West Kentucky Grain Market Project
Monthly Market Update for March 2007
March 21, 2007
The market situation in corn, soybeans and wheat is fairly well defined and has been discussed in the agricultural and even main press, for several months. It is argued that current very high corn and wheat prices started in the wheat sector due to two consecutive small global wheat harvests. Increasing demand by China and India due to several years of expanding economies and therefore improving diets served to heighten the impact of the two small wheat harvests on prices. Currently, it appears that high wheat prices have resulted in a substantial increase in global wheat acres seeded. However, given the very small projected wheat supplies for the end of the 2006-07 marketing year (May 31, 2007) – the smallest relative to use on record at the global level – the market remains well supported. It will probably take several months of harvest data in the northern hemisphere confirming a very large 2007 crop before wheat prices soften from their current lofty levels.
Another issue supporting wheat (and soybean prices) has to do with the perhaps over-publicized issue of corn ethanol production in the U.S. The dramatic increase in the use of corn for ethanol combined with a very robust domestic livestock feed demand and a very strong export demand for U.S. corn has resulted in projections by USDA of the second smallest corn carryover, relative to use, at the end of the marketing year (August 31, 2007) on record. Unlike the wheat situation described above, current very high corn prices are the result of rapidly increasing demand not a production problem due to weather or disease.
The question the market is trying to answer now is what set of price relationships is needed to allocate crop acres on a global scale to supply next year's likely uses. If corn prices are "too" high relative to soybeans or wheat, prices for these commodities could be even higher 6-12 months from now. As an example, if the U.S. is going to switch a huge amount of land from soybeans to corn this spring the market may need to provide a very strong soybean price for the May 2008 and later futures contracts to induce South American farmers to increase acres devoted to soybeans this coming fall rather than corn.
Even though corn and wheat prices are at very strong levels and soybeans prices are in the upper part of their 35 year price range, farmers should not forget that the strength of a market driven economic system is the ability to rapidly shift resource allocations as market signals dictate. Yes, with such a small projected corn carryover and such record setting use forecast for the next few years an inadequate number of corn acres planted or a serious weather/disease problem would take corn prices to new record high levels (old record summer of 1996 about $5.50). However, the December futures contract had never traded above $4.00 until January 16, 2007 and it is possible the $4.295 high set on February 22, 2007 will be the highest for the December 2007 corn futures contract when it finally expires in December.
In order to make the case of extended very strong corn prices it is necessary to assume that oil prices will stay high enough to keep corn ethanol production sufficiently profitable that rapid expansion in ethanol production capacity continues for at least 18-24 months or more. It is also necessary to assume that tariff protection and tax credits are maintained and that a higher mandate than the current 7.5 billion gallons of renewable fuel will be enacted by Congress – this will provide the base to continue to price ethanol as an additive not a fuel. And as pointed out above it is necessary to assume that wheat and soybean acres at the global level don’t give up "too" many acres to corn.
Therefore, farmers might want to consider that prices may not keep going up, corn and wheat prices are at extremely high levels, soybean prices are very strong and things could look quite different by fall harvest time.
The first marketing job of any commercial grain farm is to plan for the expected bushels that must be sold off the combine. Since there is maximum uncertainty about actual production in March and stocks will be low, a lot of price volatility will exist until the combines roll this fall. One way to "cover" the bushels that must leave the farm is to cash contract for fall delivery and purchase call options on the December corn contract or the November soybean contract. This produces a minimum price but leaves the upside open.
If a farmer is willing to make the trade-off of spending less money in the beginning in exchange for putting a cap on the up-side of price it is possible to combine a contract sale with the purchase of a vertical call–spread i.e. buy a call option that is slightly "out-of-the-money" and selling a higher strike call option. This results in a min/max pricing strategy. For example, corn can be forwarded contracted today for all-fall delivery for about $3.75 -- $3.90 depending on the exact location. The December 2007 futures contract ended up about $4.09 today, a $4.20 December call option could be purchased for about 0.38 and a $5.50 December 2007 call option could be sold for about 0.11. This results in a minimum farm price of $3.80 – 0.38 + 0.11 = $3.53 and it also produces a maximum price of $3.80 - .038 + 0.11 + (5.50 – 4.20) = $4.83, assuming the corn was contracted for $3.80.
The same type of strategy could be used on bushels that will be placed in storage except it should be best to price these bushels with a Hedge-To-Arrive (HTA) contract and hopefully gain a significant return from basis appreciation to the storage enterprise. The reason for using the cash forward contracting method for fall delivery has to do with the possibility of huge corn acres coupled with the good weather possibility resulting in a massive fall harvest and consequent poor harvest time basis.
For the bushels a farm is unwilling to price for fear of production problems it should be prudent at some point in time to purchase put options and put a floor under prices if it looks like the huge crop outcome is likely. If a major weather problem should develop the purchase of additional call options may be necessary.
If a farm has purchased crop insurance (providing protection in the range of $450 to $750 per acre, or higher) and they have corn minimum priced off the combine for above $3.50 per bushel they should be able to just squeak by for another season.
For More Information
The West Kentucky Grain Marketing Project: Monthly Market Update is edited by Steve Riggins. You may contact him by e-mail at sriggins@uky.edu.