A changed mindset regarding grain marketing

Despite high carry-over stock levels, prices reacted strongly on the warm and dry weather, which delayed the planting process. Some producers fixed prices at levels which were regarded as fair at the time, since these levels were  at significantly higher levels than the previous years and options were expensive. Although such a decision made sense at the time, given the available information, the reality is that many of these hedging levels are much lower than what can be utilised at present. Due to the nature of fixed price hedging, it is also difficult to do anything to improve the results of such a decision, particularly when prices increase due to the drought conditions. The reality of buying out contracts should a crop not materialise, is that it could have a huge financial implication. A proper marketing plan and alternative hedging methods would probably have put such a producer in a better position.

A marketing plan:
A good marketing plan must meet the following requirements:
1. It must protect the producer against the risk of downward price movement 
2. It must offer the producer the opportunity to share in price increases
3. It must be affordable
4. It must protect against unnecessary delivery risk and concomitant buying-out of contracts
5. Must align with the risk profile of the producer
6. Must be dynamic and adjust to new market information.

In order to be a good marketer, a producer must plan his marketing for the season, be disciplined enough to follow the plan, have good market information, be aware of his target and break-even prices and have a reasonable understanding of possible pricing alternatives.

It is also unrealistic to expect a producer to hedge around the market maximum. Hedging should rather be done above a break-even level - no hedge should realise a loss. The producer should also refrain from panicking and hedging at the bottom end of the market.

The emotional market cycle is explained in Graph 1.  Producers must take particular care not to become greedy at the top end of the market and to neglect to hedge. However, they should also not panic at the bottom end and hedge due to fear.

By drafting a marketing plan at the same time when production planning is done, the producer already has a point of departure in respect of the levels required for every type of crop, as well as a document which can assist with the discipline to follow a marketing plan. 

Options as insurance
It is often said in the market that options are too expensive and therefore not suitable as hedging instruments. It is important for producers to start making a mindshift in this regard and to regard option premiums as an input expense. Options can be regarded as an insurance premium against decreasing prices in the same manner as a premium is paid for hail and multi-risk insurance. Price insurance does not only offer protection (against decreasing prices), but also peace of mind (when prices increase or crops do not materialise).

The cost of options can be seen in perspective by not looking at a rand-per-ton cost, but rather at a rand-per-hectare budget. Should a producer with a 5 ton LAY budget to spend R500/hectare on options, 2 tons per hectare could be hedged by means of options which cost R250/ton. His costs, measured against the excpected LAY, will then be R100/ton. 

Simple example:
In the above instance of a LAY of 5 tons per hectare, a simple marketing plan could be drafted as follows:
Input costs : R8500 / ha
Profit margin : R1275 (15%)
Income required      : R9775 / ha
Price required          : R1955 / ton (5 ton LAY)
Basis                        : R250 / ton
Safex price required : R2205 / ton

The above is based on the assumption that the producer markets 2 tons/ha during planting time, 2 tons/ha after pollination and 1 ton/ha during harvest time.

The producer in the above scenario can approach marketing in various ways. One way is to work on the R100 ton option premium budgeted above. During planting time the producer buys R2 300 strike put options at R250/ton for 2 ton/ha. Because he is unsure about the further development of the season, he does not take any further hedging options. His exposure is as follows:

In the above scenario the producer's option costs are still R100/ton, measured against his LAY. He can share in increasing prices and has protection against declining prices. The biggest advantage of this type of marketing is the peace of mind that he gets - should prices increase due to poor weather expectations, this producer shares in the increase and his maximum exposure is already limited to R500/ha, already budgeted. Should prices decrease, he has already taken out price protection for 40% of his LAY.

The futures market is often made out to be a scam. As explained in previous articles, the main function of the futures market is die development and fixing of prices by various role players. By utilising the futures market with a well worked out marketing plan, a producer can position himself as one of the role players. By making use of specialist advice and participating in the market, a producer could manage to continuously market his production at profitable levels and limit risk at the same time.