged high prices. Should they remain high for any length of time, cereal consumption will be affected; alternative feed ingredients will gain traction; output on a global scale will be encouraged; profits will be eroded by increased input costs and the market will deliver the down side of volatility it is not a question of if but when.
What can growers do to take some of the sting and risk out of the volatile markets? The first step clearly is to have a clear understanding of individual costs of production, which is all well and good when looking backwards at what has been spent to bring in the crop now sitting in the barn, but more difficult when looking into the future and making the decision to sell forward. How much will fertilizer and fuel cost next year? What is a profitable price if your costs are uncertain? Can you shave another 1/ha off your fixed costs? How do you know where the market is when it is moving so quickly and so far? Have you missed the top? Did you sell too much too early?
The market drivers are well understood and, with food security back on the political agenda, making the front pages on a regular basis, and subject to plenty of commentary. Global population is likely to reach 9bn by 2050; meat consumption increases with prosperity (albeit perhaps more slowly with every grain price surge); bio-fuels burn 40% of north American maize; grain stocks are low and not sitting in the granaries of the major exporters; production has been disrupted by floods, drought and political upheaval. This is all well and good, but what does it mean to the British grain market this year? Or next? Market bulls have been in the ascendant since July 2010, with only hint of bearish realignment in the last few weeks. In such a bull market, bearish news is discounted. An example of such is the recent Pakistani export of substantial quantities of wheat, at a time when, for most commentators, the Indus floods in 2010 devastated Pakistans ability to feed itself.
The first decision for growers is whether to sell forward, and on what basis to make that decision. When prices are low during the more than 12 months of selling opportunity before harvest (and defining low is only easy after the event), there is no certainty that they will rise, but the balance of probability is that there is more upside than down. There is little to be lost by holding off, and waiting until the crop is in the shed. When prices are high, and they are high now even without the benefit of hindsight, there is no certainty about the next movement, but the weight of probability is that they will fall back, and therefore selling a proportion forward has got to be considered. Indeed, it may well be worth selling some of the following harvest as well. Most merchants will offer growers the opportunity to sell forward, and they will fund the futures hedge required, if there are no end users in the market. For every farmer trying to secure a margin, there is an end user trying to do the same, but often not at the same time.
The use of options to secure a minimum price has increased since 2007, although perhaps not as much as expected. Options can appear expensive, but if used as a back-stop against a price collapse can provide excellent value, while leaving the grower free to benefit from further upside movement.
For many growers, responsibility for marketing is passed to the professionals through the use of pools offering a pretty wide choice of market timing and commitment. Pools will never beat the market; but they will take the peaks out and the more successful ought to deliver a better than average return. Due to their relative scale, they tend to be less flexible and forensic in sales strategies, with sales spread over the whole marketing period of the pool.
Having made a decision on forward selling crop, a grower is then exposed to costs of production moving adversely. How can he secure his margin? That good price today might look poor next week, if prices rise further and inputs follow them. Those who held back selling in 2010, secured the benefit of low inputs and high sales values. For 2011 input costs will be higher; the price of Black Sea fertilizer has followed the price of wheat up, oil prices have moved sharply in response to Middle Eastern crises, and there is no doubt that agchem prices will see some inflation. Margins will be squeezed.
Opportunities to lock in costs are limited, having locked in a crop sale price. Fertiliser can be purchased forward, and should be if substantial sales have been made, and a profit is to be secured. To secure the energy inputs, tractor and dryer fuel, it is possible for growers to hedge against movements by using futures contracts or options, but these are unfamiliar to most, and there is no readily accessible market place, in which growers feel comfortable. Grain merchants take on the cost of funding hedges against farmer sales, and so far have not sought to go back to their farmer customers to help cover the cost of securing those good forward sales. Nobody is offering the same for fuel. It is down to the individual farmer, or perhaps some of the farmer owned co-ops to fund derivative trading in oil and gas futures.
Ag-chem costs are even more difficult to secure forward. Manufacturers and distributers are loath to commit to price when the grain market is frothy. Growers and buying groups know much of what they want for the season (or even seasons) ahead, but cannot lock away the price, and therefore the margin. There are no derivative markets in epoxyconazole or glyphosate. There is talk of an insurance product to be offered to growers to allow them to fix input costs, but no sign of it in the market yet. It is likely to be complex, and perhaps beyond the comfort zone of most growers The cost of such a product is likely only to become affordable if there is a reasonable take up.
Derivative markets are used to speculate in and hedge a wide range of commodities every day, hard and soft, metals and agricultural products. For them to operate effectively, they require a minimum degree of activity to deliver liquidity.
Market volatility does not suit most purchasers of grain, and there is increasing activity in contractual relationships. Most of these tend to be market based, so do little to remove the volatility, but there are opportunities, particularly for specialist users with particular requirements to secure tonnage at prices which removes the lows and highs. As is ever the case with such arrangements, growers wish to enter when the market is high, and the purchaser when low. Such deals require trust and flexibility to recognise that both parties can be winners.
Machinery and labour costs flex more slowly than the cereal market, and the constant refrain of efficiency does not really change in periods of high prices. If your cost structure works, when prices are low, dont let it increase in response to higher prices bank the extra profits. For those farming land for others, payments for land outside traditional AHA tenancies are increasingly linked to harvest outturn, the risk and reward shared.
Conclusions
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There are plenty of ways to lock into forward grain sales
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Focus more time and resource on marketing in periods of volatility it is likely to be the most valuable use of time
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Engage with your merchant(s) they are watching the markets all day every day
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Be prepared to sell well forward if grain prices appear high they may not be so forever
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Use options to secure a minimum price, if you are a nervous bull they may go higher (or lower)
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Having sold forward, secure inputs to lock in margin wherever possible fertilizer can be bought, oil and gas derivatives can be used to hedge energy
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Consider using contracts, if they offer an opportunity to reflect costs in the final price
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Farming is a risky business there are no simple ways to remove all the risks. Market volatility has just added another layer of uncertainty
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Look after your extra profit. It may not come again for a while