Managing the risk of price falls
GroundCover™ Issue: 20
Watching a downward spiral in grain prices can be a hugely depressing spectacle, but many farmers are now taking steps to ensure that the downward spiral does not end in a fatal crash.
The graph below from a recent survey by the Australian Bureau of Agricultural and Resource Economics (ABARE) highlights the dramatic fall in the second half of 1996 during the course of a growing season.
The ABARE survey, supported by growers through the GRDC, found that 52 per cent of grain farms used pooling and averaging schemes provided by marketing boards, cooperatives and other marketing agents.
Next most popular was forward selling, used by 25 per cent of growers either before sowing or at some stage during the growing season to lock in a price for their harvest.
A minority of grain farmers, around 16 per cent, indicated they had no price risk management plan.
Futures and options
Only four per cent of farmers said they used futures to help offset losses from falls in the price of grain.
The Kondinin Group's Bryce Banfield says futures can be very effective in reducing risks brought about by price falls. But he cautions growers that they should only use futures in this way in respect of grain which they actually expect to produce or already have on hand.
Futures have a number of advantages over customised forward contracts. They offer far greater flexibility because growers call adjust their position as their needs change, they are not obliged to deliver the physical grain, they are working on prices that are publicly available and they have a guarantee that their contract will be fulfilled.
Australian farmers have a choice between the relatively new Sydney Futures Exchange (SFE) wheat contract or US based Chicago wheat futures. Whilst using Sydney futures contracts avoids exchange rate problems and the possibility of Australian and US wheat prices getting out of kilter, Chicago futures are easier to 'get into' and 'get out of' because of greater liquidity. Usually Australian futures would be expected to more accurately reflect Australian wheat prices.
Although futures contracts have the advantage oflocking in a fixed price, as in a forward contract, they do not allow growers to take advantage of a rise in price and can cause cash flow problems for growers if they become liable to calls to 'top up' the sums they have originally deposited to enter the market.
Because futures can have these disadvantages, Mr Banfield believes that the best way for growers to use the futures market is to buy options.
Price insuranceBy paying a premium fee, a grower can buy an option which gives him the right - but not the obligation - to buy or sell the futures contract he needs at a designated ' insured' price. It is easiest to think of options as being price 'insurance'.
Options offer tremendous advantages and flexibility for Australian grain growers. In return for a known, once-only premium payment they can put in place a minimum price but still allow growers to profit from any subsequent price rises. They can provide self financed price insurance similar to the Reserve Price Scheme operated by the wool industry until 1991.
Assuming your grain is identical to the grain specified in the Sydney Futures Exchange futures contract, here is how options could work for you.
In a falling market ...
In April a wheatgrower sees that SFE January wheat futures are trading at $220. Fearing that the price of wheat might fall, the grower decides to buy a $220 option to sell a futures contract, for which he pays a premium of $J5/t. In December the January wheat futures price has fallen to $180/t. The growers sells wheat for $180/t and simultaneously sells the $220 option for $40/t.
Cash price received for wheat in December ................................. $180
Gain on $220/t option (sold for $40 less cost$15) ............................... $25
Net return ................................... $205/t
In a rising market...
A wheatgrower takes the same action as described above, but in December, the January wheat futures price, instead of falling, has risen to $260/t. The grower sells wheat for $260/t and as the $220/t option for the right to sell no longer has any value, the grower lets it lapse.
Cash price received for wheat in December ........ ....................... $260/t
Less the cost of the lapsed option .. $15
Net return ................................... $245/t
The options which figure in our examples are known as 'put' options, but 'call' options also have their uses. Your adviser or broker can help decide which you need.
The Australian wheat contract is specified to relate closely to wheat as well as other feed grains like barley and sorghum so the Sydney Futures Exchange wheat futures and options contracts can be used to protect prices for a whole range of feed grains as well.
Adapted from the Kondinin Group's ProFarmer Marketing Manual.
Contact: Mr Bryce Banfield 08 9478 3343
Try the Sydney Futures Exchange, Gram Hinrichsen, on 1800641 588 for afree wheat futures information pack.