Agricultural Hedging Strategies for Producers and Processors

1. ECON 337: Agricultural Marketing Lee Schulz Associate Professor lschulz@iastate.edu 515-294-3356 Chad Hart Associate Professor chart@iastate.edu 515-294-9911

2. 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

3. 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

4. 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

5. Short Hedge Expected Price • Expected price = Futures prices when I place the hedge + Expected basis at delivery – Broker commission

6. Short Hedge Example • As of Jan. 17, ($ per bushel) Nov. 2019 soybean futures $9.4825 Historical basis for Nov. $ -0.30 Rough commission on trade $ -0.01 Expected price $9.1725 • 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

7. Prices Went Up, Hist. Basis • In November, buy back futures at $10.50 per bushel ($ per bushel) Nov. 2019 soybean futures $10.5000 Actual basis for Nov. $ -0.30 Local cash price $10.2000 Net value from futures $ -1.0275 ($9.4825 - $10.50 - $0.01) Net price $ 9.1725

8. Prices Went Down, Hist. Basis • In November, buy back futures at $8.00 per bushel ($ per bushel) Nov. 2019 soybean futures $ 8.0000 Actual basis for Nov. $ -0.30 Local cash price $ 7.7000 Net value from futures $ 1.4725 ($9.4825 - $8.00 - $0.01) Net price $ 9.1725

9. Short Hedge Graph Hedging Nov. 2019 Soybeans @ $9.4825

10. Prices Went Down, Basis Change • In November, buy back futures at $8.00 per bushel ($ per bushel) Nov. 2019 soybean futures $ 8.0000 Actual basis for Nov. $ -0.10 Local cash price $ 7.9000 Net value from futures $ 1.4725 ($9.4825 - $8.00 - $0.01) Net price $ 9.3725 • Basis narrowed, net price improved

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

12. 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

13. 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

14. Long Hedge Expected Price • Expected price = Futures prices when I place the hedge + Expected basis at delivery + Broker commission

15. Long Hedge Example • As of Jan. 17, ($ per bushel) Dec. 2019 corn futures $ 4.0325 Historical basis for Dec. $ -0.25 Rough commission on trade $ +0.01 Expected local net price $ 3.7925 • 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

16. Prices Went Up, Hist. Basis • In December, sell back futures at $5.00 per bushel ($ per bushel) Dec. 2019 corn futures $ 5.0000 Actual basis for Dec. $ -0.25 Local cash price $ 4.7500 Less net value from futures $-0.9575 -($5.0000 - $4.0325 - $0.01) Net cost of corn $ 3.7925 • Futures gained in value, decreasing net cost of corn to the plant from the cash (spot) price

17. Prices Went Down, Hist. Basis • In December, sell back futures at $3.00 per bushel ($ per bushel) Dec. 2019 corn futures $ 3.0000 Actual basis for Dec. $ -0.25 Local cash price $ 2.7500 Less net value from futures $+1.0425 -($3.0000 - $4.0325 - $0.01) Net cost of corn $ 3.7925 • Futures lost value, increasing net cost of corn to the plant from the cash (spot) value

18. Long Hedge Graph Hedging Dec. 2019 Corn @ $4.0325

19. Prices Went Down, Basis Change • In December, sell back futures at $3.00 per bushel ($ per bushel) Dec. 2019 corn futures $ 3.0000 Actual basis for Dec. $ -0.10 Local cash price $ 2.9000 Less net value from futures $+1.0425 -($3.0000 - $4.0325 - $0.01) Net cost of corn $ 3.9425 • Basis narrowed, net cost of corn increased

20. 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

21. Class web site: http://www2.econ.iastate.edu/faculty/hart/Classes/econ337/Spring2019/index.htm