Top Crop Manager

Features Agronomy Storage
Grain contracts help manage market volatility and achieve target returns

Second in a two-part series.


November 19, 2007
By Top Crop Manager

Topics

38aContract it, then deliver. It is a simple approach, but one that can help growers
manage risk and achieve income goals for their crops, say grain marketing experts.

Contracting offers growers many choices for how to sell crops that do not go
through the Canadian Wheat Board. When used effectively by growers, contracts
soften the sharp edge between supply and demand and minimize the effects of
supply and demand on price. By buffering supply from demand, growers can gain
better prices in the long-term as well as more stable income.

Contracts also provide benefits for grain traders who need to set delivery
dates and prices. At times, grain traders are willing to agree on purchases
two years in advance of delivery because it helps them with planning and marketing.

Forward contracts
The forward contract is a basic marketing agreement and most grain companies
offer one, says Jon Driedger, Winnipeg Commodity Exchange economist. "It
simply locks in the price, today, for delivery later." It is as locked
as a savings bond, but it offers security for both sides. "It's not for
today's bills, it's for planning ahead (for future bills payment) so growers
don't end up being forced to settle for spot market prices," he says.

If they want, growers can take a price and delivery date up to two years in
advance on some crops. The forward contract enables a grain company to lock
in a supply so it has grain to offer end users. "Like a farmer, the end-user
is exposed to price risk and may want to buy far in advance of delivery,"
says Driedger.

Target price contract
A target price contract offers a grower several advantages, says Derek Freeman,
Agricore United operations manager at Moose Jaw, Saskatchewan. It is a legal
offer from the grower to a company stating a certain amount of grain is available
at a certain price for a short period. It can be offered before new crop is
in the bin, but the more frequent use is after harvest. It only becomes a binding
contract if the offer is triggered by a grain merchant.

Target price contracts are a handy option, especially if a grower will be away
for a week or two. If the market rallies while he is away, he can have a target
price offer on the table. If the market rallies to that price, the merchant
will trigger it or confirm the contract.

"Suppose canola is at $7.75 (on the market today) and the grower wants
$8," Freeman says. "He signs a target contract for $8 at no cost to
himself and offers it for a week. During that week, the producer cannot sell
that canola to anybody else. Our merchant decides whether it works for him.
If it does he can accept the contract."

Freeman explains how some of his customers used this option in 2004. Flax futures
were offering $10.50 a bushel for a while. A few astute growers spotted the
opportunity. They offered target contracts at $11.25 a bushel and merchants
triggered the contracts. In October, those contracts paid at $11.25 a bushel
when the flax was delivered. At the same time, non-contract flax was being purchased
off the combine at $8.95 a bushel.

"Both are good returns, but that's a lot of money," Freeman says,
"On 25 bushels an acre the difference was $57. On a quarter section, that's
$9120 difference for the same product."

Minimum (maximum) price contract
A minimum or maximum price contract is likely the best option when grain must
be delivered immediately, usually due to lack of storage on the farm. Instead
of taking the spot price that day, the grower buys some flexibility on the pricing
and a better return. He has the right to price the grain later, for a specific
period, but needs to watch and form opinions on the market direction.

If the market rallies above the floor price of the minimum price contract,
the grower can lock in a sale at the higher price; if the market stays flat
or drops, he loses the premium but still gets the guaranteed minimum. The opposite
is true for the maximum price contract.

"Suppose the minimum price contract guarantees $8 a bushel," says
Neil Sabourin, Agricore United grain merchant based in Winnipeg. "You don't
want to sell at today's price because you have the opinion the market will increase,
but you're worried about storage. You can deliver the grain right now, get it
out of the bins and have a floor price which is slightly less than our current
fixed price contract (because you've paid a fee for the contract). Then you
wait and watch the market.

"At a later time, if the market increases, you're allowed to lock in a
different futures value that's even better. You have the option to take advantage
of market rallies," explains Sabourin. There also is a parallel contract.
If the grower wants to deliver now and expects the market to drop, a maximum
price contract also is available and works in a similar fashion.

Basis contract
There is always a difference between price offered at the local elevator and
the commodity price on the futures market. That difference is the cost of doing
business. The amount of that difference changes and that is called the basis.
Basis contracts are considered powerful tools, but also require a grower to
be very well grounded while watching the markets daily.

"An attractive basis means the company wants to buy," says Freeman.
An attractive basis is narrow or cheap from the grower's viewpoint. Perhaps
today's price is low, but the basis is attractive. If the grower expects a price
increase, he can lock in that narrow basis for a period of time, like two or
three weeks, then wait and sell at the narrow basis when the futures price is
higher. There is also an option to roll-over the basis contract to the next
month.

"Suppose canola is showing a basis of $20 on the futures in western Canada,"
says Sabourin. "Grain buyers will pay the grower $20 less than the futures
price to deliver it to the elevator now. If the farmer would prefer a $15 basis,
he can enter that as a target contract, and it would be up to the grain merchant
to determine whether to take on that basis."

How much grain should a grower contract?
Forward contracting is a commitment to deliver. It has a certain
risk element, particularly if the new crop will not be harvested for weeks
or months.

How much to contract is always an issue, even if a grower is equipped
with a marketing plan. He knows how much cash he needs, when he needs
it and the outlook for prices. He also knows things change; planned production
does not always reach the targets.

The answer is a guideline, not a rule.

"Some growers have more tolerance for risk, some are in a financial
position to take on more risk," says Jon Driedger, Winnipeg Commodity
Exchange economist. For both, a marketing plan provides a light in the
tunnel. Generally, he suggests, it is best to diversify the risk by a
series of sales or contracts.

"In general terms, if there's a profit margin to be had, I encourage
producers to lock in a portion of it with a futures or a forward contract,"
he says. "Move it in portions over the year; adjust the amount to
contract at any time based on market conditions and outlooks. Have some
price targets and, if a price target is hit, lock in a little more."

In the bin, crop that is ready to sell can be sold according to the best
combination of cash flow needs and marketing opportunities. Ideally, take
contracts on old crop to capture market spikes throughout the winter and
spring.

When working with growers, Derek Freeman, Agricore United's operations
manager in Moose Jaw, Saskatchewan, recommends contracting the new crop
a bit at a time – in increments of five to 10 percent, to a combined
maximum of 50 percent up to harvest time.

There are three primary times for these contracts – before seeding,
after emergence and mid-season before harvest. Growers are advised to
contract at a time when the futures price is attractive and when they
are confident of their yield expectations.

For example, a mid-winter contract would reflect the yield expectations
for the new crop based on the moisture supply in the ground and perhaps
the past year's growing conditions. Yield estimates can be refined again
after the crop has emerged and again in mid-summer.

"A grower doesn't want to forward price more than 50 percent before
harvesting," says Freeman. There are two reasons. First, an early
frost or a wet fall can dash yield and quality expectations without warning.
If it happens, contract benefits can reverse quickly for a grower who
is over- committed. "There are large buyout costs for contracts on
non-board grains that can't be filled," he warns.

Secondly, holding 70 percent provides the opportunity to cash in on market
spikes that will occur in coming months. Merchants are buying on the basis
of world supply and demand, and prices they offer are always adjusting.
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