Traditional Time for Pre-Harvest Hedging

Even more than in most years, this February feels too early to start caring about new-crop grain prices. I’ve just returned from another road trip through eastern North Dakota, and although it’s difficult to judge what proportion of corn fields are unharvested versus harvested (with the stubble now buried under snow), farmers in that region tell me it’s 70% unharvested versus 30% harvested. I believe them — the number of still-standing corn fields is staggering. Seeing an unharvested soybean field or small-grains field is a gut punch. We, as an industry, still haven’t completed or fully accounted for the 2019 crop, and now we’re supposed to start trading the 2020 crop already?

Despite the surreal sense of time looping and slowing and speeding up at strange rates during the bizarre 2019 crop year, in reality the calendar has kept ticking along at its usual rate. Now February, it’s the month when reference prices will be set for the upcoming 2020 crop insurance policies. Each trading day during the month of February, the closing futures price for new-crop corn (December contract), new-crop soybeans (November contract), new-crop spring wheat (September contract) and new-crop cotton (December contract) will be collected, then each contract’s collection of February closes will be averaged together and those will be the numbers used for revenue-based policies. Therefore, those will be the numbers used by grain producers and their lenders to judge where profits might be confidently banked upon (with an insurance back-up) and how high or low those profits might be.

So far, corn is once again looking like the most attractive crop to plant, and there are only 12 trading sessions left in February to change this math. Grain futures prices have been relatively quiet and stable in recent days, with new-crop December 2020 corn futures hovering around $3.93 per bushel. New-crop November soybeans at $9.19 per bushel are therefore 2.34 times the price of corn, which means soybeans are historically underpriced compared to corn. New-crop September spring wheat at $5.72 per bushel, or 1.46 times the price of corn, is also historically underpriced (compared not only to corn, but also to other wheat varieties). New-crop December cotton at 69 cents per pound is also underpriced compared to corn, which isn’t a natural comparison to make when the two crops aren’t substitutes, but they are competitors for southern acres as spring planting gets started in Texas.

The real question, however, is whether or not these new-crop market prices represent a good selling opportunity. If the aim of a grain-production business is to make sure it sells its goods for more than it costs to produce those goods, then mathematically speaking, yes, it looks like that can be done right now for 2020 corn. The current futures price, at $3.93 per bushel, suggests a cash price of around $3.53 per bushel in the center of the Corn Belt at harvest time in 2020 (that’s $3.93 minus let’s guess around 40 cents of local basis). Iowa State University’s latest estimates of the costs of crop production suggest a bushel of corn can be grown in 2020 for about $3.23 per bushel, assuming the field was in a corn-following-soybeans rotation and achieves 199 bushels per acre after paying $219 per acre in cash rent (or equivalent opportunity costs).

That $3.23-per-bushel cost-of-production estimate is wildly variable based on individual fields and production practices and input costs and other assumptions. Not every bushel of corn in Iowa, let alone across the United States, will be grown for $3.23 per bushel in 2020. But let’s say that as a benchmark, this figure serves as a good representative for the overall industry. Using it, we see about $0.30 per bushel of profit opportunity between cost of the production and the expected price of the grain. That’s profit that can be locked in and “guaranteed” right now, today, for any producer willing to write a forward contract with a grain buyer or hold a futures or options hedge in an individual brokerage account.

I say the profit from pre-harvest hedging is “guaranteed,” but of course it isn’t guaranteed. The 2019 crop year reminded us of all the unusual ways things can go wrong — a predicted crop may not even get planted, let alone properly developed, free of hail and disaster, then harvested in time to fulfill a forward contract at the elevator. Those risks are reason crop insurance exists, but they nevertheless make some grain producers hesitate before committing large portions of their crop to a marketing decision. Then there is the size of profit on offer right now — 30 cents. Is that good? Is that enough? Will there be higher or lower profit opportunities in the future?

So, although locking in the currently available profit opportunity right now may look like the screamingly obvious thing to do, there are many reasons why producers may not be choosing to do so. The most common reason, however, tends to be the psychological fear of missing out on potentially larger profits in the future, which would be available if — and only if — we believe the December corn chart could move upwards between now and harvest.

The traditional timeframe for pre-harvest hedging tends to be anywhere between February and July, capturing the chances for a spring or summer rally, which has sometimes occurred when poor crops are harvested in South America or poor weather is experienced in North America. Looking back at the past six crop years, during that February-to-July timeframe there has always been some opportunities to lock in new-crop corn futures prices above the expected cost of production.

Sometimes those opportunities were fleeting, and sometimes they weren’t offering very large profits, but there was always something. There is that same “something” on the table right now. February may seem particularly early in 2020 for farmers who’ve just caught their breath after the late 2019 harvest, but nevertheless, the season for making these decisions starts now.

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Are you better than the “average” marketer?

It’s generally considered rude to ask a farmer or rancher how many acres she owns or how many cattle he’s got. On the other hand, if two neighbor farmers discuss how much grain they’ve sold or how their marketing plans are going, it’s usually a welcome topic. The responses might not always be true (“Oh, I sold 70 percent of my beans at $10.50!), but the subject is one which farmers enjoy discussing with each other. They might compare their own choices to those of the rest of the gang at the local coffee klatch, or perhaps they participate in more formal peer networks to establish benchmarks.

One thing farmers don’t do – because they can’t do it – is compare themselves against the entire farming population’s marketing decisions. A field’s growing condition or yield can be confidently compared against the county, state, and national averages, which are real numbers measured and released by the USDA. But the farming population’s marketing decisions? What percentage of the 2018 corn crop is currently hedged by a forward contract or futures / options contract? There is no unbiased, independent source that measures and publishes such data.

Until now.

Agricultural economists Gary Schnitkey and Jonathan Coppess from the University of Illinois last month released the results* of a survey they and the Illinois Corn Growers Association administered to corn producers across the Midwest. The survey didn’t have a large or a randomly-drawn sample (only 194 responses from self-selected survey participants), so it can’t be used to draw statistically-valid conclusions about the entire population of U.S. farmers. Nevertheless, its results showed interesting patterns in pre-harvest hedging practices, which all farmers can use to consider their own risk scenarios and evaluate their own marketing plans.

The survey responses came from Indiana, Iowa, Kentucky, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, Texas, Wisconsin, and 70% from Illinois, all indicating how much of the farmers’ expected 2018 corn production was hedged by a forward or futures contract by April 1, 2018. Also, the survey asked what proportion of their corn crop the farmers typically like to pre-harvest hedge by the following benchmark dates: January 1, April 1, and July 1.

Of these 194 farmers, only 16 percent said they hadn’t hedged any of their new crop corn as of April 1, 2018. The average indication was that by January 1st these farmers typically had about 10 percent of their upcoming crop hedged; by April 1st they typically had about 22 percent of their upcoming crop hedged; and by July 1st they typically had about 41 percent of their upcoming crop hedged.

July 1st is right around the corner, so this is a perfect opportunity for readers to compare their own 2018 marketing progress against this sample of fellow corn producers.

Only 9 percent of the survey respondents said they typically didn’t have anything sold by July. That jives with my instincts about the farming population’s marketing habits. It would be unusual for someone to have totally procrastinated up to this point. And farmers are more likely to choose pro-active or aggressive marketing strategies based on their individual risk profile, which is partly a matter of personality but mostly a matter of circumstances.

Schnitkey and Coppess’s survey helpfully sorted the responses according to farm structure. Was farming the sole source of household income? The primary source of household income? Or was off-farm income “very important” to the household? Furthermore, how much of farmland was rented? Higher proportions of rented farmland are associated with increased financial risk.

And sure enough, those survey respondents with the most at stake – the ones with a lot of rented ground or their entire household income dependent on farm profitability – were the ones with the most conservative marketing practices. Forty-two percent of the respondents said that farming was their sole source of income, and these were the ones who were more likely to have upwards of 10 percent of expected corn production hedged before April 1st (72 percent of them did). Among those who had diversified off-farm income, there was more willingness to gamble on upcoming corn prices – 29 percent of those respondents said they had nothing hedged as of April 1, 2018.

A similar pattern was seen in the risk profiles according to the percent of farmland that’s rented. The survey respondents with the most at risk (the ones with over 90 percent of their farmland rented) were the ones most likely to have conservative hedging in place by April. Their most common response was that they had somewhere between 25 to 50 percent of their expected corn production hedged with forward or futures contract by April 1, 2018.

Again, I’ll caution that just because these 194 corn producers said they like to have 41 percent of expected production hedged by July 1st, we shouldn’t be too confident that the entire population of U.S. farmers behaves this way, or that 41 percent of the actual 2018 corn crop will really be priced by that time (especially not with the markets in their current condition). This surveyed sample was drawn from the members of state corn growers’ associations, so it was likely already biased toward pro-active agriculturalists. I’m particularly suspicious that among the general population of farmers, there might be a much higher proportion than 16 percent who didn’t have anything locked-in by April 1st. I’ve also always wondered how marketing practices differ from state to state or region to region, and this survey, with respondents who were so concentrated in Illinois, can’t address that question.

Still, it’s a treasure trove of data. It allows individual grain marketers not only to benchmark their own plans against a broad average, but more importantly, to consider how their own risk circumstances may be shaping their behavior. There is always fear of marketing too many bushels before planting weather and yield uncertainty have been resolved (fear which is somewhat mitigated by crop insurance policies that include a Harvest Price Option). But perhaps that fear should be weighed against the risks of getting left behind. This seems frustratingly true in 2018 when outside markets and geopolitical risks have disrupted the typical seasonal price pattern in the grain markets.

Schnitkey and Coppess’s survey showed pre-harvest corn marketing decisions in just one snapshot of time. It’s a nearly impossible task to gather this information broadly or consistently year by year or state by state, because of course no one likes to give out private business information. So what a fascinating snapshot it is – and what an opportunity to evaluate one’s own choices.

* Schnitkey, G. and J. Coppess. “Pre-Harvest Hedging and Revenue Protection.” farmdoc daily (8):88, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, May 15, 2018. http://farmdocdaily.illinois.edu/2018/05/pre-harvest-hedging-revenue-protection.html

Elaine Kub is the author of “Mastering the Grain Markets: How Profits Are Really Made” and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

The multiple problems with multi-year cycles

Perhaps, sitting in a bar one evening, a friend told you that corn yields tend to be great during years that end in “6.” Or perhaps you’ve heard of the 18-year cycle in the stock markets? Or the 60-year cycle in wheat prices? Or the 14 3/4-year cycle in soybean prices, which only holds true if the previous year’s price ended with an even number?

Okay, I made that last one up. But that’s alright — other people baselessly fabricated all those other examples, too, and they all have the same statistical significance (zero).

I hadn’t heard of the 60-year cycle in wheat prices until a gentleman told me about it after a recent market presentation. He has many more years of experience in the wheat market than I do, and I’m always willing to learn new things, so I promised I would look into it. More on that later.

All these multi-year cycles are interesting bits of folklore, and they’re kind of neat to think about. If thinking about them and analyzing the underlying economic reasoning behind them helps market participants better understand the world around us, then that’s great. But if blindly believing them motivates farmers to make or postpone marketing decisions based on unsound science, then that’s bad. That’s why I’m going to try to bust the myth of the multi-year cycle as clearly as I can.

In this universe, many phenomena tend to occur frequently near their averages and less frequently at unusual values, measurements or strengths. This is often shown with the bell-curve chart of the normal distribution. But even if a phenomenon isn’t “normally” distributed, if that thing happens a large enough number of times, it will still always tend toward some average value. That’s the Central Limit Theorem, roughly speaking. It is powerful because it allows us to calculate whether a particular event is truly unusual, like someone who’s 6 feet 7 inches tall. Is that just part of the randomness of the universe? All heights will vary somewhat from person to person.

Therefore, among an entire universe of values, taking just one sample — or just a few samples — is extremely unhelpful when it comes to predicting future values. The Chicago Board of Trade was established in 1848 to exchange cash grain, but a standardized record of corn, wheat and soybean futures prices only exists since 1959. That means there are only six samples of an annual corn price from “a year ending in six,” and six samples is way too few to be confident that whatever trend our human brain might think it sees is anything more than just random statistical noise.

I was slightly more willing to believe in a statistically provable multi-year pattern in wheat, however, because I remember seeing an amazing chart of wheat prices from 1750 through 1960, collected by Hugh Ulrich. I updated that data through 2018, and that made 268 years of information — which is a lot! It’s only four samples of any 60-year period, however, once again, it’s difficult to prove there is anything significant beyond randomness in any purported 60-year cycle in wheat prices.

Furthermore, even the 268 years of data was problematic. Some of it was from England in the 18th century, quoted in English cents per bushel. Some of it was CBOT futures quoted in U.S. cents per bushel. More importantly, the structural economic reality of wheat itself has drastically changed between 1750 and today. The number of man-hours that go into a bushel of wheat, the proportion of a farm family’s income that comes from a single bushel, the proportion of an urban consumer’s budget that goes into a single bushel — none of this is apples-to-apples from one economic timeframe to the next. This is called time-period bias in statistical sampling. Even comparing U.S. stock prices from the inflation-plagued 1970s compared to the easy-money 2010s is problematic.
Let’s actually try to test a multi-year cycle. Say we look at the so-called “decennial pattern” in the stock market, which colloquially claims that years which end in “0” tend to have poor performance, and years which end in “5” have “by far the best” performance. We can gather 90 years of stock market returns since 1928. Maybe 90 years sounds like a lot, but it’s only nine sets of 10, or nine samples from years that end in “5.”

Let’s say the average of all 90 annual returns is only 11.4%, but we calculate the average of annual returns from years ending in “5” at 14.6%. Woohoo! Sounds like those years ending in “5” really are winners — notably including 1995’s 37.6% return. However, if we conduct a two-tailed test for statistical significance using the student’s t-distribution, which mathematically considers the standard deviation of all those returns and the small number of samples, and then compares them against what can occur by mere happenstance, the difference between the all-year average returns, and the years-ending-in-5 average returns is proven to be nothing but statistical noise.

However, if we were magically able to use 300 years of stock market data, and therefore had 30 samples to draw from (30 is widely considered to be the minimum statistically useful number of samples), we could calculate a somewhat larger critical value for this statistical test. And then say there’s maybe 80% confidence that the difference between the two sets of returns might actually be significant (and a 20% chance they’re not). There still wouldn’t be any fundamental explanation for why the final digit of a calendar year should affect equity performance.

Anyway, look and see that stock returns in 2015 were only 1.38% — the worst annual performance since 2008. Anyone who actually invested money based on this hokey idea of a decade-long market pattern would have been sorely disappointed.

To all the believers in multi-year patterns or cycles: please continue to tell me about them! I love hearing about these fables, and I collect them like other people collect pretty seashells. But please don’t sell your grain (or not sell your grain) based on someone else’s flimsy idea that has only ever been sampled four times in history.

Elaine Kub is the author of “Mastering the Grain Markets: How Profits Are Really Made” and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

© Copyright 2018 DTN/The Progressive Farmer. All rights reserved.

The Farming Cartel

“So it’s decided. We’ll all cut back our production — all of us! And then we’ll announce it to the press, and prices will go up. But it’s only going to work if every single producer of this commodity here at this meeting sticks to the plan. Got it?” The other members of the cartel nodded in grim determination. What they lost in business volume, they hoped they would make up in price. Like any cartel, they were meeting in the swankiest place they could book, which in this case was an American Legion dance hall instead of a Vienna boardroom or a Dubai skyscraper. And they all wore seed caps instead of keffiyeh headdresses. They were … the Corn Cartel.

Would it work? If all American farmers agreed to cut back production of corn, or soybeans, or wheat, would prices jump high enough to offset the lost revenue from fewer bushels being sold? Well, the big crude oil cartel — OPEC — has had some success with this strategy in recent months.

OPEC, the Organization of the Petroleum Exporting Countries, perhaps ought to change its name to the Organization of “Some” Petroleum Exporting Countries, or of “countries that represent a diminishing proportion of global production.” Its membership includes 14 countries, primarily in the Arabian Peninsula and Africa, although late last year they notably convinced Russia (not technically an OPEC member) to join them in pledging to withhold 1.8 million barrels per day of crude oil production from the global market.

That sort of worked.

Crude oil futures shot up more than 9% in one trading day, then continued to trend upward, above many producers’ breakeven costs around $50 per barrel, then topped out above $55 per barrel at the start of 2017. More recently, late last month, the alliance pledged to continue those cuts through March 2018, but the futures market had already started to doubt the effectiveness of all this pledging. Now this week, three OPEC members, including Saudi Arabia, have cut diplomatic ties with a fourth member, Qatar, the world’s top seller of liquefied natural gas. The spat is reportedly due to payments that may have ended up in the hands of terror groups, and not related to energy production. But, nevertheless, it makes those former OPEC pledges look precarious … if they were ever effective to begin with.

That 1.8 million barrels per day of crude oil OPEC members have pledged to withhold will only hobble global production by 2% in 2017, when total world production is forecast at 98.3 million barrels per day. The non-OPEC oil-producing countries, including the U.S. and Canada in their shale oil heyday, are projected to pump over 59 million barrels per day, or 1 1/2 times as much as OPEC itself.

When we look at equivalent cuts to grain production, what would American farmers have to do, or how much would they have to lose, to achieve a similar market effect? Well, if U.S. corn production, for instance, were to only reach 13.3 billion bushels in 2017, instead of the currently projected 14.1 billion bushels, that would be a 5% loss roughly equivalent to OPEC’s pledged production cuts. But farmers can’t just turn off some pumps to achieve a production cut. What would they have to do? Make everyone vow not to use any fungicides and hope that results in a 5% nationwide yield loss? Or maybe everyone could pledge to set their corn headers slightly wrong at harvest?

A 9-bushel-per-acre drop in the nationwide yield projection, going from 171 bpa in the latest USDA table to 162 bpa by harvest time certainly sounds like something that could spark a rally in corn prices — similar to the one crude oil experienced after OPEC announced its cuts. It could theoretically take prices above breakeven costs for many producers. And some would argue that perhaps we have already lost those bushels. The late planting and wet conditions in much of the Eastern Corn Belt, now joined by a dry forecast at a critical growth period for the U.S. crop, make a bullish case that the nationwide crop will not have its full agronomic potential this year.

Weather is the only way those corn production cuts will be made, if they’re made at all. Cartels only work, OPEC is discovering, if their members represent a significant majority of a commodity’s production sources — that is, if no one else can come into the market and undercut their plan. This was possible in the oil market in the 1960s when a dozen or so men from autocratic countries could all get together in a room and decide to move a market. It’s not possible in the grain markets, where thousands and thousands of individual decision makers all over the world would never all agree to the same decision.

In any scenario of global commodity overproduction, or simply of abundant commodity supply, unfortunately there’s really not much a single producer — or even a group of producers — can do to affect prices. If end users have “enough” of the commodity, however we define “enough,” then they won’t be obliged to pay higher prices or to ration their demand.
So, in the absence of taking an action to change prices, producers of an ample commodity have only one action they can take. They can aggressively hedge when prices pop above the cost of production.

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