| October 19, 2007 | Archived Issues |
Selling When You Don't Want To Sell
Grain prices remain favorable. Corn basis has improved dramatically in southeast Missouri, but for most locations in Missouri corn and soybean basis remains weak (wide negative spread between cash and futures prices). But, in spite of weak basis, soybean cash bids are near the top or above the USDA's projected 2007-08 range of farm prices from $7.85 to $8.85. With the exception of northwest Missouri, corn prices at many locations are in the mid to upper one-half of USDA's forecast corn price range of $2.90 to $3.50. These cash prices are the result of soybean futures prices that are at levels achieved less than three percent of the time during the past twenty years. Corn futures prices, while well off earlier highs, are at levels reached less than ten percent of the time.
Most believe that price outlook is optimistic. World corn supplies are tight, domestic soybean carryover is expected to drop dramatically, domestic demand is strong and export opportunities are good. These and a number of other factors represent reasons to be optimistic about prices. But there are also risks. US corn carryover that is expected to approach two billion bushels, slower growth of ethanol production and a good South American soybean crop, which would reduce worries about US supplies, are among a number of other factors that suggest considerable downside risk at current lofty price levels. Successful marketing depends upon balancing higher price expectations against the downside price risks and being prepared to make sales when the market price objectives are achieved.
Overall, it has been a good year for crop producers. Grain prices began rising more than one year ago. Last year's crop that had been stored was sold at good prices. Those with good, or at least better than expected, 2007 production have delivered (or will deliver) grain at historically high harvest time prices. Much of the balance of new crop production is in (or is going into) storage. With significantly higher than normal returns, farmers using cash accounting for income tax reporting may not want to sell any more grain this year. But this may not be a good marketing strategy.
It is always better to base marketing plans on market signals and pricing objectives rather than tax management objectives. There is a valid argument that, if additional cash sales are not offset with pre-paid expenses or other deductions, the net effect of added income taxes can represent a significant discount to the net price received. But avoiding or delaying sales and income tax may lead to marketing and storage losses if pricing opportunities are passed up. The objective in storing grain should be to capture basis gain and market carry or higher price levels. Once these objectives are accomplished, holding grain becomes more risky. Spot sales may result in more income tax, but other sales methods can be used to capture market opportunities. The choice of selling methods depends upon market signals and the risks associated with the marketing tools used.
The most common method of capturing favorable prices, while delaying delivery and cash receipts, is to simply forward contract for cash delivery in the New Year. The objective is to also capture basis gains that have occurred and futures market carry along with locking-in a favorable price. Unlike pre-harvest forward contract sales, with stored grain, production risks and deliverable quantity is no longer a major concern. The major disadvantage, especially where basis remains weak, is that additional basis gains (an important storage objective) cannot be captured.
A hedge-to-arrive or no basis established contract, if offered by the buyer, may offer a better cash market choice when basis is weak. Grain for delivery in the New Year is priced on a futures price, which captures market carry and protects favorable price levels. But, since basis is not established, basis or cash price gains can be set later or at the time of delivery. If basis has improved, additional storage returns will be captured and the net cash price will be higher than could be obtained with a forward contract. The disadvantage is that delivery is obligated to the buyer and, when delivery is made, other buyers may be offering a better basis opportunity. Although the very weak basis at some locations suggests it is unlikely, there is also the risk that basis will get weaker instead of improving.
Selling a futures contract (or hedging with futures) allows locking-in a favorable price that captures market carry without a delivery obligation to a specific grain buyer. This separates setting a price level from cash merchandising of the grain and allows eventual cash sales and delivery to made at the location offering the best cash price at the time of delivery. The disadvantage is the dreaded margin calls or performance bond. If the futures price goes up, additional funds will be needed to provide a margin in the futures account. In volatile markets, this can become a significant cash drain. However, unless basis weakens further, futures market losses will eventually be offset by cash market gains. When using a futures hedge, it is important to understand how it works and do it correctly along with being prepared for cash flow needs if prices move against the futures position.
Put options can be used to protect a favorable price level and, like futures, the eventual cash sale can be made at the location offering the best cash price. The advantage to using a put option is that it offers the right to sell futures (hedge), but no obligation to do so if prices increase. Options eliminate the risk of margin calls and even allow selling at higher futures prices if prices move higher. The disadvantage is the option premium or the cost of purchasing the option. For example, a March 2008 at-the-money corn put (an option with the right to sell at or very near the current March 2008 futures price) would cost nearly twenty-five cents per bushel and a March soybean at-the money put would have a premium of more than sixty-cents. This reduces the net price by the amount of the option premium. Market advisors and commodity brokers sometimes recommend using one or more of a variety of option spread strategies to reduce the net cost of option price protection. This is done by buying the desired put option price protection and then selling an out-of-the money option. The premium from the option sold offsets the cost of the purchased option and results in a lower net cost. However, these strategies limit the amount of protection or opportunity for additional gains. It is also very important to understand how the strategy works and the risks involved, including the potential for margin calls that accompany some of these strategies.
Not wanting to sell should not be a part of business or marketing plans! Not making any additional cash sales will avoid tax consequences, but "locking the bin doors and not making any sales until the New Year is not likely to be a good strategy. Current futures prices offer historically high prices and basis is improving in some areas. Additional marketing opportunities may come and go before the year ends. It is important to be prepared to make sales. A variety of sales methods can be used to meet marketing objectives. None of the previously mentioned examples of alternative sales methods are perfect or fit every situation. But neither does making spot cash sales only. Volatile futures prices and wide swings in basis can make separating the establishing of price levels (futures price) and merchandising the cash grain (protecting basis or making cash sales) important in order to accomplish market goals. Volatile markets also requires taking advantage of pricing opportunities whenever they occur, which has everything to do with risk management and very little to do with tax management.