May 26, 2023
Risk Management Framework and Contract Rules
Grain producers tend to focus their grain marketing decisions solely on price considerations without necessarily factoring in other details of their risk management plan that may have a big impact on returns. The price a grower receives for the bushels they market consists of a futures contracts component in commodity markets, the reference or benchmark price based on the delivery date, and a basis component that relates the value of those bushels back to the local cash market at that point in time. This cash price is often referred to as a “flat price.” A spot sale would be derived from the nearby or soonest to expire futures contact and the current basis in that local market while a forward sale would reference the futures contract that represents the spot market during the deferred delivery period and the forward basis that is offered for that delivery window.
Comprehensive Risk Management Plan
In thinking about a flat price as two separate components of futures and basis in commodity hedging, it may often be the case that one is attractive while the other is not. On the one hand, the futures price may be high while the basis is weak, or it may be that the futures price is depressed while the basis is strong (more on this later). Growers can separate these components in their grain marketing decisions so this need not be an impediment, although in practice this can still pose challenges for effective price risk decision making. Traditionally, the lack of on-farm storage has hurt growers who were often forced to sell more grain than desired during harvest at depressed futures contract prices and cash basis levels.
Today, most growers have storage on their farms and actively use it as a marketing tool. While there is a seasonal tendency for basis to strengthen from the fall harvest period into the summer (Figure 1), there is also a cost involved with holding on to grain that must be factored into the storage decision. Most producers who intend to store corn on their farm will dry it down to about 13.0%-13.5% moisture to keep it in condition until the summer whereas corn destined for commercial storage can be delivered at 15.0%-15.5% moisture. The energy expended to dry down grain at harvest is a cost that will need to be overcome with higher prices later through either basis appreciation, and/or a stronger futures board.
Figure 1. Central Illinois Corn Basis History
In addition to drying costs, there is also interest expense in holding on to corn that could otherwise be monetized at harvest and placed in an interest-bearing account or instrument. This cost is higher for a farm carrying a balance on a line of credit with their lender as interest must be paid on this outstanding balance monthly while grain in storage pays no interest and will instead lose value over time with shrink and quality risk. Interest expense historically may have only cost the farm around 2 cents per bushel per month in a low or zero interest rate environment that we have been stuck in since the onset of the recent Federal Reserve Bank tightening cycle; however, that cost today is likely closer to 4 cents or more given the combination of both higher corn prices and interest rates.
Since every operation has different costs, it is important to understand how much stored bushels will “lose” in value over time that must then be made up by higher futures prices and/or stronger basis levels. It is also important to acknowledge market structure and dynamics, and how this likewise plays a role in marketing decisions and sales timing. The current structure of the futures market is inverted, meaning that nearby contracts are trading at a premium to deferred contracts. This is atypical for a storable commodity like corn where there is a cost of storing grain that is reflected in the forward curve or spread between nearby and deferred futures contracts.
Currently, the spot July 2023 futures contract is trading at an approximate 70-cent premium to the December futures contract. Another way of thinking about this relationship between old-crop and new-crop currently is that there is a negative return to storage as the futures board is paying you less in a deferred marketing period than you would receive today. This reflects the relative shortage of old-crop supply left over from the yield-reduced campaign last year and expectations for a large crop this season to restore supplies in the grain supply chain.
While basis may technically “increase” as the reference price moves from the July futures contract to either September or December in the cash market, the flat price may not necessarily appreciate and may even decline if more bushels start moving out of storage through domestic demand channels ahead of harvest later this fall. As a result, growers may be wise to consider capturing the strong old-crop basis and inversion between old-crop and new-crop futures spreads on the forward curve before this market dynamic changes.
In thinking about new-crop marketing decisions and whether to sell or store the upcoming crop at harvest, a big consideration will be the cost of storage or carry from fall into next summer. New-crop spreads reflect a normal “carry” relationship in the forward curve where each successive contract trades at a premium to the preceding one. At current interest rates which increasingly appear likely to hold at higher levels into 2024, if it will cost 4-5 cents per month to store corn on farm at harvest, the spread between December 2023 to July 2024 corn should pay this cost of storage for the grower to justify holding onto their crop.
Figure 2 shows the historical relationship between December and July futures over the past 20 years. While there indeed is carry being built into the new crop spread profile, the market is not paying the carry that it will cost to store corn at 4.5 cents per month for the 7-month period between the December and July expirations. This would be closer to the 30-cent or more carry that historically has been the widest for this spread looking back over the previous 20-year period.
Figure 2. December – July Corn Futures Spread 20-Year Range
With any marketing decision, growers need to understand their cost of production and how their grain checks help to cover those costs. In addition to flat-price considerations, other costs must also be evaluated to determine whether certain decisions in their price risk management strategy make sense or not and ultimately add to the bottom line. In a tightening profit margin environment, these other factors will become more critical in both old and new-crop marketing plans.