By now most grain producers are done with harvest. In many cases, the crops have been tucked away in the bin and no significant marketing decisions will be made until 2017 when cash flow is needed.
Since the 2005 lows, producers have experienced an active market, what I call a trending market. This implies the market moves from high to low and results in opportunities to sell well above the cost of production, if producers are patient enough to wait for something to bail them out. The significant market activity is related to a combination of fundamentals, including growing demand, easy money and weather stress.
This is the real danger: An active/trending market is not the natural state. In fact, from 1980 to 2005, there were several periods when the market was range bound or moved sideways. Essentially, these were periods when the overall fundamentals were opposite of what had occurred in previous years—stable demand but no excessive growth, adequate supply with limited weather distortions and a rather tight overall monetary policy.
As we move into what I believe is a sideways market, here are the implications:
- We will still see the pattern of carry—the deferred contracts will be at a premium to the nearby contracts. The problem is many producers don’t make storage decisions based on carry; it’s usually based on flat price. Don’t be surprised to see a pattern where the nearby contract or cash contracts stay in a rather tight price range and the deferred contracts drop over time to the nearby contract price. As a result, the producer takes all the risk of storage but gets limited flat price gain unless a significant supply reduction event occurs. The implication is even if flat price is not reached, carry needs to be defended. Selling the deferred and buying the nearby is called a bull spread.
- Because supply and demand are in balance, the markets aren’t going to overly reward producers for increasing production. The risks are quite high for the net selling price to be close or below the overall costs of production. According to Gary Schnitkey at the University of Illinois, overall producer excess working capital has diminished to pre-2006 levels. Remember, 2005 was a bearish price period. As a result, farmers will be relying more on off-farm financing, which can affect what crops are planted and when the crops are sold to pay off short-term debt. If 2017 is another year of trend line-plus yields globally, we must assume the seasonal risk of fall lows and January to March lows will be intensified. A farmer will need to be even more aggressive when selling during May and June weather scare periods.
- The cost of out-of-the-money calls and puts will get less expensive, but this could be a trap. With limited flat price opportunity, the time value decay of options will be costly. Granted I’m proposing producers have out-of-the-money September calls bought to offset 2017 forward cash sales to be made from April to July 2017. I call these courage calls; they can give a producer the flexibility to price during the intensity of a spring or summer weather scare. If at all possible, keep the cost low by selling out-of-the-money puts or out-of-the-money calls so at the end of the year the net cost is at a level that will not discourage yearly participation in a courage call plan.
By the time a producer realizes he’s dealing with a sideways market, the damage to his bottom line will have been done. At that point, the challenge is knowing how long the sideways market will persist before acres and carryover are cut due to aggressive farmer selling and increased global usage. What is your marketing plan if this bear market has staying power?
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