Advance Trading Inc Merchandising Seminar The Warehouse Industry
How does the marketplace assure the consumer an adequate supply of grain all year? Consumption January-December October Production How does the marketplace reward participants for assuring an adequate supply of grain all year?
The warehousing industry acts as the reservoir of grain for the marketplace... Storing grain in periods of excess supply and releasing grain during periods of demand. The marketplace reflects these supply/demand imbalances through adjustments in the basis, spreads, and price. SELL Strong Basis Inverted Spreads Higher Price Lower Freight MOVEMENT Store Weak Basis Carry Spreads Lower Price High Freight
Fundamentals of Merchandising 1. The role of the country elevator in the grain pipeline is to act as the reservoir of grain 2. We do what the market tells us to. When the market needs grain we sell, and when it doesn t we store. 3. The function of the marketplace is to insure an adequate supply of grain throughout the crop year. 4. Basis and futures spreads are the primary method the market uses to move grain from where it is produced to where it is consumed.
Mechanics of Hedging By definition, hedging is Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related futures contract. In a true hedge, the moving piece is considered the Basis Basis is the difference between the futures price and the flat price Futures Cash Basis March Corn Farmer Bid $4.00 $3.75 -$0.25 Few things to remember about Basis: Basis direction is referred to as stronger or weaker- avoid higher or lower Basis reference is made to underlying futures month- for example vs the March or May
How do Elevators profit in Grain marketing Profitability is not determined by flat price predictions In general, warehousemen do not care about the grain price True hedgers in the grain business are considered basis traders
At its core, a futures contract IS a sales contract. By hedging or selling a futures contract on the exchange, you are selling 5,000 bushels delivered the Illinois Waterway Delivery System Very few contracts are finalized via this route, but it is the starting point for merchandising Merchandising/Hedging is the process of determining which market is a better cash sale...the local market or the futures market? We then need to determine what constitutes a good sale or purchase in deliverable space!
Basis- where do we start? Futures are just one part of the real price of grain Basis is in essence the premium or discount for grain based on supply and demand as well as transportation Logical- corn should be valued higher in areas of high demand- ie Hereford versus South Dakota We need a starting point for basis, then we can build off that value Remember that a futures contract is really a sales/purchase contract The delivery point for a futures contract is Chicago-so we start there
Illinois Waterway Delivery System Underlying Instrument: (no changes to current quality differentials) Primary Delivery Point: Locational Differentials: Delivery Instrument: Premium to Futures for FOB water or rail conveyance Premium Charge: (previously referred to as storage charge) #1 YC + 1.5 c/bu #1 YS + 6 c/bu #2 Y CORN par #2 Y SOYBEANS par #3 YC -1.5 c/bu #2 YS w/ 3% fm -6 c/bu Illinois Waterway from Chicago, IL (including Burns Harbor, IN) to Pekin, IL. for Corn & to St. Louis for Soybeans. Corn & Soybeans Soybeans Only Chicago at par Havana-Grafton @ 3.5 c/bu Lockport-Seneca at 2 cents Alton-St. Louis at 6 cents Ottawa-Chillicothe at 2.5 cents Peoria-Pekin at 3 cents Shipping certificate only CORN SOYBEANS 6 cents/bu 6 cents/bu $0.049 cents/month on River $0.00165 cents/day
Cost of Freight + Load out = DVE
Buying futures= buying physical corn delivered to Chicago, IL at option price (board price) $0.06 load out fee (by contract rule, defined) Premiums for locations south (less cost of freight) #2 corn delivered at par, discounts apply for off grade quality. As a buyer/seller of corn- this is a gauge for what values you can buy/sell corn. Option Chicago, then cost of freight from their to final destination (by rail, truck, river, ocean)
Todays Bids are Chicago Corn +12 December March Delivery +6 March I m guaranteed corn at option price Chicago plus a 6 cent load-out...which means you owe me corn in this barge at +6 over the December.. But you don t understand...it will cost me +12 over the December to get you your corn!...my only choices are to find the corn or BUY back my futures...that s what I better do!
The Long Sure I ll let you out...when I get the grain you owe me! The truth is I won t let you out until I see enough grain move to cover all my nearby needs. March Futures Spreads Narrow The Out of Position Short Please let me out of my short December Futures
In VERY basic format, spreads help the commercial elevator determine when to move grain into the cash market. Spreads allow us to quantify a return on our space (storage)- when there is carry in the market. Full carry - calculation is storage cost plus interest. There are many factors that must be calculated as well before moving grain- Cost of freight Futures Spreads Space/time/money: Do you have space to hold grain, time ( vs. next crop year, harvest, inverse), and money to maintain hedges as well as interest of cash ownership Opportunity cost moving one commodity and storing another
Full Carry Definition: Full Carry Lets look at the December 2013/March 2014 spread. 5 cent/month storage * 3 months= 15 cents. Interest rate of 2.24%= 3/4 cents per month. So full carry is around 17 1/2 cents. We look at the % of full carry to determine whether the return to carry the corn is worth more than selling today. The Dec/Mar spread is currently at 70% of full carry- the decision is does that return justify a necessary return on space.
Basis & Spreads In general, spreads and basis work together to tell the market whether movement of grain is needed today- or if it will pay carry for the grain to be moved at a later time. Example: Inverted spreads (nearby month at a premium to deferred)- generally means basis is strong nearby as well (above DVE). This tells us that the market wants physical movement of grain today vs. tomorrow. Carry (nearby month discounted to deferred)- basis weaker today- market doesn t need movement (often around harvest when grain naturally moves into the marketplace) and it will pay more at a later time
Agricultural Spreads Unlike flat price, spreads offer a predictive response to market conditions- Art vs Science or both? Spreads are not necessarily stand-alone instruments, they are used in conjunction with cash positions. Spreads minimize the cash exposure Future and options spreads are key tools to be part of any risk managers tool box 18
Common Spreads Bull spread Spread that buys the front month and sells the deferred month. For example Buy December 14 Corn and Selling March 15 Corn This would be buying the spread. This is also considered a substitute-purchase. Why? A firming spread is reflective of higher basis. Bear Spread Spread that sells the front month and buys the deferred month. For example Sell December 14 Corn and buy March 15 Corn. This would be selling the spread. This is also considered a substitute-sale. Why? A weaker spread is reflective of weaker basis.
How Much Risk do we have with a Bull-Spread?
Bull-spread risk is limited to Full Carry Outside of very unique and rare situations, futures spreads will not trade beyond full carry. Why? Because if the spread return is greater than paying the storage and interest to hold the grain, anybody with available cash would buy the nearby futures, accept delivery, pay the storage and redeliver vs the next futures month at a premium to the cost.
How Much Risk do we have with a Bear-Spread?
Bear-spread risk is unlimited Full extent of the bear-spread is defined by the limits of futures inverse (premium of the nearby month to the deferred month) and that is unlimited. In unique scenarios of very tight supplies, the only cash origination available could be the delivery market, and if the short (sell side) needs to exit the position, the long (buy side) can force the spread relationship to move to extreme levels.
X/H Bean Inverse- Unlimited Risk
Freight is a major driver in basis and spreads
Barge Freight Matters!
Final 2014 Storage Space Situation: Change from last year Updated Space Analysis for 2014 012615:/SPACE/.ppt. USDA 2014 U.S. forecasted prod ( Bbu )/yield (bpa) Corn: 14.216 (171.0) +116 - +173 +154 +110 +130 +180 +23 +130 +230-5 +9 +73 +62-137 +102 +181 +68 +107 +2-20 +36 --31 100-2 -57-90 +22 +71-345 +160-99 +199-138 - 422-244 -364-72 - 3 +23 +63-49 -49-405 +143-64 +67-304 - 5 +72-22 +55 +338 +102 +90-53 +109 +418 +95-243 - 127 +57 +194 +106-3 - 124-115 +131-41 +327 +114 commercial +321 +114 +148-33 +314 +40 +47 +116 +104 +287 +93 +229 Soybean: 3.969 (47.8) * Number in each state represents the change in storage space surplus or deficit in million bushels compared to the previous year. A positive number indicates a more surplus space situation while a negative number indicates a tighter situation. ppt Updated January 26 +9 +15-23 +94-22 0 +24-29 - 80 +4-62 +7 +211 +89-59 +27 +30 This This will will influence transportation logistics & spreads. It s time to take a closer look look at at these issues before I m faced with some difficult decisions at harvest this this fall. fall.
Country Elevators are like big funnels Holding and metering out grain that is harvested once a year as the market demands
My Options When a Producer Sells Grain 1. Sell to an end user immediately Back-to-Back Fixed handling margin Very Limited Risk / Very Limited Reward 2. Sell a CBOT futures contract Hedging Fixed handling margin Expecting the basis will improve between this harvest and the next harvest
When to Hedge? Basis is weak Harvest Spreads are wide offering carry Will Hedging Work?? Futures and Cash must converge Convergence occurs at Delivery Value Equivalent every delivery month DVE becomes our Basis Target
Where to sell the hedged Grain?
Where to sell the hedged Grain? Discounts Fee Structures Logistics Ability to pay for grain Relationships