Released April 14, 2008
COLLEGE STATION, Texas – Extremely volatile commodity prices due to high energy costs has led to the suspension of forward price cash contracts – a marketing tool used among farmers to reduce price risk and increase profits each year, according to Texas AgriLife Extension Service economists.
The suspension of forward contracts is a result of grain elevator operators’ and merchants’ inability to cover margin spreads, said Mark Welch and John Robinson, economists in College Station.
Corn, wheat, cotton, soybeans and other commodities have eclipsed record prices this year as a result of increased biofuel demand, acreage adjustments, production shortfalls, tight carryover stocks and speculative investment, Welch said.
“Many farmers wanting to lock in prices at these historic levels are turning to forward price contracts,” he said.
Forward price contracts of a growing crop establish a “price and delivery provision,” Welch said, which transfers price risk from the producer to the writer of the contract.
“(This is) usually a grain elevator or cotton merchant,” Welch said. “The elevator or merchant may then transfer this price risk to speculators by hedging in the futures market.”
A contract hedge consists of selling an equivalent amount of cotton or grain in the futures market to cover inventory or forward contracted commodities that they hold, he said.
“If prices are lower at harvest, gains in the futures market offset the price difference between the higher contract price and the current cash price, protecting the elevator or merchant’s price margin,” Robinson said. “If prices go up at harvest, losses in the futures market are offset by the ability to sell the forward contracted grain or cotton at a higher price.”
Those participating in the futures market must have enough margin money deposited to cover potential losses. The margin is balanced daily and those profits accrued in excess of the margin requirement may be withdrawn.
“Any losses that draw the margin account below the minimum maintenance level must be offset by additional deposits to restore the account to its initial balance,” Welch said.
Those that fail to bring the account up to the initial required level results in liquidation of the position and the holder of the account must absorb all losses.
As a result of rapid escalation of commodity prices, elevator and merchants who wrote forward price contracts are facing “enormous proportions,” Welch said.
“Wheat that was hedged at planting last October for a then all-time record high price of $7 a bushel has incurred margin calls of $6 per bushel or $30,000 per contract.”
Forward-contracted corn last fall has increased in price by more than $2 a bushel, he said.
“The margin requirement to maintain each of those contracts is now around $10,000,” he said. “For a medium to mid-sized grain elevator to maintain their hedged positions, they have had to deposit millions of dollars in margin money. Add to this the interest cost of funds required to maintain margin requirements and the financial burden of offering and maintaining forward contracts is considerable.”
Farmers are now left with the option of either hedging their crops by selling futures contracts, buying options or a combination of the two, Welch said.
“The impact of severe margin calls on the commercial sector should give growers renewed pause about the margin risks of hedging via selling straight futures,” he said. “Many producers are uncomfortable or unfamiliar or had unprofitable experiences with these marketing alternatives. It’s important that a prospective hedger learn all they can about these markets and understand the risks and rewards before initiating a hedging program.”
In order for producers to stay updated on changing market conditions, Welch and Robinson advised them to have ongoing communication with lenders and the grain or cotton merchants.
“Working together, it’s possible to forge an effective strategy to manage price risk even in these volatile markets,” Welch said.
Commodity organizations representing grain and cotton industries have complained to the Commodity Futures Trading Commission the markets are no longer working as intended. A public hearing is scheduled April 22 in Washington as the Commodity Futures Trading Commission will hear from representatives of the U.S. Department of Agriculture, the commodity exchanges, traders, merchants and producers.
“Some of the topics to be addressed are the lack of convergence between cash and futures markets, the impact of higher margin requirements, and the role of speculative investment in the commodity markets,” Welch said.
Both Welch and Robinson distribute weekly e-mail marketing newsletters. To subscribe, contact Welch at JMWelch@ag.tamu.edu and Robinson at jrcr@tamu.edu.
Editor’s Note: The following can be used as a breakout box or sidebar to the accompanying article:
Lower Corn Production Could Result in Wild Price Swings
- When will the commodity price volatility end? It’s not likely to die down soon, according to Texas AgriLife Extension Service economists Drs. Mark Welch and John Robinson. Projected corn plantings in the latest U.S. Department of Agriculture planting survey indicate farmers intend to plant 7.6 million fewer acres of corn this year compared to 2007. At current yield estimates of 154.9 bushels per acre, total corn production in 2008-2009 will be 6.5 percent less than last year.
- What does this mean? With low carryover stocks and ever increasing demand from the fuel, feed and food sectors, the stage is set for wild price swings, according to AgriLife Extension economists. Markets will be sensitive and are likely to react strongly to weather events that impact yields, the influence of outside markets and other supply/demand fundamentals.
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http://agnews.tamu.edu/showstory.php?id=438
Contacts: Mark Welch, (979) 845-8011, JMWelch@ag.tamu.edu
John Robinson, (979) 845-8011, jrcr@tamu.edu
Blair Fannin, (979) 845-2259,b-fannin@tamu.edu
