Grain Marketing in the BioFuels Era: Session 1: January 22

1. Grain Marketing in the BioFuels Era:Session 1: January 22 Ethanol

2. Massive Demand Growth

3. Nearly Unlimited Fuel Usage U.S. Gasoline use is about 140 billion gallons per year. All our corn crop would only provide 14% of the energy in gasoline.

4. FOOD Markets Must Find Balance Between FUEL

5. Rebalancing Includes Inputs Sector • Input supplies usage • Acreage in production • Specialization in certain crops • Technology used • Crops grown • Crop prices • Domestic vs. Export Markets • The way livestock are fed • Consumer demand for food products Farm Level Response Demand Structure Consumer Impacts Linkage Adjustments

6. How BioFuels Era Impacts Prices and Marketing Level of crop prices rise Relationship of crop prices change Volatility of crop prices increases Government programs: Limited importance Risk Exposure--$ of Exposure grow Cyclical Uncertainties as Boom/Bust Odds Grow Coordination of linkage between growers and end users

7. Government Support-Bear Strategy • Price early (spring) • LDP at harvest • Store • Earn carry in the market Government Support Line Opportunity

8. Market Opportunity-Bull Strategy • Price later (wait for a big event) • No government programs • Consider selling at harvest-replace with long futures/calls • Smaller returns for storage Opportunity Government Support Line

9. About 1/3 of course is: BioFuels Era Marketing and Outlook Changes in market relationships About 2/3 of the course will be: Learning about marketing decisions: Futures, Options, Basis Storage Pricing Alternatives Seasonality Price Forecasting Strategies and planning Your Course Includes: Each Monday Night Jan 22, Jan 29, Feb 5, Feb 12

10. Introduction to the mechanics of futures markets (CMS Disk 1, Unit 2, module 3a)

11. What are Commodity Futures Contracts?

12. Futures Contracts Definition: A commodity futures contract is a legal instrument calling for the holder of the contract to deliver or to accept delivery of a commodity on or by some future date.

13. Two Distinct Markets! Cash Market Futures Market

14. Futures Contract Jargon Sell Short: means the contract holder has a legal obligation to make delivery of the commodity. Buy Long: means the contract holder has a legal obligation to accept delivery. Round Turn: is the completion of a “sell and buy back” or of a “buy and then sell” set of transactions

15. Futures Contracts • Commitment to Accept or to Make delivery of a commodity with the following specifications: • Grade • Quantity • Delivery Location • Delivery Time • Each commodity contract is standardized with these four items determined….the only variable to discover is price.

16. Example: No. 2 Soybean Futures

17. Contracts Change Value as Prices Change March 20: 5,000 bu of July corn futures @ $2.50 = $12,500 March 25: 5,000 bu of July corn futures @ $2.60 = $13,000 10 cent change in price = $500 change in one contract Change in Value for: Buyer = +$500 Seller = -$500

18. Margin Margin can be thought of as a performance bond—a deposit of cash that shows each trader acknowledges their responsibility when trading on the exchange. Two types of margin are: Initial Margin and Maintenance Margin.

19. Initial Margin Initial Margin is the amount the trader must deposit to enter a futures contract. The initial margin is kept in the margin account. • The exchange sets initial margin based on volatility of the market. • Historically, initial margin seldom exceeds 5% of the face value of the contract. • Brokerage firms can choose to charge more than the minimum level of margin.

20. Maintenance Margin • Maintenance Marginis the minimum level at which the account must be maintained. It becomes a threshold for the “margin call” when the position is losing money. • The margin call is a request for additional money to restore the margin account to its initial level. In general, margin calls are initiated when the margin account is about 2/3 of its original value. • Margin calls must be handled in 24 to 72 hours, depending on the broker’s business practice. If margin calls are not met, the position can be liquidated.

21. Futures Positions Require Margin Money Margin means you do not have to pay the full value of your futures position….JUST a MARGIN Controls a LARGE amount of Commodity Value A small amount of Your $ $20,000 $4 corn example $1,000

22. Margin Key Concept If you trade futures contracts, you must be prepared to meet margin calls!

23. Using Futures Contracts (CMS Disk 1, Unit 2, module 4a)

24. Objectives • Understand the many uses of futures contracts • Define the concept of hedging • Show how futures contracts can be used to establish prices for a growing crop • Show how futures can be used to establish a favorable storage return

25. How Do Farmers Use Futures in Their Marketing? • To forecast prices • To establish prices of growing crops or livestock • To establish feed prices or other input prices • To gain a return to storage • To speculate on paper rather than with inventory

26. Futures Prices as a Forecast Buyers and sellers formulate an ask and bid price based on their expectations of supply and demand. When an ask or bid price is accepted, the market has reached an agreement about the future value of the commodity. In essence, the futures price is a market determined forecast. However, while futures prices may be a good estimate of future prices today, do not assume that prices will be at the same level when the contract matures. Remember, new information will cause prices to change.

27. Futures Prices as Forecast The corn futures market is suggesting that prices will move higher into July. This gives a stronger incentive to store. On the other hand, soybean futures suggest prices will fall. So, consider selling now rather than continuing to store.

28. Futures Prices as Forecast How Long Should You Store? The final answer is more complicated, but the futures market shows corn storage might make sense to May. On the other hand, soybean futures suggest prices may not increase much after March.

29. Futures Prices as Forecast Say it’s fall and you have to make a decision about how many acres of wheat to plant for next year and… Next year’s futures prices are: July wheat futures $3.70 November soybean futures $6.30 December corn futures $3.25 Of course, which crops to plant next year is a complex decision, but futures markets are hinting that both wheat and corn are expected to be more favorable compared to soybeans. Note: These months are the most common to use when considering new crop

30. Key Points • Futures prices are determined by buyers and sellers armed with information. • Futures prices are forecasts made by the market. • Futures prices can be a useful (but not perfect) decision tool.

31. Discussion Topic • Let’s look at futures prices and discuss what information it’s providing about the future for: • Corn • Soybeans • Crude Oil • Unleaded gasoline • Interest rates

32. Futures Hedging: Establishing Forward Prices: Hedging Short (Selling) Hedge: 1. Forward Pricing a Growing Crop 2. Establishing favorable returns to storage Long (Buying) Hedge: 1. Establishing price on corn feed needs for a livestock business

33. Price Risk • Prices are volatile – today’s price (at planting) is not likely to be tomorrow’s price (at harvest). • Futures market positions will allow us to balance the losses for cash commodities with futures contract gains. (Hedging!) • But, the futures market position will also limit our ability to take advantage of higher futures prices.

34. Hedging • The goal of hedging is to reduce risk associated with the cash market through the use of futures market transactions • Hedges are used to: • Establish the price for a crop • Establish the cost of an input like corn feeding needs • Protect the value of inventory like stored crops • Hedging may be accomplished with futures contracts or futures options contracts

35. How to Hedge with Futures • When hedging, the futures market position taken today is a temporary substitute for a transaction that will occur later in the cash market. • End Result—Losses in the cash market are offset by gains in the futures market.

36. Why Hedging Works • The cash and futures markets are different but closely related markets • The cash and futures prices typically move together Prices Futures Cash Time

37. What is Basis? Cash Price - Futures Price BASIS

38. Establishing Prices on a Growing Crop • (Decision Time) When hedging with futures, you would sell a new crop futures contract. This takes the place of a cash sale to be transacted in later months. • When you are ready to sell your cash crop at the elevator you would lift the hedge or liquidate it by • Selling cash grain to the elevator, and • Buying back or liquidating the futures contract

39. Establishing Prices on Growing Crop (continued) • The price you receive for your grain is therefore: • The cash price for the grain at the elevator • Plus or minus • The gain or the loss on the futures contract • A hedge diagram is used to illustrate positions for the cash and futures markets.

40. Establishing Price Begin Here They reached their goal of pricing 5,000 bu of corn at $2.50/bu. The decline in the cash price was exactly offset by a decline in futures. Net Price Received = $2.50/bu (before any futures commission or hedging costs)

41. What If Prices Moved Upward? Net Price Received = _______________/bu (before any futures commission or hedging costs)

42. The Answer: They reached their goal of pricing 5,000 bu of corn at $2.50/bu. The increase in the cash price was exactly offset by a increase in futures. Net Price Received = $2.50/bu (before any futures commission or hedging costs)

43. Example of Basis Speculation What’s Different? They exceed their goal of pricing 5,000 bu of corn at $2.50/bu and net $2.58. WHY? Because on Oct. 20, the cash price was 12 under, rather than the expected 20 under. Net Price Received = $2.58/bu (before any futures commission or hedging costs)

44. Hedging and Basis Risk • Basis influences the effectiveness of the hedge • Hedging is effective in reducing price risk because changes in basis, over time, are much smaller and more predictable than changes in price. • Basis risk is less than price risk.

45. Price vs. Basis

46. Establishing Price: Current Example They reached their goal of pricing 5,000 bu of corn at $3.44/bu. The decline in the cash price was exactly offset by a decline in futures. Net Price Received = $3.44/bu (before any futures commission or hedging costs)

47. Establishing Price: Current Example They reached their goal of pricing 5,000 bu of soybeans at $6.95/bu. The decline in the cash price was exactly offset by a decline in futures. Net Price Received = $6.95/bu (before any futures commission or hedging costs)

48. Hedges “Lock In” the FUTURES Price • Actual price will depend on actual final basis when hedge is liquidated and converted into a cash position • In session 3 we will discuss basis in more detail

49. Storage Hedge (CMS Disk 1, Unit 2, module 4b)

50. Objectives • Examine Post Harvest Marketing Decisions • Understand the Components of Storage Costs • Examine a Post Harvest Marketing Alternative (Selling Futures = Storage Hedge) • Understand the Advantages & Disadvantages of the Storage Hedge