Lock in Margins

January 28, 2014 06:16 PM

Marketers focus on cost and return spread

seed safe  margins

A small but growing number of producers such as Steve Compton are moving away from a focus on price and toward margins.

"To me, margin management is no different from any other aspect of farming—it just has to be done," says Compton, who grows 20,000 acres of corn, soybeans, wheat and milo near Scott City, Kan.

Compton must be vigilant every day to know the tools available and understand the opportunities, as well as risks. You can bet Compton stays in close contact with his marketing adviser. It’s one thing to watch for opportunities and another to take action based on his cost structure.

"I became 25% sold on the 2014 corn crop late last summer," he shares. "At that time, futures prices were $1.60 above current levels."

Nothing is complicated or even new about the concept of margin management: locking in production costs and crop prices near the same time frame, which provides hard numbers for your profit potential.

Seeking to lock in an acceptable margin is light years removed from trying to pick the best price and requires a new way of thinking, says Lawrence Kane, a branch manager with Stewart-Peterson in Yates City, Ill. Without a focus on margins, producers are marketing in a vacuum, Kane says.

T14037 Dive Into Margins Craig Duley

"I need to use options to protect my income, protect my family and provide opportunities to expand."—Craig Duley, Maquon, Ill.

Compton begins margin management in August and September, when he locks in nearly all his inputs for the following crop year. In comparing input prices throughout the years, he’s found that’s typically when the best deals are available.

For instance, he says dealers have unused crop chemicals that have been returned and might offer attractive prices. "You have to lock in crop sales at the same time," he says, to guarantee a profit margin.

Compton has irrigated and dryland crops and forward sells a higher portion of his expected production on his center-pivot land because it has less production risk.

Admittedly, early January’s $3.80 per bushel cash corn in the Corn Belt didn’t provide much in the way of a profitable margin for all but the lowest cost producers. Even so, Compton was selling unpriced corn for March delivery to a local feedlot because basis was 50¢ above Chicago Board of Trade futures, or about $5 per bushel.

"We have a unique situation here because Scott County has the most cattle on feed of any Kansas county," he explains. "While 50¢ is unusual, local feedlots often offer 20¢ basis." Feedlots don’t like to contract more than 9 to 12 months out. So when he sees a positive margin in the futures market beyond that, Compton uses a combination of futures and options.

Impetus for Change. Compton embraced margin management 10 years ago for two reasons: "volatility and size." Markets started becoming more volatile, and more was at risk because of his production volume.

"Prior to that, prices often moved no more than 20¢ to 30¢ in a year, so forward pricing wasn’t so critical," he explains. "Now they can move that much in two hours, with annual swings of more than $2."

Kane likes to call it asset management. "It’s really all about managing equity in a different way—protecting it," Kane says. "Crop insurance has been a great crutch that has covered a multitude of marketing sins, but for 2014, it won’t guarantee a profit."

For example, if you have 3,000 acres in Illinois with nothing pre-sold, the drop in prices from last summer to present has cost you a minimum of $100 per acre, Kane explains. "You’ve just chewed through $300,000 worth of equity," he says, noting that there’s a better way.

First, know your costs, lock them in and when the opportunity presents itself, pull the marketing trigger. Kane acknowledges that sounds simple. "But probably less than 5% actually do it," he says. Kane expects more producers to embrace the concept moving forward—in large part because of the direction markets have taken. He thinks part of the impetus will be pressure from lenders.

Kane says you don’t need to know all costs well in advance, but figure the big ones. He encourages producers who lock in three-year cash rent deals to consider offsetting those risks in the futures market when opportunities for margins are present.

"This year is a wake-up call," he says. For example, producers who signed three-year cash rent deals in 2012 had the opportunity to offset that risk for the 2014 crop at $6.25 corn, he explains, noting that would have reduced the number of bushels required to make the land payment by one-third, compared to January 2014 prices. "When you have a long-term cost, it’s better to look ahead at offsetting that risk."

Chad Hart, an Iowa State University ag economist and firm believer in managing margins, advises against marketing before major inputs are locked down. He also argues against marketing two to three years out, even when prices look promising, unless key inputs are purchased during the same period.

Craig Duley, a Maquon, Ill., corn and soybean farmer, began locking in margins for the 2014 corn crop as early as May 2013, when he purchased $5.50 per bushel put options for 10% to 15% of his crop.

"I’ve rolled down those put options and put some money in my pocket," Duley says. "I have lower strike-price short-dated puts covering me in case prices drop before the February crop insurance price is set."

Duley also has corn and soybean puts for fall contracts to protect the rest of his growing season. While $4 corn is not fun, he thinks $8 corn was not such a great deal, either. It hurt end users, ultimately curbing demand that the U.S. is now trying to buy back. "I’d rather have $5 corn and keep everybody happy," he says.

Protect Margins. After Duley has purchased major inputs, he uses calls to give him upside potential and puts for downside protection.

"I can’t afford to lose $1 per bushel, and I don’t like to have more than 25% of my total expected production unpriced," Duley says. He’s also looking at selling calls on a rally this spring to generate more premium.

For the 75% he pre-sells, half is marketed with options, the other 25% forward contracts and the latter is typically marketed in the spring.

"I begin marketing when I start buying inputs–about 10 months out," Duley says, adding that he doesn’t like being exposed. He began margin management two years ago due to crop and input price swings.

"This is different than what my father did," he says. "He said you shouldn’t sell unless you have it." But Duley believes today’s market requires a different strategy. "I need more flexibility," he says. "I have more inputs, more bushels and more at risk. I use options to protect my income, protect my family and provide opportunities to expand."

 In the past, Duley did a lot of after-the-fact marketing and missed a lot of opportunities. "With more acres, I have to manage it better," he says. "If corn drops 40¢, that’s an $80-per-acre loss in just one day." 

Let Go of Marketing

So why do so few farmers manage margins? "Farmers, like almost all entrepreneurs, are natural optimists," says Lawrence Kane, a branch manager for Stewart-Peterson. "They have faith that things will work out."

While optimism is important, leaving money on the table when profit opportunities present themselves is an unnecessary risk. That gives farmers a dangerous long position with no coverage, he says.

This isn’t the only reason why so few farmers manage margins effectively. Another big one, Kane says, is that when producers lock in a price—even a profitable one—and prices go up beyond that, they view the marketing move as a mistake or a lost opportunity. They have difficulty forgetting it.

"Producers view hitting the top of the market as what is supposed to happen and not the exception that it actually is," Kane explains.

Margin management is anything but easy. For one reason, the best windows for locking in input prices and crop prices do not align. "This is a big struggle," Kane says.

Find specific solutions and new ideas from other successful farmers reviewing your business. www.tpexecutivenetwork.com

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