MGEX Agricultural Index Futures and Options 07 Crop Outlook and Int l Durum Forum Minot, ND 1 Thank you very much for having me here. I would like to acquaint you with a new set of risk management tools. They are financially settled agricultural index futures and options contracts developed in cooperation with DTN. Before we start, I would like to take a look at a couple of definitions. I will be making reference to the term basis. Basis is your local cash price less some futures price, most often it is associated with physically delivered contracts, say CBOT corn. This is how your local elevator will quote your cash price. Your local basis may be, say 45 under and be based on the CBOT corn contract. I will be referring to basis in my talk and will compare and contrast the basis as it relates to these new contracts to the traditional delivery contract s. Convergence is the tendency for a futures contract and its underlying cash component tending to be equal as the contract expires. The better the convergence, the more effective the hedge should be. Cash settlement is a term which I will refer to shortly. As with any futures contract, you start out the day with a dollar balance, the contract trades and closes to a price. Your account is then marked to market. In other words, your beginning daily balance is subtracted from the closing price and your account is increased or decreased by that amount. This works the same way with our new agricultural Index contracts. However, instead of going through a messy physical delivery process at expiration, the index contracts expire to a national spot price at the end of the month and open positions are marked against this price and are cash settled. Therefore, it allows producers to remain involved with the contract until it expires if it is desirable to do so. The monthly cash settlement is like a final mark to market to the average of the last three day s spot price. 1
MGEX Agricultural Index Futures and Options Five agricultural indexes futures and options Financially settled to DTN spot indexes Guaranteed convergence with the cash market at expiration Trades in all calendar months 2 2 2 There are five financially settled Agricultural index products (corn, beans and 3 wheats) that trade all 12 months and expire (last trade day) on the last business day of the month rather than trade to only the middle of one of 5 delivery months like traditional agricultural contracts. DTN calculates the spot index values on a daily basis and these values are what the futures contracts will cash settle against. In other words, there are no deliveries and positions can be held to the end of the month and then cash settled to the calculated spot index values. Or they may be traded out of prior to settlement, as with any contract. Since the contracts financially settle to a spot value, it will remove the disconnect that is often seen between futures and cash prices in the current marketplace and will, as a result, guarantee convergence and make your hedges work as predicted. Since they trade all 12 months, they allow for greater flexibility in hedge timing and better options pricing, in that you can better time your risk management needs to the applicable month in which it is needed. Also, since they trade all 12 months, there is an opportunity to save on option premiums since you may be able to purchase an Oct or Nov option versus a Dec option and save on the extra time value. 2
Today s Environment Today s Evolving Risk Management Challenges 3 There are unique challenges in each of the segments of the agriculture market. Now we d like to delve into the specific challenges facing producers, originators, and merchandisers. 3
Risk Management Challenges Producers High margin requirements High option premiums Limited risk management alternatives 4 Many of you here today are on the producer side of the agricultural market and recognize there are unique and additional risks you must manage. Producers face the additional challenges of high margin requirements, high option premiums, and limited alternatives. 4
Risk Management Challenges Grain Originators (Ethanol, Feedlots, Etc) Basis volatility Managing slippage High options premiums 5 Moving now to grain originators and end users such as ethanol plants and feed lots. The risks are in different areas such as the lack of basis stability and the need to closely manage your slippage by timing the placement of your hedges with your physical purchases. Options are expensive in the traditional market, given equal volatility. 5
Risk Management Challenges Merchandisers Unprecedented market/basis volatility Historical patterns between cash and futures markets have been lost. Lack of convergence 6 Let s take a look at the merchandisers concerns. Due to the large influx of capital from nontraditional investment money into the agricultural markets, tight global stocks and the usual crop concerns, the markets have reached unprecedented levels of volatility. Further, due to this perfect storm occurring in the agricultural sector, predicting basis moves has become challenging. Since historical basis patterns have been lost, it is making it difficult to place traditional hedges. Rather, merchandisers are forced to try and time their hedges which can lead to slippage concerns which can effect their returns. Also, these factors have lead to a general lack of convergence in the agricultural markets and there has been a rather large disconnect, at times, between futures and cash prices. Even if the merchandiser can accurately time his hedge, it often results in less than anticipated returns due to the lack of convergence in these markets. 6
Index Advantages Lower basis volatility Guaranteed convergence Trading in all months. 7 Lets talk high level advantages of the Index products for all groups: The index products will provide a more traditionally stable basis, overall. The reason is that it is based upon a national average spot price versus delivery to a single location. I will be showing a graph shortly which shows this. Again, since the contracts financially settle to this national average spot price for corn, wheat or beans, you will have guaranteed convergence to a spot value, thereby removing the disconnect between futures and cash, Again, in a moment, I ll display this in graphical form. Finally, trading in all months leads to advantages from a timing perspective when it comes to placing your hedges and can also lead to option premium savings due to timing. 7
Better Hedge and Lower Basis Volatility - Corn Corn Basis Levels, North Central Iowa, 2003-2007 0-10 NCI Cents per Bushel. -20-30 -40 CBOT -50-60 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Month NCI CBOT Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 8 This is a chart of the NCI corn basis in relationship to the CBOT corn basis in North Central Iowa. Overall, it becomes clear that the NCI basis holds many of the traditional patterns that groups are used to seeing, while also allowing for less basis volatility over time. 8
Better Hedge and Lower Basis Volatility - Wheat N.E. Montana HRS Wheat Basis, 2005-2007 40 Cents per Bushel. 20 0-20 -40-60 -80 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Month MGEX Spring Wheat Sep-06 Nov-06 Jan-07 Mar-07 HRSI Futures May-07 Jul-07 Sep-07 Nov-07 9 Another example of these historical patterns and basis volatility for HRS in N.E. Montana. The same pattern and case will repeat itself regardless of the location. 9
Convergence comparison September 2007 Corn Contract Convergence Cents per Bushel. 10 0-10 -20-30 -40-50 -60-70 8/1 8/8 8/15 8/22 8/29 Date CBOT NCI 9/5 NCI CBOT 9/12 10 Now lets take a look at the issue of convergence: Here you see a graphical depiction of the September convergence patterns for NCI versus CBOT futures and cash. The purple line depicts the difference between the NCI Spot (cash average) index value and September futures prices. The blue line depicts the difference between Chicago, Illinois river elevator cash prices and Chicago September futures. What is interesting to point out here are two things: 1. I have talked about the lower basis volatility in the index products. This chart easily depicts the more volatile Sept basis (difference in cash versus futures) in CBOT corn versus the NCI contract, 2. As I have mentioned before, there is guaranteed convergence. You can see how the NCI contract continues to move towards convergence over time and converges to within less than a 4 cents at expiration. However, when you look at the CBOT contract you can see how, as expiration approaches, it actually moves away from convergence and widens out to approximately 58 cents. 10
Producer Advantages Lower margin requirements Lower options premiums Better timed hedge 11 Now lets talk a few specifics for each of our groups: For the producer: Due to lower basis volatility, margins are not set quite as high. (CBOT Corn Maintenance Margin $1,000, MGEX NCI $900). The lower basis volatility and availability to trade all 12 months may lead to option premium savings. Further, by purchasing the necessary coverage when needed and having a better timed hedge, Oct and Nov (Index) versus Dec (traditional) options, the producer will save on option premiums by not needing to purchase excess time value. 11
Index Examples Producer Pricing Early Planted Corn in Central Illinois, 2005 Crop ( sell at planting, exit at harvest) Date Action Dec. 05 CBOT Sep. 05 NCI April 29, 2005 Enter Hedge, Sell Futures @ 230.75 201.25 Sep 30, 2005 Exit Hedge, Buy Futures @ 205.50 159.00 Gain/Loss 25.25 42.25 Hedged price with CBOT= 192.75 Hedged price with NCI= 209.75 Increase in price using NCI= 17.00 12 Now, lets take a look at an example. Let s say producer who is in Central Illinois, planting in April and expecting 1000 acres, plans to market his grain at the END of September. Therefore, his choices are to use the CBOT Dec or NCI Sep contract. Why can the producer use the NCI September contract? Because, unlike traditional agricultural contracts which cease trading the middle of the month, the Index products trade through to the end of the month! At the end of April, the producer sells December CBOT futures at $2.30 and ¾ cents per bushel and lifts their hedge on September 30 th at a price of $2.05 and ½ cents yielding a gain of 25 and ¼ cents. With the NCI contract, the producer sells the September futures at $ 2.01 and ¼ cents per bushel and lifts the hedge on September 30 th at $ 1.59 even with a gain of 42 and ¼ cents per bushel. The hedged price with the CBOT contract is $ 1.92 and ¾ cents per bushel. The hedged price with the NCI is $ 2.09 and ¾ cents per bushel. The increase in price using the NCI contract is 17 cents per bushel. Remember, the indexes trade in all 12 months and are cash settled. Users can limit their market exposure by remaining in positions to the end of the months and more accurately time their hedges. 12
End User Advantages More stable basis Lower options premiums Better timed hedge Guaranteed convergence 13 Basis stability will provide the end user a better hedge resulting in better estimation of costs. Index contracts allows end users to protect input costs by using options at a lower initial expense, thereby the potential for premium savings. All 12 months are traded allowing end users to more closely match purchasing horizons with hedges. Since they are financially settled to a spot price, convergence is guaranteed. 13
Index Examples End-User Hedging Example (Hedging 1st Quarter 2006 Usage, North Central Iowa) Date Action March 06 CBOT Dec. 05 NCI Local Cash Sep. 30, 2005 Enter Hedge, Buy Futures @ 216.00 177.75 Dec 28, 2005 Exit Hedge, Sell Futures @ 216.25 184.50 176.5 Gain/Loss 0.25 6.75 Hedged Input Price with CBOT= 176.25 Hedged Input Price with NCI= 169.75 Savings using NCI= 6.50 14 Suppose that an ethanol plant in North Central Iowa wants to lock-in pricing for the first quarter 2006 usage on September 30, 2005. They have the choice of using CBOT corn or the NCI. If using the CBOT contract, they will enter a long hedge on September 30 th and exit that hedge on December 30 th, when they procure the cash commodity. The long hedge is placed in the March CBOT corn futures at a price of $ 2.16 cents per bushel. The long hedge is lifted on December 28 th at a futures price of $ 2.16 and ¼. The gain on the hedge is 1/4 cent. Note the need to use the CBOT March contract as traditional delivery contacts only trade to the middle of the expiring month. However, using the NCI contract allows the end user to better time his or her hedge. Therefore, on September 30 th, the plant would place the hedge in the December NCI futures at a price of $ 1.77 and ¾ cents per bushel. On December 28 th, the NCI hedge is lifted at a futures price of $ 1.84 and ½ cents yielding a gain of 6 and 3/4 cents per bushel. Since all 12 months are traded and the index products are cash settled, users can more closely time their hedges and remain in positions to the end of the expiring month. Using the NCI futures lowered the ethanol plant s corn cost by 6 and 1/2 cents due to a more predictable basis than CBOT corn contract. This gives the plant a higher degree of certainty about their hedged price. 14
Merchandiser Advantages Lower basis volatility Guaranteed convergence Create synthetic basis 15 Merchandisers can expect a less volatile basis, as well. The guaranteed convergence will provide the connect lost in the traditional futures/cash relationship. Also, the indexes allow for Synthetic basis positions to be established. Long or short synthetic basis positions can be added to physical basis positions to gain desired exposure or to lock in a national synthetic basis. 15
Index Examples Long Synthetic Basis (In anticipation of strengthening basis) Date Action Dec. 05 CBOT Dec. 05 NCI Long Synthetic Basis Sep. 30, 2005 Buy NCI, Sell CBOT 205.50 181.25-24.25 Nov. 30, 2005 Sell NCI, Buy CBOT 187.50 172.50-15.00 Gain/Loss on Synthetic basis 18.00-8.75 9.25 16 One of the advantages of the index products is that they will allow a national basis position to be established by using the index products in conjunction with the traditional delivery products. This example explains how this type of transaction would be entered into. This is purely to explain how the transaction is entered in to. Lets suppose you are a merchandiser and have entered into a forward basis contract with a feed manufacturer. Now you have the basis exposure and are short the basis. By creating a synthetic long basis, you can hedge your exposure to a strengthening basis in your merchandising area. In this example you would buy the NCI contract at $ 1.81 and ¼ cents and short CBOT position at $ 2.05 and ½ cents, creating a synthetic basis of 24 ¼ cents under. On November 30 th, you would sell the NCI and buy back the CBOT contract, indicating a basis of 15 cents under. The merchandiser, using this strategy, has covered 9 ¼ cents of their basis exposure. Long or short synthetic basis positions can be added to physical basis positions to gain desired exposure by the merchandiser. 16
MGEX Agricultural Index Futures and Options 07 Crop Outlook and Int l Durum Forum Minot, ND 17 Thanks again for allowing me the time address this group. If you have further questions, you may contact me at 612-321-7151 or by e-mail at jalbrecht@mgex.com or Roger Hipwell at 612-321-7164 or by e-mail at rhipwell@mgex.com Our website is www.mgex.com and has more information on the five cash settled agricultural index contracts offered by the MGEX. 17