Plan for a Black Swan

November 1, 2017 10:23 AM
Chip Flory

Unforeseen. Unexpected. Almost unimaginable. Things happen and “Black Swans” almost always have an impact on ag commodity prices. Some argue the flood of investment money onto the long side of grains in 2008 was a Black Swan. Some say droughts qualify, and a few believe George W. Bush’s commitment to renewable fuels was nearly unbelievable for a president from an oil state.

Supply and demand balance sheets influence the degree to which Black Swans can impact prices. In the 2007/08 marketing year, the corn balance sheet had a comfortable stocks-to-use ratio of 12.8%. That indicator of “real supplies” was poised to widen to 13.9% in 2009/10. Soybeans were working with a relatively tight stocks-to-use of 6.7% in 2007/08 and were set to tighten further to 4.5% in 2008/09. Total soybean use was expected to expand by 10% the next year. It did, and even a record 2009 crop resulted in a slight tightening of the stocks-to-use ratio.

At that time, the soybean market was primed for a Black Swan event. Production was climbing, but demand was climbing even faster. The investment community knew it and when the financial crisis hit, their money found a new home in soybeans. Corn, wheat, cotton and other ag commodities followed soybean’s lead.

The current corn and soybean situation is different. U.S. corn stocks-to-use ended 2015/16 at 12.7%, 2016/17 at 15.7% and is projected at 16.4% in 2017/18. Soybeans ended 2015/16 with a stocks-to-use ratio of 5%, 2016/17 at 7.1% and 2017/18 is projected at 9.9%. (Global stocks-to-use levels are tightening for both crops.)

Stocks-to-use ratios for U.S. corn and soybeans are at levels that could take some energy out of a potential Black Swan event, but the unexpected does happen. There are a few ways to prepare for such events in a risk-management plan. The uptrend in supplies has drained some volatility from the grain markets, making it possible to prepare for a Black Swan next year.

Option premiums are determined by intrinsic value, time value and volatility value. The lower the volatility, the lower the cost of put and call options, especially for out-of-the-money options (less intrinsic value).

To prepare for a surge in grain prices, consider buying out-of-the-money call options against a portion of expected 2018 production. The calls would appreciate in value if futures rise, giving you the courage to forward-price a portion of expected 2018 production at a profitable level on a price rally. You lock in a profitable price in the cash market and the “cheap” call option purchased in advance of the rally allows you to capture further price increases.

Selling into a rally that starts from depressed price levels is never easy, but this strategy will give you the courage to lock in profitable prices and the flexibility to capture additional price gains.

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