Agricultural Marketing ECON 337: Agricultural Marketing Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356 1

Short Hedgers Producers with a commodity to sell at some point in the future Are hurt by a price decline Sell the futures contract initially Buy the futures contract (offset) when they sell the physical commodity

Short Hedge Example A soybean producer will have 25,000 bushels to sell in November The short hedge is to protect the producer from falling prices between now and November Since the farmer is producing the soybeans, they are considered long in soybeans

Short Hedge Example To create an equal and opposite position, the producer would sell 5 November soybean futures contracts Each contract is for 5,000 bushels The farmer would short the futures, opposite their long from production As prices increase (decrease), the futures position loses (gains) value

Short Hedge Expected Price Futures prices when I place the hedge + Expected basis at delivery – Broker commission

Short Hedge Example As of Jan. 12, ($ per bushel) Nov. 2018 soybean futures $9.8350 Historical basis for Nov. $ -0.30 Rough commission on trade $ -0.01 Expected price $9.5250 Come November, the producer is ready to sell soybeans Prices could be higher or lower Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis In November, buy back futures at $10.50 per bushel ($ per bushel) Nov. 2018 soybean futures $10.5000 Actual basis for Nov. $ -0.30 Local cash price $10.2000 Net value from futures $ -0.6750 ($9.8350 - $10.50 - $0.01) Net price $ 9.5250

Prices Went Down, Hist. Basis In November, buy back futures at $8.00 per bushel ($ per bushel) Nov. 2018 soybean futures $ 8.0000 Actual basis for Nov. $ -0.30 Local cash price $ 7.7000 Net value from futures $ 1.8250 ($9.8350 - $8.00 - $0.01) Net price $ 9.5250

Short Hedge Graph Hedging Nov. 2018 Soybeans @ $9.8350

Prices Went Down, Basis Change In November, buy back futures at $8.00 per bushel ($ per bushel) Nov. 2018 soybean futures $ 8.0000 Actual basis for Nov. $ -0.10 Local cash price $ 7.9000 Net value from futures $ 1.8250 ($9.8350 - $8.00 - $0.01) Net price $ 9.7250 Basis narrowed, net price improved

Long Hedgers Processors or feeders that plan to buy a commodity in the future Are hurt by a price increase Buy the futures initially Sell the futures contract (offset) when they buy the physical commodity

Long Hedge Example An ethanol plant will buy 50,000 bushels of corn in December The long hedge is to protect the ethanol plant from rising corn prices between now and December Since the plant is using the corn, they are considered short in corn

Long Hedge Example To create an equal and opposite position, the plant manager would buy 10 December corn futures contracts Each contract is for 5,000 bushels The plant manager would long the futures, opposite their short from usage As prices increase (decreases), the futures position gains (loses) value

Long Hedge Expected Price Futures prices when I place the hedge + Expected basis at delivery + Broker commission

Long Hedge Example As of Jan. 12, ($ per bushel) Dec. 2018 corn futures $ 3.8050 Historical basis for Dec. $ -0.25 Rough commission on trade $ +0.01 Expected local net price $ 3.5650 Come December, the plant manager is ready to buy corn to process into ethanol Prices could be higher or lower Basis could be narrower or wider than the historical average

Prices Went Up, Hist. Basis In December, sell back futures at $5.00 per bushel ($ per bushel) Dec. 2018 corn futures $ 5.0000 Actual basis for Dec. $ -0.25 Local cash price $ 4.7500 Less net value from futures $-1.1850 -($5.0000 - $3.8050 - $0.01) Net cost of corn $ 3.5650 Futures gained in value, decreasing net cost of corn to the plant from the cash (spot) price

Prices Went Down, Hist. Basis In December, sell back futures at $3.00 per bushel ($ per bushel) Dec. 2018 corn futures $ 3.0000 Actual basis for Dec. $ -0.25 Local cash price $ 2.7500 Less net value from futures $+0.8150 -($3.0000 - $3.8050 - $0.01) Net cost of corn $ 3.5650 Futures lost value, increasing net cost of corn to the plant from the cash (spot) value

Long Hedge Graph Hedging Dec. 2018 Corn @ $3.8050

Prices Went Down, Basis Change In December, sell back futures at $3.00 per bushel ($ per bushel) Dec. 2018 corn futures $ 3.0000 Actual basis for Dec. $ -0.10 Local cash price $ 2.9000 Less net value from futures $+0.8150 -($3.0000 - $3.8050 - $0.01) Net cost of corn $ 3.7150 Basis narrowed, net cost of corn increased

Hedging Results In a hedge the net price will differ from expected price only by the amount that the actual basis differs from the expected basis So basis estimation is critical to successful hedging Narrowing basis, good for short hedgers, bad for long hedgers Widening basis, bad for short hedgers, good for long hedgers

Class web site: Have a great weekend! http://www2.econ.iastate.edu/faculty/hart/Classes/econ337/Spring2018/index.htm Have a great weekend!