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The Cost of Not Knowing How a Hedge Works

Even If You Never Use Futures, This Is Just One Reason Why You Need to Understand Futures and Hedging

Joe had attended a seed dealer’s field day in the early fall of ’92 at which I gave a 30-minute summary of the market outlook for corn and beans. In 1992, the Corn Belt had benefitted from an El Nino summer. El Nino causes above normal moisture with cool temperatures, and the usual result is record corn yields. Such was the case in 1992. The biggest threat to a farmer’s corn crop in an El Nino year is getting the crop planted during the wet cool spring.

After my field day presentation, the crowd moved on to the soybean plot. But Joe patiently waited a few minutes while I talked to another farmer who then followed the crowd. Joe stepped forward and said he was afraid that he had contracted too much corn. The wet spring hindered his planting; his fields had wet spots, etc.

At about 55 years of age, Joe had been a full-time farmer all his life. He no longer raised hogs but still fed about 50 head of fat cattle. His crops consisted of a little mixed hay and wheat and 400 acres or so of corn and the same in beans. Like most farmers who used to feed all their corn and grow hay and wheat instead of beans, he knew next to nothing about marketing grain. He was very low key and a hard worker. His word was more binding than any contract ever written.

I asked him about how many bushels of corn was he going to be short, and he said maybe 5000, probably a little less.

I was thinking to myself this was really no problem. Obviously, Joe had contracted corn before the planting season, which must have been a traumatic expansion of his comfort zone. I knew he was not the kind of guy who would run the chance of contracting too much corn after a wet spring. And obviously, his contract price had to be in the $2.70+ area because that was where December corn was before planting that year. Given December corn was now in the $2.15 area and the basis was most certainly weaker now than when Joe forward contracted, his problem really was no problem.

I asked if his contract was an HTA of forward contract. He asked me what an HTA was.

I asked Joe what was the basis when he did his forward contract. He confessed he did not know what basis was.

I asked him if he knew the price on his forward contract; I was confident he would know that.

Joe said the contract price was $2.61 for fall delivery. I asked him which elevator, and he told me. It was a co-op with which I was familiar.

I told him he had nothing to worry about: go harvest his corn and deliver what he had to find out if he was actually short on bushels. I said, “There is a chance your corn will do better than you think!”

Joe muttered, “I don’t think so.” I was quite sure he was correct. Joe was that kind of a farmer.

Joe said, “I have been losing a lot of sleep over this for more than three months. I have never broken a contract yet, but I am really worried about this corn contract.”

I told him he was not the first farmer to have over-contracted corn. I said, “You are in good shape because the price of corn is more than 70 cents lower than your contracted price. The futures price is down about 60 cents from where it was when you contracted, and the basis is at least ten cents weaker. The elevator will be glad you cannot deliver because they will replace your corn with someone else’s corn at a weaker basis, and they should write you a check for the profit in their hedge minus maybe a 5-10 cent cancellation fee at the worst.”

The expression on Joe’s face told me I might as well have been speaking Chinese.

I said, “Joe, here is my card. Call me after you find out how many bushels you are short and I will talk you through it. I want you to understand the math on these contracts before you tell the elevator you are short on bushels.”

Joe asked, “Do I need to sign-up for your consulting service first?”

I said, “Not at all, Joe. This is an opportunity for me earn your business by showing you how I can save you money, help you through this pickle of a situation, and provide you a level of comfort. Go home, get a good night’s sleep, and call me when you are done harvesting corn. Joe, really, this is not a problem.”

The expression on his face was, “Easy for you to say!”

I had not heard from Joe by the second week of November, so I called him early one morning. Yes, he had finished corn about two weeks ago, but he had not asked the elevator how many more bushels remained on his contract.

I asked him, “Why not?”

“I am afraid they will ask me when I am going to bring them the rest of the corn on the contract, and I will have to tell them I have no more corn.”

I said, “Joe, this is like getting a sore wisdom tooth pulled. Every day it causes you pain and keeps you awake at night. The fact you put off getting it pulled does not make the pulling process less painful. It only adds to your daily stress in the meantime. Furthermore, the longer you wait, the more likely the price of corn is to go higher - that is not good for this particular situation. Call the elevator, Joe!”

I waited a week, but no call from Joe. December corn futures was getting close to the delivery period, which would only make Joe’s situation more complicated. I called him and was surprised (actually astounded) by how happy he sounded!

“Roger, you were right! This was no problem at all! It only took me about 20 minutes to get settled-up, and they were not at all upset I could not deliver the corn. Just like you said!”

I told Joe, “Tell me how they did the math.” I was annoyed Joe had not let me explain this to him before he had settled. I was afraid he would be screwed, at least a little bit. The elevator had a hedge profit, and I wanted to know how much they let Joe have.

The short futures position to hedge the forward contract would have been established at about $2.76 and liquidated about $2.12 for a profit in the futures market of about 64 cents. The basis was at least ten cents weaker. I would not expect the elevator to pay him that, but it was 10 cents in their pocket because Joe had over-contracted.

Joe said, “I have the settlement sheet right here someplace. Let’s see, oh here it is! OK. My contracted price was $2.61, and the day I settled they were paying $1.78. They charged me a 15-cent-a bushel-cancellation fee. The total came to $3,842.58.”

My heart jumped into my throat. This was going to be very good, or very, very bad.

“Joe, how many bushels were you short?”

“Let me look. It was 3,921.24 bushels.” This was going to be bad, very bad.

I asked Joe, “Did the elevator write you a check for $3842, or did you write them a check for $3,842?”

“Why, I wrote the check, of course! I was the one who breached the contract. I can’t tell you how happy I am to get this behind me!”

The math:

The elevator made about $2,510 on the hedge (sold 3,921 bushels at $2.76 and bought the same number of bushels at $2.12).

Joe had to pay $2,510 to “cover that amount” to the elevator. The elevator doubled their money on the decline in futures. How? They made $2,510 in the futures by selling high and buying low, and then Joe paid them another $2,510.

The basis had widened about 19 cents from when the contract was written to cancellation day.

Joe had to pay $745.04 for the weakening of the basis. The elevator doubled their money on the weaker basis. Not only were they able to buy corn to replace Joe’s 3,921.24 bushels with about a 19-cents-weaker basis than his contract had been, they made him pay the same!

And to add insult to injury, they charged him a 15-cent-a-bushel cancellation fee of $588.19 (15 cents on 3,921.24 bushels)!

They should have written Joe a check for $2,314. That would be the futures profit of $2,510 minus a 5-cent-per-bushel cancellation fee ($196). They would still have in their pocket the 19-cent-($745)-negative basis change!

Joe had fixated on his fear of breach of contract. He did not hear a thing I had said. Worse yet, he did not want to understand anything I said.

Consequently, the elevator made $6,353 on the 3,921.24 bushels Joe could not deliver. If Joe had delivered the corn, the elevator would have made 20 cents a bushel at the most ($784) and would have had to handle it at least twice, while suffering shrink and damage loss.

If Joe had understood how a hedge in the futures market worked, he would not have given away many thousands of dollars. This is just another reason why you need to understand how the futures market works to maximize your cash grain marketing expertise.

What should Joe have done?

Joe should have started negotiation knowing the merchandiser had a profit in the hedge for the corn Joe did not deliver.

Secondly, Joe should have made the merchandiser aware he knew there was a profit in the futures hedge and the basis on his forward contract was much firmer than the current basis.

Thirdly, Joe offered to let the merchandiser keep the profit on the basis hedge if he would write a check to Joe for the futures profit, to which most merchandisers my clients use would agree. These merchandisers instead counter-offer with a five-cent charge for the service fee and write a check to Joe for the futures hedge profit less 5 cents.

Fourthly, if the merchandiser would not settle for a cash buyout, ask the merchandiser to roll the delivery obligation to the next crop year at a reasonable fee (2 to 4 cents).

Fifthly, Joe could have had his neighbor, who was delivering out of the field anyway, deliver the bushels on Joe's contract and pay the neighbor a ten-cent premium for doing so.

It was important to resolve this problem as soon as one knew the problem existed in order to have all possible resolutions on the table. Once harvest was over, it would be much more expensive to get a neighbor to deliver corn out of his bin during the fall delivery period,

Joe should have recognized there was a lot more to grain marketing than just delivery and that he was not qualified to negotiate a settlement. I thought his lack of knowledge is why he asked me what he should do before harvest began.

People must realize about 70% of all contracts ever written for all business deals are changed before the completion of the contract by mutual consent, as a result of negotiation.

And they didn’t even send Joe a “Thank You” card...

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