Pre-Harvest Sales-Risk or Opportunity?

USDA's May 12 Crop Reports provided the first of the monthly supply and demand projections for the 2003-04 crops. Using trend yields, they are projecting a record corn crop of 10.060 billion bushels- slightly larger than 1994's 10.051 billion bushels. Trend line soybean yields project the 2nd largest soybean crop of 2.855 billion bushels, somewhat less than 2001's 2.891 billion bushels. While demand projections for both crops are relatively large, ending- stocks will increase-a situation that is expected to result in lower prices. How does this information impact decision-making for new crop corn and soybean sales strategies? A good place to start is USDA's projected average prices.

The U.S. average corn price for the 2003 crop is estimated to range from $1.90 to $2.30 with a mid-point average price of $2.10. While planting delays, other production problems or stronger than expected demand could change these estimates, they are the "best current information" for market planning. December 2003 (new crop) corn futures have traded near $2.50, which should produce cash prices at many locations in the upper one-half or above USDA's projected price range. Several market analysts have targeted prices in this area for new crop sales, but what is the best way to do this?

Futures hedges or cash contracts for harvest delivery (forward contracts) are two methods of making pre-harvest sales. Both methods "lock-in" a price. The futures contract offers some flexibility in that it can be lifted (offset), if the market situation changes and delivery obligations can be avoided if production is reduced. However, it carries a margin requirement and liquidating the contract in mid-season could produce a loss. The cash contract carries production risk, due to the delivery requirement, but does not require margin money deposits or offsetting transactions. The cash contract also captures basis (difference between cash and futures price), which the futures hedge cannot. Capturing basis can sometimes be the deciding factor between a futures hedge and a cash contract.

In recent years, with large production, harvest time basis has been very weak (wide cash/futures price spread). Old crop (2002) corn prices reflect a strong basis (narrow or positive cash/futures price spread), but this may not be the case with the 2003 crop if record production occurs. Currently, new crop cash corn bids vary considerably across the northern two-thirds of Missouri, from lows near $1.90 in northwest and north central to highs of about $2.35 near the Mississippi River in the northeast. The lower bids in northwest and north central reflect a weak basis. Producers in these areas, desiring to make new crop sales, may want to consider futures hedges or hedge-to-arrive-cash contracts since basis appears to discourage delivery sales. In contrast, bids in central and northeast MO reflect a somewhat more normal basis and producers in these areas may want to consider locking in the basis with cash delivery contracts.

What about using put options to protect prices? There are concerns that planting delays or other factors may push prices sharply higher. In fact, these concerns are contributing to the current price strength. Buying a $2.50 (strike price) December corn put option would provide the right to sell (hedge) December corn futures at $2.50, potentially "locking-in" a price in the upper portion of USDA's projected price range if prices decline. If prices increase, the cash corn could be sold at a higher price with no obligation on the option. The disadvantage is the option premium (cost)-about twenty-cents (more or less) at current prices for a $2.50 put option. This effectively reduces the net price for corn by the amount of the option premium and possibly producing a net price in the lower one-half of USDA's price range.

Another alternative is to purchase call options to offset cash contracts or futures hedges. However, purchasing a $2.50 call options also requires a premium cost of more than twenty-cents, producing net prices similar to the put strategy. One method of reducing premium cost and still providing some pricing flexibility is to purchase out-of-the-money call options to offset hedges or contract sales. For example $2.90 December corn call option premiums are about nine-cents. This would reduce the net price by only nine cents, possibly keeping the hedged price in the upper end of the projected price range. If production problems send prices sharply higher, the call option would capture price gains above $2.90. Another strategy to reduce premium cost would be to use September corn options. These option premiums have less time value, which makes them somewhat lower cost, however they would not provide frost damage price protection if a significant portion of the nation's crop is planted late.

USDA's projected average price range of new crop soybeans is $4.45 to $5.45 with a mid-point of $4.90. While old crop (2002) prices are much higher because of very tight supplies, these prices reflect the impact of the projected increase in new crop supplies and carryover. Recently, November 2003 (new crop) soybeans have traded near $5.70. This suggests cash prices near the top of USDA's projected range-this may be a pricing opportunity and some market analysts are beginning to recommend sales.

Missouri new crop cash soybean bids are producing basis patterns similar to those for corn. Central and northeast Missouri basis strength appears equal, or better, than most years' harvest time basis. Northwest and north central bids suggest a weaker basis, similar to those of recent large crop years. Capturing average or stronger basis with cash contracts, while avoiding cash contracts and using other strategies in weak basis areas may be desirable strategies.

Soybean options tend to be expensive. For example, $5.60 November soybean put options are about thirty-three cents (5-15-2003). Options provide for effective price risk management in a potentially volatile price environment, but the higher cost of soybean option premiums and their impact on net price should be recognized. Using out-of-the-money calls, as a lower cost alternative to offset hedges or cash contracts, requires giving up significant price potential in order to get a "cheap" option.

USDA's estimated corn and soybean prices suggest the potential for LDP (loan deficiency payments) and CCP (counter cyclical payments) at harvest time. If this occurs, early season sales in the upper portion of the expected price range would be "enhanced" with a LDP. For example, if pre-harvest sales are made near $5.45 and prices decline to $4.45, then collecting a $0.55 LDP ($5.00 loan price minus $4.45 equals $0.55 LDP) produces a net price of $6.00 ($5.45 pre-harvest sale plus $0.55 LDP). This net price, along with a CCP, could produce acceptable revenue from the pre-harvest sales.

A variety of marketing research has shown that, over time, pre- harvest sales tend to average higher returns than harvest sales or storing grain. To manage production and price risk, it is important that pre-harvest marketing plans remain flexible. Using options and other market tools such as minimum price cash contracts or strategies to spread out sales provide flexibility in uncertain and volatile markets. Each strategy has shortcomings and timing of sales or "pulling the trigger" is always a difficult decision. Some advisors may recommend other strategies that require complicated futures/options transactions, which must be understood. The "new generation" or managed sales cash contracts also provide methods of managing risk associated with pre-harvest sales. What ever strategy is chosen, past history for the success of early pre-harvest sales suggests current market action may be offering opportunities- especially when considering USDA's first supply and demand projections for 2003-04 corn and soybeans.