Grain Marketing III MAKING LOGICAL MARKETING DECISIONS: Substituting Probabilities for Emotion

Why Marketing is Critical Typical Corn Net Profit W Margin, Past Years: $.30/bu. $.10 increase in Price = 33% W increase in Net Returns Also Works in Reverse W

MARKET MANAGEMENT 2. The Plan A. Cost of production for firm 1. A plan to market consistent with firm’s objectives on profits, risk and growth 2. The Plan A. Cost of production for firm B. Establishing price goals C. Price projections based on solid information D. Processing of information E. An execution process F. Records for future: how & why G. Evaluation: accomplishments, future changes

MARKETING CHALLENGE Uncertainty: not enough history for probabilities Risk vs. uncertainty Uncertainty: not enough history for probabilities Probabilities: based on history Requires recognition & actions

PROFITS ARE A RETURN TO RISK OF LOSS Land earns rents Labor earns wages Capital earns interest Management earns salary “If you produce & market the same thing many other people produce, and in the same way, your profits will not be sustainable” Paraphrased from Dr.John Ikert, U. of MO.

Custom hire and labor hire 9 9 4.50 9 Soybean Cash-Flow Costs Per Acre, Selected Types of Farms 1/3-2/3 50/50 Owners Renter Crop-share Buyers Seed, fertilizer, pestic . $72 $72 $36 $72 Insurance, interest, misc . 10 14 7 16 Fuel and repairs 10 10 10 10 Drying  0 0 Custom hire and labor hire 9 9 4.50 9 Rent and real estate taxes 21 135 90 Fixed debt payments 11 11 74 Family living, income tax 69 56 57 50 Total cash flow needs $191 $307 $125.5 $321 Adapted from M. Duffy & D. Smith, Estimated Costs of Crop Production in Iowa, FM-1712 Rev. , ISU Economics Department, Jan.20 02

Cash Flow Risk Ratio for Corn Partly from Dr. William Edwards, ISU Economics Department 50/50 Crop 1/3-2/3 Owners Renter Share Buyer Cash flow cost per acre $271 $397 $181 $416 Govt. payments? -$90 -$90 -$45 -$90 Cash needed from sales $181 $307 $136 $326 Expected or actual yield (bu.) 145 145 72.5 145 Cash cost breakeven price $1.25 $2.12 $1.88 $2.25 Hedged market price ($/bu) $2.15 $2.15 $2.15 $ 2.15 Cash flow risk ratio 58% 99 % 87 % 105 % Cash flow R. R., $1.85 price? 76% 115% 102% 122% Interpretation: @ $1.85 price, Owners need to sell 76% of crop to cover cash-flow needs.

Net Worth Risk Ratio, Continued   Owners Renters Crop-share Buyers Corn price where 10% 10% -$0.62 $1.96 $1.56 $1.74 of net worth is lost: (after Govt. Pmts.) Cash flow Break even Price $1.25 $2.12 $1.88 $2.25 Price decline below B/E for 10% equity loss $1.87 $0.16 $0.32 $0.51 Fall bid, 2/25/02: $1.88 $1.88 $1.88 $1.88 (N. Central Iowa) Fall bid, 4/03/03: $2.02 $2.02 $2.02 $2.02 (N. Central Iowa)

Key Points Starting point in a mktg plan: financial needs of the business Know your break-even price Know your risk-bearing ability Plan marketing with a goal of at least covering cash-flow needs Look for mktg. & insurance tools to minimize risk of losing the business

Types of conventional grain contracts Forward contract: establishes price & basis Delayed price: neither is established Price later: same as above (credit sale) Hedge-to-arrive (non-roll): establishes futures, but not basis Delayed-payment: shifts income for tax purposes Basis contract: establishes basis, not futures Minimum-price: retains upward flexibility

Grain Contracts: Areas of Risk Exposure Price Level Basis Spreads (Intra-and Inter-Year) Options volatility risk Production risk Counter-party risk Control risk Tax risk

Key Elements in Grain Contracts Quantity & quality Delivery date Delivery location Pricing formula Quality differentials Adjustments if quality is not met Date Signature of both parties

Grain Marketing Alternatives Timing considerations: (1) Pre-harvest, for fall? or later delivery? What is the market telling you? How early to start pricing? (2) Post-harvest: what to do about the LDP Sell at harvest? Store? How long? What does it cost? What is the market telling you?

Grain Marketing Alternatives What tool to use?

Challenge: Can 2003 soybeans be priced before harvest? • Cash flow pressures are large for some producers • LDP adds large risk when pricing below loan rate • Forward contracting adds risk • Hedging adds risk • Are workable alternatives available for price protection?

increased t test, signif. at 8% level Avg.

82% of years, price declined, winter/spring to harvest, 18% prices rose Past history does not guarantee future performance.

Avg. Dec. Corn Futures, Normal Crops 1975-1999 2.20 2.25 2.30 2.35 2.40 2.45 2.50 2.55 2.60 $/Bu. Dec.4 Jan.2 Feb.1 Feb.4 Mar.3 Apr.2 May 1 May 4 June 3 July 2 Aug.1 Aug.4 Sept. 2 Oct.1 Oct4 Nov.2 Dec.1 Avg. Dec. Corn Futures, Normal Crops 1975-1999 Occurred 81% of time 1st. wk. July 3rd. wk. May Hedge lifted

WEEKLY AVERAGE, DECEMBER CORN FUTURES PRICE,SHORT CROP YEARS, 1975-2001 Occur 19% of Years 2.5 2.55 2.6 2.65 2.7 2.75 2.8 2.85 2.9 2.95 Dollars per Bushel 1st Week July 3rd Week October 3rd Week May Dec 4 Jan 2 Feb 1 Feb 4 Mar 3 Apr 2 May 1 May 4 Jun 3 Jul 2 Aug 1 Aug 4 Sep 2 Oct 1 Oct 4 Nov 2 Dec 1 Weeks

Options & Grain Pricing • Two Kinds: puts & calls • For farmers: generally buy. Sell is risky • Buying put for owned grain sets floor price • Buying calls after sale : lets you follow mkt . up--retains ownership • Financial exposure: premium + broker. • Tax treatment may be different on call purchases: could be speculative

Pricing 50% of yield with puts • Declining price : put value tends to rise, adds value to half of crop • Rising price: Value of 100% of crop increases; only cost is options prm. + brokerage • Unchanged price: Worst-case? Premium lost, price doesn’t rise

Determining Minimum Price With Put Purchase Select Strike Price: $2.50 Deduct: expected basis at delivery -0.40 premium -0.20 transaction cost -0.01 Expected Minimum Price $1.89

Corn Put Example, 1999 March 26, $2.50 put prem., : $.20/bu. Min. price:$2.50-.20-.40 basis= $1.90 Sept. 30 put prem.=$.42, fut. = $2.08 Harvest Cash corn = $1.60 Corn priced with puts: added value: $.42-.20 = +$.22 Net Price = $1.82 Upward price flexibility retained

Corn Put Example, 2000 May 18, $2.60 put prem.: $.16/bu. Min. price:$2.60-.16-.40 basis = $2.04 Sept. 30 put prem.=$.52, fut. =$2.08 Harvest Cash corn = $1.55 Corn priced with puts: added value: $.52-.16 = +$.36 Upward price flexibility retained, can store, collect LDP, hedge for May 2001 Gain on 600 A. corn: $32,000 Hedge gain: $0.50/bu. or $45,000 on 600 A.

If prices had risen sharply: Corn Put Example, 2000 If prices had risen sharply: $2.60 put prem., May 18: $.16/bu. Min. price:$2.60-.16-.40 basis= $2.04 Sept. prices for Dec. corn: $3.60 Sept. 30 put prem.= $0 Harvest Cash corn = $3.25 Corn priced with puts: Net price $3.25-.16 put prem. = $3.09/Bu. Corn Contracted in May: $2.20/bu. Difference on 600 A. corn, 85% yld.:$76,500

Put Options Position is Similar to Minimum Price contract Elevator protects position with options Elevator contract locks farmer into specific delivery location Pre-harvest contract basis may be greater than actual harvest basis If prices rise, farmer can follow the market higher Avoids need to trade through broker

Synthetic Put Options Position: Hedge Sale + Buy Call, 1999 Example March 26, Sell Dec. futures = $2.50 Less expected harv. basis -0.40 Hedge price 2.10 Buy Dec. $2.50 call option @ -0.21 Minimum selling price $1.89

Synthetic Put Options Position: Hedge Sale + Buy Call, 1999 Example, Rising Price Sell March 26, Dec. futures = $2.50 Buy Dec. $2.50 call option @ -0.21 Minimum selling price $1.89 September: Dec. futures = 3.50 Cash price 3.10 Margin call on futures: -1.00 Hedge price: 2.10

Synthetic Put Options Position: Hedge Sale + Buy Call, 1999 Example, Rising Price, Cont. Hedge price: $2.10 $2.50 Call Value, $3.50 fut. 1.00 Net price: $2.10-.21+1.00= 2.89 Gain vs. hedge, 600 A.= $71,100

Options Fence Sets a floor & a ceiling for prices Costs less than put purchase alone Creates exposure to Margin Calls in options mkt. Involves greater risk exposure if farmer has low yield Procedure: Buy put & sell higher call Price can range between put & call New Generation contracts offer fence

Options Fence, 1999 if prices rose sharply March 26: $2.50 put prem.= $.20/bu. Sell $2.90 call @ $0.09 prem. Min. price:$2.50-.20-.40 basis + $.09 = $1.99 Sept. 30 put prem.=$0, fut. = $3.50 Harvest Cash corn = $3.10 Call Margin call: $3.50-2.90=$0.60/bu. Net Price: $3.10-.20+.09-.60=$2.39

Summary, 1999 Alternatives, Net Price Add. $ 600 A. $0.00 90,000 $36,000 Harv. Cash Price $1.60 Forward contract 2.10 Put Purchase 1.90 Synthetic Put 1.89 Fence @ $2.50/$2.90 1.99 $3.10 2.10 2.90 2.89 2.39

Key Points Cash marketing only restricts opportunities Strong need to understand options, futures Basis behavior & spreads are important for use of these markets Yield risk: must consider in pre-harvest pricing

Key Concepts Price risk is substantial: in both directions There are tools that give floor & flexibility Pre-harvest behavior of new-crop futures doesn’t follow normal distribution Creates opportunities Marketing tools: cut off lower part of income distribution