DTN Editor’s Note: In our “Tariff Realities” series, DTN is looking at challenges facing U.S. farmers and grain elevators this fall as they market, store and transport soybeans under conditions related to China’s 25% retaliatory tariffs. Even as the trade dispute continues, the market has to absorb a projected record soybean crop of 4.69 billion bushels and larger-than-expected stocks of 438 mb of old-crop beans.
This column, written by farmer and contributing analyst Tregg Cronin, was originally published in our regular Todd’s Take column location for paying subscribers last week. Cronin will be a familiar name to those who have attended our DTN/Progressive Farmer Ag Summits in Chicago, as he’s been a regular speaker on grain marketing, particularly on how to effectively use “hybrid” cash grain contracts that have become popular with many grain buyers. You’ll also see his name attached to some of our daily market commentary such as Early Word Grains.
As the trade war between the United States and China gets set to enter its third official month, with escalating tariffs implemented on both sides, farmers across the Midwest are faced with a harsh reality as combines start to roll: What to store and what to sell.
It’s a question many face as cash prices sit at or just off decade-lows for corn and soybeans. In past years, the decision to sell beans was easy. Demand pull for U.S. soybeans from Chinese importers made it imperative that the soybean pipeline was flush with the new U.S. crop before the Brazilian export program took over in February.
With limited Chinese demand, the Northern Plains soybean crop and the Pacific Northwest export system, which were both grown and constructed to satisfy China, are finding limited interest. This has prompted a discussion of how soybean producers should position themselves for a prolonged trade war.
As of this writing, the national average soybean basis, compiled by subtracting nearby futures from the DTN National Soybean Cash Index, was sitting at -$1.01/bushel (bu.), which was a penny off its lowest level since March of 2008. Many producers across the Northern Plains would be thrilled with a basis level near that as -$1.50 to -$1.70 is quite common. The fortunate part is that weak basis levels are usually associated with large carrying charges as the market must pay producers and elevators to store the grain until the market actually wants it.
As an example, the November 2018-to-May 2019 calendar spread is trading at -39.75 cents, which accounts for 81.6% of full financial carry (LIBOR+200bp). The November 2018-to-July 2019 calendar spread is trading at -50.50 cents, which accounts for 78.2% of full financial carry. These sort of carrying charges are unheard of in soybeans, with inverses common as recently as a couple of years ago.
The thing producers must remember is that while the market is telling them to store soybeans, farmers can only earn these unusual carrying charges if the beans are sold using some pricing tool — either with a direct futures contract or a hybrid “cash” grain contract that grain companies offer — once they’re stored.
What commonly happens in large carrying charge markets is the deferred futures prices eventually come down to spot prices once they take over as front month, wiping out the storage premium the market was once paying.
As an example, at this writing, spot-month November futures are trading at $8.45 to $8.50 versus May futures at $8.85 to $8.90. Next March, when the May futures contract becomes the spot month and those contracts are trading $8.45 to $8.50, the market erased the premium it was paying for storage. Farmers who only stored soybeans without pricing them essentially stored the beans for free. This is what is meant when traders and analysts say, “carries are not earned until they are sold.”
What is the best way to lock these carries in? Enter the hedge-to-arrive contract. HTAs, as they are commonly known, have been around for decades but their use remains somewhat limited. HTAs can be put on with almost any elevator or end user for a small fee or sometimes even free. They remove the margin risk a producer has in the event of a market rally, placing that obligation on the buyer. They do lock a producer into a delivery location, but producers who deliver a majority of their grain to one or a couple of destinations carry less basis risk than does a farmer surrounded by end users.
The HTA allows the producer to lock in the carry by selling the futures price, and guaranteeing the market will not eliminate the storage premium should futures prices fall over time.
In addition, with decade-low basis levels, keeping the cash side of the equation open for several months allows potential basis appreciation to occur if an export trade deal does get completed and demand returns. With basis at such depressed levels, the risk of significantly weaker cash values from here is much more muted than it might otherwise be.
Potential futures upside is capped, which is the drawback from an HTA, but unless a producer is completely sold out of soybeans, they still have some futures exposure on their unsold bushels.
Buying futures exposure via call options is one avenue to sell for cash and retain ownership, although it is not recommended until a producer is at least 50% sold in the cash market.
GENERATING CASH FLOW
For producers who may have to sell bushels off the combine but want to keep the upside open in case a trade deal gets done, a minimum price contract is an alternative. This contract works when a producer sells bushels to an end user or elevator at a set cash level, and for a fee, the elevator/end user will essentially buy a call option in the producer’s name. Once again, this contract allows the producer to avoid paying option premiums or dealing with a hedge account if they do not have one or do not have interest in opening one. This allows the producer to participate in upside if it occurs but keeps the minimum price in case futures decline.
However, the minimum price contract does not provide the ability to lock in the large carrying charges or allow for any basis appreciation should it happen later on this marketing year. To contrast it with the hedge-to-arrive contracts, the producer puts the HTA on to capture carry and possible basis appreciation, foregoing any potential futures rally, while the minimum price contract allows the producer to capture a futures rally if it happens while protecting against a futures’ sell-off. For that right, a producer forgoes the premium to store and any cash rally.
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Some farmers might be quick to note delayed price programs, or storage at the elevator, which allows potential futures upside as well as cash appreciation if it should occur. While this is true, the basis risk being faced by many commercial elevators has forced them to ratchet up storage charges, hitting $0.08/bu. per month, with minimum charges of $0.20 if they offer soybean storage at all. If a trade deal gets done around Christmas and futures rally, the producers’ beans would need to overcome a $0.24/bu. hole from the storage. The deficit could be larger if cash continues to weaken through harvest.
The minimum price contract only needs to recoup the price of the call option.
A third choice, which tries to combine benefits from the aforementioned contracts, would be an over-the-counter (OTC) contract offered by several commercial grain elevators. It has various names, but the premise is a guaranteed floor price on a set number of bushels. The price is established by pricing a small portion of bushels each day throughout the life of the contract to provide an average, which gives either the guaranteed floor price or better, wherever the market settles each day.
This contract accomplishes several things:
- It allows the producer to sell the carry as they would with a futures contract, or an HTA with a delivery slot at some established date in the future. The contract averages each day from its inception until delivery.
- It allows the producer to participate in a rally should one occur by pricing bushels at either the guaranteed floor contract if price falls below that level, or the market if it happens to be above the floor contract.
- It allows the producer to take advantage of a basis rally should one occur as the contract is only pricing in futures until the basis is established.
The drawback to an OTC contract is the fee for establishing it, which often costs more than an exchange-traded put option at a similar strike price.
As with any hybrid or OTC contract, the producer must understand the parameters and obligations completely before entering into the agreement. Of all OTC contracts on the market, this guaranteed floor contract is probably the most vanilla and contains few if any surprises.
To recap, the soybean market is offering some of the largest carrying charges in history because of our depressed export market. These carries are telling producers to store their soybeans until the market wants them. However, these lucrative carries are only earned if they are locked in by way of futures contracts, hedge-to-arrives or some sort of OTC contract. All producers are hoping for a trade resolution and an eventual board rally. A minimum price contract allows the producer to lock in a guaranteed floor price and participate in any prospective rally, but board carries and basis appreciation will not be captured. OTC contracts do a nice job of combining several of these contracts but often carry a heavy cost for the security and upside potential they provide.
Commercial storage will be expensive and fleeting and may not be the best place for bushels that cannot be stored on farm.
No single contract is a silver bullet in this environment, but standing on the sidelines with no plan is not an acceptable alternative. Talk with your local grain merchandiser or marketing specialist about your options and put a plan together. 2018 has been a turbulent year, and we have every reason to believe 2019 will be more of the same.
Tregg Cronin can be reached at firstname.lastname@example.org
Follow Tregg Cronin on Twitter @5thWave_tcronin