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Market Commentary for 5/31/19
Everyone I spoke with this week wants to know how high the corn market will go.
The problem is that the market needs to know how many acres won't get planted and a better idea about what the July/August weather will be like. Corn may have hit it's high this week, or prices may go up several more dollars. No one knows, because last week’s 58% planting progress has NEVER been seen this late in the year. The country has never planted less than 90% of the intended acres from the March USDA intentions report.
This uncertainty has sparked the market to rally and start rationing demand. This is also encouraging farmers to plant well beyond prevent plant dates and squeeze production from every possible acre.
Three weeks ago, there was widespread fear $4 would never come for 2019 corn and $4.50 December corn seemed out of the reach for farmers for another year. But here we are, 90 cents off the lows and wondering where the top will be.
The Dreaded Margin Call and Why I Don’t Fear It
Some of my trade targets hit during this rally. These sales will make me short futures, and if the rally continues, I'll face margin call. That may sound scary to some, but there is a lot of unwarranted fear and misconceptions about margin calls.
Margin Call Misconceptions
I've heard some in the industry say they would never short the market because if the market rallies significantly, the seller would face unlimited margin call. They say farmers can't protect themselves against these types of situations, and that they'll go broke placing these types of trades.
That could occur if a farmer chased a speculative position trade. That's why I wouldn't place place any trade that require me to chase a market rally. I'm fine limiting my upside potential on some of my production in exchange for guaranteed prices at targets I set before a rally.
Do You Ever Trade Out of Your Positions If the Market Moves Against You?
I have said many times before, when I place a trade, I'm comfortable with all outcomes. If I’m not comfortable with an outcome, then I don’t place the trade. I hope I'm forced to sell some of my grain at prices I thought would have been profitable during the winter. I don’t need to worry if the market goes higher, because I always have more of my crop to sell at some point.
Aren’t You Afraid of Margin Call If the Market Rallies?
Margin call makes a lot of farmers wince and keeps many from selling options or making forward sales using futures.
Sadly, these farmers don't realize they are removing an important marketing tool out of their grain marketing tool box. Eliminating margin call is like telling a baseball player to not swing at anything IN the strike zone. A player may do alright swinging at questionable pitches, but they increase their odds to miss and strike out. Just as it sounds silly to tell a baseball player to not swing at strikes, it sounds silly to me to tell farmers not to hedge their grain using futures or selling calls because they don't want to pay margin call.
The chance the market would rally 90 cents in the last 15 days was an EXTREME long shot. While maybe a handful of people bet it would happen and put positions on to take advantage of it, most of the time this would have been a losing bet. There is a lot of risk betting on something that’s never happened before. As a farmer my job is to reduce my risk and plan for normal, but I do leave myself some room for the market to move higher by not selling everything I produce at one time.
Why Should Farmers and Their Bankers Not Fear Margin Call?
As a true hedger, I don’t like calling it a "margin call," because that term is most often associated with speculators. A speculator making a margin call is in a bad financial situation because a trade has gone against them. I’m not a speculator because I have the underlying commodity to cover any sale I’m making. That’s why hedgers look at grain marketing and risk management decisions differently than speculators. For true hedgers, making a “margin call” is more accurately just making a finance decision. It’s not a bad thing. Let me explain.
Margin Calls for Hedgers Are Typically A Net Neutral (Neither A Gain or Loss)
When using the futures market to hedge or sell grain, it doesn’t really matter if I have to make a margin call. Following is an example:
Let's say in May, December futures are $4/bu., so I sell some corn because that seems like a good value. Then in June there is a weather scare and December corn rallies to $6/bu. Margin call means I need the difference between what I have my grain sold for in futures ($4), and the new higher CBOT futures price ($6). So, in this example I would need to make a $2/bu. margin call to my futures trading account.
This part frightens farmers, because that can be a lot of money. But there is no reason to be worried, because I’m not losing that money.
Let’s assume I will harvest my grain in October and take it to the elevator. For simplicity, let's also assume the price in October is still the same as it was in June - $6. (Note: the actual price in October would not really matter because the final outcome will be the same at any price level). So, I sell my grain for $6/bu. cash to the elevator and they hand me a check for $6/bu. At the same time, I sell to the elevator, I buy futures back in my hedge account for $6/bu. This buy back keeps me net neutral on my hedged position that I had already sold in May when I picked a price for my grain of $4.
(Note - Basis values can change slightly during the summer from what an end user is bidding for harvest delivery. But overall, they are usually about the same. If you’re in an area with -30 basis now, it’s likely it will still be around -30 at the beginning of harvest.)
Keeping My Position Net Neutral
The important part of this example was when I sold the corn for a cash contract, and then immediately bought back the same number of bushels in my hedge account. If I hadn’t done this, I would have become a speculator. To remain a hedger, I must keep my position net neutral when I have a futures position and sell for cash, even if I think futures can move up or down. Not doing so crosses the line from being a hedger to a speculator instantly.
Where Does The $2 Difference Go?
When I combine my hedge account and the check for the physical grain from the elevator, I lose $2/bu. in my futures account. But I still sold the corn for $6/bu. cash. This is where I net out $4/bu. between the hedge account, and my original sale.
This is also when I get back all of my margin call money ($2). The check from the physical grain ($6) less my original sale ($4). That premium offsets the loss in the hedge account and fully pays down the margin call amount in the account.
I Don’t Have Cash Just Lying Around to Make Margin Call Payments. This Sounds Bad.
Most farmers don’t have a lot of cash laying around. Farmers hedging grain need to work with their bankers ahead of time. When I work with farmers, I work with their bankers first to make sure the banker understands the long-term plan and help set up a path for margin calls as a part of a hedging position. This is a low risk loan for bankers, so they are usually extremely supportive. Many bankers will set up what is called a hedging line that is related, but separate from the operating note.
In the above example I sold futures in May and delivered at harvest (5 months later). If the rally didn’t start until June, it would mean a $2/bu. loan for 5 months (June to October). With a typical interest rate of 6% on a hedging or operating loan, this means only 5 cents/bu. interest for the margin call for those 5 months (math = $2/bu. x 6% interest / 12 months for a monthly rate x 5 months).
Bankers must constantly update their clients' balance sheets to recognize that the asset growing in the field or stored in the bin is now worth much more than before. As margin call goes up, so does the value of grain on the balance sheet penny for penny. This is why banks should be supportive of margin call for hedging purposes, because the farmer has an asset that is increasing in value.
Why Would I Even Do This Then? I Could Have Just Sold Grain to My Elevator and Not Worried About Margin Call and the Interest on My Money.
If corn rallies due to a major weather pattern, you can’t take advantage of increasing basis levels and other premium opportunities unless you use futures contracts or Hedge To Arrive contracts (HTAs). For instance, in 2012 (a drought year), I received $.50/bu. more for my corn from a basis increase using futures than farmers who sold corn for a flat price to an end user the same day as me and took the cash price quoted on presells before harvest.
Why Not Use an HTA And Let Someone Else Make My Margin Call?
There are several reasons:
Benefit #1 – HTA Costs Are About the Same or Worse Than Doing It Myself
HTA costs vary by end users, but they range from 0-8 cents with most in the 3-5 cent range. In the above trade example, I would have 5 cents of interest and 1 cent in commissions to my broker for the trade. However, elevator charges to handle an HTA are comparable. And that’s assuming a huge $2/bu. margin call, which is rare. With a 50-cent margin call, I would only have 1.25 cents of interest ($.50 x 6% / 12 months x 5 months = about 1.25 cents) and be ahead of HTA costs. In the long run, over several years, I’m going to be more profitable doing my own hedging.
Benefit #2 - I'm Not Locked into Any One End User
Doing my own hedging allows me to select the end user paying the most at harvest and certainly any time after. Often end users will have 10-20 cent basis pushes when they have localized production issues. However, these “bumps” are not available to those locked into an HTA or have grain stored at the end user’s facility. I want to be able to take advantage of this premium in the market.
Plus, I can’t guarantee where the best bid will be in 3-6 months, so I don’t want to lock my grain up with an end user now. Last year, farmers shipping corn in late November directly from their fields were getting much better basis opportunities, because of wet weather, with different end users than was available earlier in the summer for harvest delivery.
Some farmers switch destinations at harvest because of long lines at their preferred end user or elevator. For some, taking 1-2 cents less in their basis price to keep the combine running is a better use of their assets and time. I’ve also seen farmers who needed to switch end users during harvest due to production issues.
The market is always changing, so having complete control over my own bushels allows me to take advantage of every available opportunity. Having a futures positions on makes this process very easy.
Benefit #3 – It’s Easier to Get Out of Sales If I’m Short on Production
If I am unable to produce corn (ex. due to weather), it’s easier to get out of sales by moving them forward with futures to the next year. Plus, in most years I can usually capture a market carry profit doing this.
If I have to ask an end user to be let out of contracts, for cash trades or HTAs, there will probably be a cost penalty. Even if the end user offers to move the sales to the following year for free, that could be a huge loss, because I would miss out on all of the market carry profits available from one year to the next.
Last year there was a 40-cent premium to move sales from ’18 to ’19. In the last 30 years, only 3 years didn’t eventually have carry in the corn market (95/96, 11/12, and 12/13). Even in those years end users wouldn’t likely move the sales forward at the same price, and would have charged the spread difference between the crop years anyway.
Right now, there is a 30-cent inverse from Dec ’19 to Dec ’20, so it will cost producers 30 cents to move any sales forward to next year on crops they might not produce regardless if one was using cash sales, HTA’s or hedging their own position with futures.
Benefit #4 – Risk with End Users
In 2012, when the market rallied above $7, some elevators refused to place more HTAs, and a few elevators made farmers with HTAs set basis near their lowest/widest value. These elevators were scrambling because they didn’t secure large enough lines of credit from their banks and were forced to liquidate their position.
I don’t want my profits reduced because of someone else’s failure to plan ahead. I want to be in control of my money, my bushels, and my profits. This is also why I have conversations with my bank before margin calls begin so that everyone is on the same page and what happened to these elevators doesn’t happen to me.
Myth – Making A Margin Call Is Bad
Many farmers and bankers may be shocked by this, but making a margin call can be a GOOD thing. Here’s why….
Typically, I don’t price all of my corn at one time, and I doubt most farmers do either. I usually hold some back for potential market rallies. As described above, I have to pay margin call on all of my priced or sold grain with every rally. But this means the corn I haven’t priced or sold yet is now worth more. ALL future unsold grain is now worth more. Since I plan to farm well into the future, I have more corn to sell, maybe not this year, but next year I will.
*** Margin call means corn I haven’t priced or sold is worth more. I embrace it. ***
I Understand That the Math Makes Sense, But I’m Still Too Scared of The Margin Call.
Many of the farmers I have worked with expressed reservations and fear the first year they cut several $20,000 margin call checks during the months of June and July (despite knowing they will eventually get it ALL back). It can be a lot of money. However, once they saw that not only did they get the money back later, but they also had more opportunity at improved basis levels than their neighbor, who didn’t use futures. In the end, they were happy with their decision.
If I feared margin calls it would keep me from using the biggest marketing tool there is to hedge my grain and take advantage of market opportunities. Savvy farmers understand it and use the tools that are available to increase profits and minimize risk. The most important thing I have seen to guarantee success is to make sure that a farmer is working with a bank that fully understands margin call. As long as the bank understands what will happen if corn goes up $2/bu. or more, and there are plans in place for both parties to be successful and reduce risk, there shouldn’t be any problems and everyone will be more profitable in the end.
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