Cautionary times ahead.
Dec 01, 2008
Chore time for me isn't what it used to be when I was growing up on our eastern Iowa farm, but taking care of two horses in the morning before I head in for work gives me a little time to think about the day ahead. Each morning, stop at this spot to get a feeling for the "tone of the day" - and some attitude about agriculture and the markets.
I was thinking…
... "it was the best of times; it was the worst of times."
What a great line! It could probably be the first line of a book -- build the whole story line around it, or something like that!
"Best of times" might have been 2008! If you didn't see the latest on farm income, USDA says net cash farm income in 2008 will total $90.7 billion, up $3.3 billion from 2007. That's also 33% above the 10-year average. Net farm income is forecast nearly unchanged from 2007 at $86.9 billion. (Net cash income varies due to a carryover of 2007 crops that are sold in 2008.)
The value of 2008 crop production is pegged at a record $181 billion, up 20% from 2007, while the value of livestock, dairy and poultry cash receipts are forecast at a record $143.5 billion.
"The worst of times" might be ahead -- USDA puts 2008 production expenses (crop and livestock combined) at $292.5 billion, up 38.2% (or 15%) from 2007. If accurate, this would be the sixth straight increase in production expenses.
What does USDA see ahead? For now, its economists only offer this: "Farm income may well be lower in 2009." The official forecast won't come until the next update in February 2009.
How do you market grain coming out of what was the best year ever for many growers when we're looking at what might be one of the toughest years ever to put money in the bank? (Maybe we should as a hog producer... long-timers have done that more than once in their lifetimes!)
Number one -- and this horse has been ridden to its death -- is to know your production costs for 2009. I know... the markets are changing and production costs are swinging fairly dramatically. And, for the first time in a long time, many growers are looking at tapping the fertility bank they've built up in their soils by cutting fertilization rates in 2009 to cut total production costs. Most can get away with this for one year and still get close-to-maximum yields from their corn.
The last two years, our marketing strategy on corn and soybeans has been fairly simple. Ahead of the planting season, we advised selling enough of the upcoming corn and soybean crop (through forward contracts, hedges, hedge-to-arrive contracts and a combination of all the tools available) to cover 100% of production costs. Depending on costs, most growers could do that with something between 50% and 70% of expected production. That left 30% to 50% of the crop for profit.
For 2009 -- at today's price -- it would likely take 100% of expected production to cover 100% of expected production costs... and maybe more than 100% of expected production to cover all the costs. But hey... we've been here before (too many times)! It's not a "panic" situation. But, it is one of those years we've got to plan more aggressively than in the last two years. So... know your production costs. Push the pencil to get as accurate an estimate of production costs as possible. And don't just look at total expenses to figure out what you'll grow in 2009. Not that long ago, corn looked like the best option for 2009. Of course, choosing to grow corn in 2009 was choosing to spend more (higher production costs than soybeans) to lose less. That is changing some as markets continue to fluctuate with ever-increasing volatility and some input costs have come down. But just make sure you know what it'll cost to grow corn, soybeans, wheat and cotton for harvest in 2009.
Step 2: Protect breakeven. When cash markets give you a chance to cover production costs via forward contracts, start making sales. While we have not yet said the markets have bottomed, we are well aware the bottom could be posted any day. Unfortunately, traditional market fundamentals don't have a lot to do with predicting the bottom -- what happens in the dollar, the Dow and crude oil is playing a bigger role in price action in crop prices than supply & demand for each commodity. That makes it almost impossible to put any high degree of certainty on "calling the bottom."
Step 3: Maintain upside potential. While protecting breakeven is the number one priority (right now) for 2009 production, you should also be looking to maintain upside price potential on grains sold in the cash market. That's easier than it sounds. Use a minimum-price contact -- or construct one on your own. A minimum-price contract is a cash sale along with a long call option against those sales. Here's the math:
(Futures price + basis) - call premium = minimum price.
At today's quotes:
($3.97 + -.20) - .67 ($4.00 Dec. '09 call) = $3.10 minimum price.
Obviously -- that doesn't cut it -- $3.10 doesn't come close to covering 2009 production costs on corn (for most growers). The big reason is the high premium on the Dec. '09 call option... if you would buy a Dec. '09 call option today, you're buying 354 days of protection... that's a lot of time to purchase in a market with all-time high volatility. One strategy would be to substitute a Sept., July, May or even March call option -- the "closer" options mean you buy less time and the premium reflects that.
So why worry about the call option? Why not just sell 2009-crop corn at your expected breakeven price "and call it good?" This is an extreme example... but -- if you sell 100% of expected production at your expected breakeven price, you will guarantee you won't lose any money -- and you'll also guarantee you won't make any money! By selling out, you remove all downside risk and remove all upside potential. (Zero risk = Zero opportunity.) To some, that might not sound like a bad deal for 2009... but the markets almost always provide an opportunity to make some money. By combining the cash sale with a call option purchase, you set a minimum price, but not the maximum price. If the markets rally, the call option will appreciate in value and when profits are taken on the long call option, those profits are added to the selling price. Simply put, you participate in the rally without risk below the established minimum price.
Think about it... it's almost an idiot-proof strategy. If the market goes down, you were sure smart to sell the cash grain. If the market goes up, you were sure smart to buy the call option. A minimum-price contract removes downside price risk (below the minimum price), but maintains upside price potential. (Zero risk with upside opportunity.)
It's not a strategy to use today... the cost of the at-the-money Dec. '09 call option makes it unworkable. But, this is one strategy we'll be looking to employ for 2009-crop marketings. It might take a while to get there... and the strategy might be constructed over time... but this is "a cautionary strategy built for cautionary times."
(Hey... that's not a bad line either! Maybe that could be the storyline for another book!)