Risky 2014 Calls for a Good Hedging Strategy

20 Dec Risky 2014 Calls for a Good Hedging Strategy

Friday, December 20th, 2013
2014 could be a rocky year for farmers.

Some respected analysts are predicting $4 corn, $10 soybeans and $0.75 cotton even as variable costs like inputs and cash rents remain the same or increase. Wrapping up 2013, a healthy supply of most commodities is in storage, the federal government is poised to reduce ethanol requirements, and other countries are ramping up production of soybeans.

Working with a tighter profit margin next year, farmers should take a look at one of their best risk management strategies: Hedging.

“You should consider your hedging every year because you are going to have dips and spikes,” said Glen Arnold, a broker in Cochran, Ga., who helps farmers across the Southeast get the information they need to develop a good hedging strategy. “Right now, there is not any one commodity in short supply. I think 2014 is going to be a very challenging year for our farmers.”

“Cotton, there is an ample supply. We have nearly a year’s supply of cotton on the world stocks. The Midwest had a bumper crop of corn. Currently, we have plenty of soybeans. Even though there is high demand for soybeans, South America increased soybean acres this winter and their soybean crop is looking good,” Arnold says.

By taking advantage of put options on the futures market when prices are profitable, a farmer can mitigate his losses. If prices in Chicago go down, the put options are there to gain value to compensate losses in the cash market.

There are two types of people who use the market: hedgers and speculators. Speculators who invest in commodities are taking a lot of risk considering all the factors that cause price volatility – from weather to energy policy to international politics.

But farmers who use hedging aren’t gambling on the market; they are buying options to shift risk and protect themselves in a volatile market.

“If you are a producer – you are producing corn or cotton or selling feeder cattle at a certain time – you have every right to buy put options as a hedger to protect the value of your products,” Arnold says.

First off, Arnold advises, producers have to accept that “no one knows for sure what’s going to happen in commodity prices.”

“Nobody knows what the market is going to do,” he says. “We talk about it all the time and make educated guesses, but we have to admit, we don’t know. There is so much that impacts prices that is completely beyond our control.”

The next step in planning a hedging strategy is estimating the cost of production.

“If it costs you $4/bushel to grow corn, then why would you forward contract at $3.75? You have to know what your costs are. For every farmer, it’s different,” Arnold says.

Once a farmer has a realistic picture of his production costs, he decides how much of his crop to put under forward contract.

“If you expect to produce 50,000 bushels of corn, for most the rule of thumb is locking down 50 percent of what you know you can make. The reason is, you may have a drought or catastrophic event and you don’t want to lock in the full 50,000 and you make 30,000. Then you are financially obligated for the difference,” he said. By the same logic, Arnold says he understands why farmers working on dry land may wait a little longer to decide how much to sell in a forward contract until they can judge the weather conditions and expected yield for the year.

While most farmers use forward contracts, many stop there and don’t take advantage of another hedging tool to protect the other half of the crop.

“The last 50 percent, the last 25,000 bushels, they gamble on the market. It goes up and down,” Arnold said.

Instead, he advises farmers to utilize a combination of forward contracts and put options.

“If prices are profitable and you can live with it, use a forward contract to lock in up to 50 percent of what you know you can make,” Arnold says. “Then on the balance of your production use put options to set a price floor in case of a meltdown in prices. Put options allow you to set a price floor and give you downside protection, while keeping the topside open in case of a sharp rebound in prices. Should prices crash, your puts options would gain value to compensate and if prices rise sharply you can sell at the prevailing high price, which would also help your contracted price as well.”

Puts are not always something you want to do all by itself, Arnold say, but they work well along with forward contracts. With forward contracts and put options in place, a farmer can rest easier knowing he is OK no matter which way the market goes. He has created a bit of certainty in an uncertain business.

Hedging isn’t a money-making strategy, but a money-protecting strategy and needs to be kept in place until harvest.

“For example, if you planted corn and bought a put option for 30 cents per bushel and in mid-season the market has fallen and your put is now worth 60 cents, there is the tendency to take your profit. After all, some justify it by saying they have doubled their money. In the investment world, that’s 100 percent return, that’s awesome. In the investment world, you get out.

“But in farming, removing a hedge before harvest could be a costly mistake. Remember your objective is to protect the crop in the field until it is sold. You don’t want to lift your hedge early,” Arnold explains.