Using hedging to protect farm product prices

Introduction

Prices for farm products rise and fall due to changes in the supply or demand fundamentals, real or perceived, for that product. Periods of tight supplies usually cause high prices.

Farmers do not often have stored grain or marketable livestock on hand at a time when the price is high. Hedging, using futures contracts, is an alternative way to lock in prices in higher priced periods.

What is a hedge

Hedging, by strict definition, is the act of taking opposite positions in the cash and futures markets. To understand what a hedge is, first recognize that there are 2 markets:

• the cash market is the physical market where farm production is actually bought and sold
• the commodity futures market is the paper market where futures contracts are bought and sold

For example, a farmer intends to plant a field of canola. Even before seeding, he acquires, or buys, canola production with inputs of fuel, fertilizer, seed and chemicals, and his land and labour. When he buys these inputs, he has bought a canola crop. In other words, he has bought a piece of the cash canola market. If, at some time during the growing season, he hedges the crop by selling futures contracts, he then has an opposite position in the cash market (bought production) and the futures market (sells futures).

The hedge locks in the price by taking the opposite position in the futures market (sell) to what he has (buy) in the cash market. If the sell hedge is in place, a drop in the price of canola futures (and the value of cash canola) will make the growing, or cash grain, worth less, but the seller's short futures hedge will be worth more. The money lost in one market and the money made in the other will balance each other off very closely.

Types of hedges

There are 2 types of hedges:

• Sell hedge – also known as a short hedge
• Buy hedge – also known as a long hedge

Most grain producers would use a short hedge to protect against falling prices.

A buy, or long hedge might be used by a canola crusher to lock in the forward price of raw canola seed, or by a feedlot operator who wishes to lock in a price for feeder cattle that will be needed in the future. Another example of a buy hedge would be a grain exporter who has sold grain to a foreign buyer but still has not purchased it in the cash market. In this instance, the grain exporter would use a buy hedge to protect against a price rise in the cash market until purchases are contracted in the cash market to cover the export sale.

The rest of this section focuses on sell hedges as they are the kind of hedge used most often by crop producers.

Although buy and sell hedges can control the chance of adverse price changes, known as price risk, there are direct costs associated with using a hedging strategy. These costs are the exchange fees and commissions charged by commodity brokers for their services. The costs vary with futures exchange, the futures contract being traded and the brokerage firm.

Sell hedge example

The example in Table 1 shows a hedge using a canola crop. In the spring, a producer decides to target a local cash canola price of $450 per tonne for 100 tonnes of canola that he expects to have on hand to sell in November. He decides to use a hedge to protect that target, if the opportunity occurs. He knows that a typical basis – the difference between the cash price and the canola futures price – in November for his location is $20 per tonne under January futures. Therefore, if he wants a $450 per tonne, or better, cash price with a $20 basis, he needs January canola futures to be at least $470 per tonne.

On May 3, next January's canola futures are trading at around $470 per tonne and the hedge opportunity occurs. To hedge, the producer instructs his commodity broker to sell 5, 20-tonne January canola futures contracts. The actual sell price of the futures contract is $470 when the futures contracts are sold on ICE Futures.

On November 23, after harvest, the producer decides to sell 100 tonnes of canola to a local crusher for $400 per tonne, which is the highest local price, reflecting the best basis available from any buyer. The actual basis that he sells the cash canola at is $20 under January canola futures.

At the same time as he prices his physical canola, the producer offsets his canola hedge. He does that by calling his broker and buying back 5 January canola futures contracts. The buy order is filled at $420 per tonne. The calculation looks like this:

Table 1: Example 1 – Sell hedge using a canola crop

Final canola sale price equals cash received $400 per tonne plus futures gain $50 per tonne equals $450 per tonne.

The farmer sold his canola to the highest local cash price at the time he wanted to sell. The farmer received $400 per tonne from the cash sale and an additional $50 per tonne in profits from the hedged or short futures contract. In this example, the combined price totalled $450 per tonne – right at the target price set in the spring.

This is what is called a perfect hedge because the final return matched the grower's original target price. Hedging lets a producer lock in a futures price, later check with buyers for the strongest basis level and deliver to the any buyer selected.

How estimates work

Hedges usually do not work out to exactly the target price the way Example 1 did. The usual reason is that the basis at the time of the cash sale differs from the estimate done when the futures hedge was placed. Again, basis is the difference between the futures price and the local cash price on any particular day. In general, a strengthening basis is good news to the hedger.

Read Basis – How grain prices are established for more information

The next example, in Table 2, looks at the same canola example but with a strengthening basis:

Table 2: Example 2 – Strengthening basis

Final canola sale price equals cash received $405 per tonne plus futures gain $50 per tonne equals $455 per tonne.

In this case, the combination of cash selling plus futures hedging returned $5 per tonne above the target set in the spring. The cash price was $405 per tonne even though the futures price at the time of the sale was no different than in Table 1.The actual basis was $5 per tonne stronger than estimated when the hedge was placed.

The third example, in Table 3, looks at the effect of a weakening basis.

Table 3: Example 3 – Weakening basis

Final canola sale price equals cash received plus futures gain $440 per tonne equals $390 per tonne plus $50 per tonne

In Example 3, the basis, which weakened from an expected $20 per tonne to $30 per tonne, reduced some of the effectiveness of the hedge. The final price is $10 less than the target price of $450 because the basis weakened by $10 per tonne.

Remember that for grains the basis risk – the odds that basis will change – is less than the overall price risk. Historically, in Alberta, canola basis levels at a given location have varied by approximately $20 to $40 per tonne within a crop year. The actual cash price variation for canola may range by $150 per tonne or more over the same period. Cash price risk is about 5 times greater than basis risk.

Producers who hedge livestock or grains should stay aware of both cash and futures market price moves as well as basis levels. Watching only cash price levels can mean missed opportunities in the market.

Choose the right futures month

Futures contracts are traded for specific contract months. For almost all  sell, or short hedges, the commodity is not actually delivered to the futures contract. However, choosing which futures contract month to use for a hedge is still important.

For more information, read Commodity futures markets for an explanation of contract months.

The choice of futures month to use for a hedge depends on:

• when the cash commodity will be available for sale
• the amount of buying and selling of a contract month, that is, volume
• the planned delivery time for the cash grain, the main factor to consider when selecting a futures contract month

The rule of thumb is to select a futures contract month just after the product is expected to be sold. For example, if the plan is to sell cash canola in February, then use a March (or possibly a May) canola futures contract.

Choosing a month close to the time of the expected cash sale ensures that the futures price and the cash price will closely follow each other. Using a month just after the planned cash sale will simplify the hedging process and eliminate the need to buy back (or offset) the hedge before the cash grain is priced.

A good guideline is to never hold a futures contract into the delivery month. For example, do not hold a March futures contract into March. Prices of futures contracts can have unpredictable price swings during trading within a delivery or expiry month.

Also, holding a futures contract into the delivery or expiry month can mean becoming involved in the physical delivery process though the futures market, which was unlikely the original intention of the hedge. Making or taking physical delivery to offset a futures position can be complex and costly.

The second reason to lift a hedge before the expiry month is that trading activity of a futures contract in its expiry month is often very thin. A thin market means there are few buyers and sellers and very little trading. A hedger has better success trading contracts with lots of buyers and sellers actively trading.

There are 2 reasons for avoiding a thin market:

1. It is easier to buy and sell contracts in an actively trading market.
2. Pricing accuracy is improved in active markets. The accuracy or effectiveness of a hedge depends on the ability to sell a futures contract immediately when the price is favourable, and the ability to buy back the contract, that is, lift the hedge, immediately when the cash grain is priced. If there is no buying and selling activity in a futures month, a hedger may not be able to easily lift the hedge. Thin markets may not closely follow prices in the cash market.

The third consideration in choosing a futures month for a hedge is the expected basis at the time of delivery, since basis affects the net cash price received. Know what basis is currently offered for the expected delivery period. Know what a typical basis is for the crop for that time.

Study how basis is likely to change over the lifetime of a hedge. If the basis is expected to strengthen, will it strengthen enough to cover the costs of interest and storage over that period? In fact, a strong basis, offered for the expected delivery period, is an indicator to consider other price locking methods such as a deferred delivery contract or a basis contract. Both of those alternatives will lock in the strong basis level.

Typical Alberta basis ranges for canola are par to $40 per tonne under futures. However, canola basis ranges have been much weaker (e.g., $75 under futures) and much stronger (e.g., $20 over futures) in canola price history.

A strengthening basis during the time the hedge is in place, that is, when the basis moves to the better end of the range mentioned above, will add profit to a hedge. A short or sell futures hedger may select futures months with a weaker than average basis within a crop year in the hope that basis will strengthen by the time of physical delivery.

Rolling futures contracts

Rolling a short hedge forward, which involves buying back the original sell contract, and at the same time selling a new contract in a more distant month, may be necessary for 2 reasons:

1. Rolling may be necessary when a hedger cannot use a futures month that follows the planned cash grain sale date. For example, in January, a canola grower wants to hedge some of next year’s unseeded canola crop for delivery fifteen months later in April.
   
   However, there is so little trading in next May’s contracts, a thin market, that the hedge order cannot get filled. Instead, the hedger decides to place sell orders on next January’s contract with the plan to roll the hedge forward to the May contract sometime before January.
    
2. Rolling may also be necessary if the decision is made to delay the cash grain pricing beyond the futures month used when the original hedge was placed. For example, in December, a farmer plans to sell the grain in late February, so hedges by selling a March canola contract.
   
   As February approaches, the basis is very weak. Tighter supplies and a stronger basis are expected in late May or June. As a result, cash grain selling is delayed. In order to continue protecting the futures price with a hedge, the futures contract must be rolled. In late February, the original March sell contract is bought back and the July futures contract is sold. When the cash grain is priced in June or before, the July contract is bought back and the hedge is then complete.

The advantage of rolling futures contracts is that rolling can protect a local cash price for an extended period of time even if distant futures months are thinly traded or not being traded at all. By rolling a futures contract, a very good price can be carried forward for 2 or more years.

There are 2 disadvantages to rolling. First, every roll results in a commission charge. However, futures commission charges are very small relative to futures price changes. Second, the accuracy of the hedge may be affected slightly by differences in the basis between each of the futures months and the local cash price. This is referred to as the spread between the 2 futures months.

The risk that spreads will damage a hedge result is low compared to the risk of basis or futures changing.

Hedging hints and pitfalls

Hedging can be an efficient way to lock in favorable prices for later delivery. There are a few cautions that hedgers should be aware of:

• Do not hold a contract into the futures expiry month. Commercial buyers usually roll their reference futures month forward in the month prior to the nearby futures month. Lift hedges before the expiry month begins.
• Do not buy or sell contracts that are too far in the future or that are thinly traded.
• Be sure to take the correct futures position when hedging: sell the futures contract when producing the commodity, then buy the futures contract back when pricing that commodity.
• Avoid using today's basis, especially if it is a strong basis, as an indicator of what the basis will be at the expected time of delivery. It is very important that the hedger consider what the basis is likely to be when the cash grain is sold rather than use today's basis.
• Be sure to match as closely as possible the tonnages of futures contracts to the tonnages of the grain expected for sale.
• Unless your production prospects and marketing plan changes substantially, leave the hedge in place because the goal is to reduce risk and lock in favorable prices.

Summary

Hedging, used with common sense, allows a producer to lock in favourable prices until actual deliveries can be made.

The mechanics of placing the hedge are simple; the difficulty lies in knowing when to place the hedge.

More Information

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