How do you weather volatile commodity prices? By managing your risk and protecting your profit margins with futures and hedging. These tools have never been more popular!
A good Corn Belt crop, a politician’s inflammatory remark about free trade, a new virus going around or a long drought can lead to yo-yoing profits for grain producers, fluctuating pork prices or the dollar to go off the rails. So how do you deal with volatile commodity prices? To protect your profit margins and make sure you’re not at the mercy of the local market, you should become familiar with market risk management, hedging, futures and other derivatives. You can use the futures market to protect against price fluctuations by setting prices and quantities yourself.
Know your costs
Simon Brière is a market strategist at the Montreal office of R.J. O’Brien & Associates Canada, a brokerage firm that has a referral agreement with Desjardins. It’s his job to trade on the Chicago Mercantile Exchange. Before buying or selling futures, he says you need to know the basics: namely your costs so you can develop a better strategy. “When you know how much it costs to produce one ton of corn, you know what price you’ll start to make a profit at. If not, you’ll always be unhappy, either when you sell and the price keeps going up or, when you sell and see that you had the chance to sell even more at that price!”
If you can reduce your financial losses by buying and selling positions in the commodities market (corn, soy, wheat, canola, pork, veal, steer), can you also make money on the market? “Financial derivatives like futures don’t just allow you to even out the highs and lows, but also to seize opportunities. You can make a profit, even after brokerage fees have been paid,” says Brière, who’s careful not to confuse hedging with speculation.
Unlike speculators who are willing to assume risk, hedgers use futures to avoid risk. How many agricultural producers, grain farmers and speculators are there in the market? Brière say speculators are 20% at most. “While speculation can distort prices, speculators don’t have enough power to affect supply and demand in the real economy. They’re mostly motivated by profit and aren’t able to influence that dynamic long term. And ultimately, they’re not able to outsmart Mother Nature, which always has the final say in farming!”
Benoit Marcoux, Manager with Foreign Exchange, Derivatives and Network Support at Desjardins, also warns that futures contracts aren’t casinos. “The businesses that are most at risk are often those who don’t know how to manage their risk with derivatives,” he likes to say. Derivatives aren’t used like investments; they’re tools that are part of a risk management strategy with measurable objectives. The idea isn’t to passively sell your crop or cattle at a discount, but to play an active role to limit losses or benefit from price increases. The goal is to maximize return while limiting risk.
Knowing costs and prices is important. There are many apps and websites you can use to track real-time quotes and understand the various risks. The price has three components:
- Price on the exchange market (Chicago Mercantile Exchange)
- Exchange rate
- Basis (difference between the local cash price and the futures market price for a commodity). It reflects local supply and demand for a commodity at a particular place, including transportation costs
Because the basis reflects the actual market, it also corresponds to the proportion of risk that can be covered with derivatives.
How much of your production should you hedge?
“As with any good portfolio, a marketing plan should spread the risk, so it’s not 0 or 100% of production,” says Brière. “If you’re new to the derivatives market, go slowly, but steadily, and hedge more and more of your production every year.” However, Brière advises against hedging more than 50%. Obviously, every business will be different, depending on their storage capacity. Some will want to spread income over the year, while others can accept huge cash inflows over short periods. Farms that are in a growth phase, have a lot of debt or have successors will want to manage their risk more carefully, because falling prices can jeopardize their profitability.
What percentage of farmers use hedging?
If it’s 100% of grain centres, it would be between 50 and 60% of grain farmers. Between 5 and 10% of those would even have enough volume and use their own brokerage account to buy and sell futures, says Brière. To participate in this market, you have to produce and trade a minimum of 5,000 bushels of corn (the equivalent of 127 tons). In practice, though, you need at least six times that much, he says.
Why does hedging seem so complicated? “You don’t have to understand all the market mechanics to implement a hedging strategy,” says Marcoux. “Once you know how much you expect to trade and the price (or rate) you can make a decent margin at, you can set a timeline and start with some simple strategies. But the key to confident trading is getting the right support.” Brière adds, “We expect farmers to understand accounting, agronomy, veterinary medicine, banking—they shouldn’t have to know all about the stock market, too! Good managers surround themselves with experts; that definitely includes a broker who can make trades or offer advice.”