Basis for Grains. Why is basis predictable?

Transcription

1 Basis for Grains Why is basis predictable? Average basis levels (expectations) are determined by transportation and storage costs associated with the commodity. Variations in basis levels (outcomes) are influenced by short-run economic factors. Explain average basis levels... (A) Transportation Costs ex) Hard red winter wheat The major area of U.S. Hard Red Winter wheat production is KS, OK, and CO. Major consumers of HRW wheat are the population centers of the world. AREC 412 Lec F Grain Basis & Yield Risk 1

2 Regional wheat trade... Refer to the PowerPoint slides... The lines denote rail, water, and road routes. The cents figures are costs. The dollar figures are prices. We first need to identify excess supply and excess demand regions. Wheat is grown in the Great Plains and consumed in the population centers of the world. Thus, wheat needs to move from excess supply to excess demand regions. Moving grain is a marketing service and that service must cover economic costs. Start with the Rotterdam price this is a world price. Suppose it is $6.50/bu. The economic costs of moving wheat from US ports to Rotterdam is 100 /bu economic costs are not just accounting costs because normal profits must be included. Profits are required to attract capital to an industry. So what is the US port price? If it is higher than $5.50 then no wheat will be moved and this will cause the price to be bid lower. If it is lower than $5.50 then pure profits will be earned by shippers and this will cause the price to be bid up. So $5.50 is just right. Make the same argument back down the rail, barge, or truck line... Then pick a location and evaluate the basis in the delivery month AREC 412 Lec F Grain Basis & Yield Risk 2

3 (B) Storage Costs ex) Hard red winter wheat Grain elevators must cover the cost of providing storage services. 1) Fixed costs ( /bu.) shrink (1% x $5.00/bu.) 5 depreciation ½ profit and handling ½ Total Fixed Costs 6 /bu. 2) Variable costs ( /bu./mo.) insurance, electricity, chemicals ¼ interest costs (opportunity) $5.00 x (9% / 12 mo.) 3¾ Total Variable Costs 4 /bu./mo. AREC 412 Lec F Grain Basis & Yield Risk 3

4 Refer to the pdf of costs of storage... Harvest is an excess supply period. We consume wheat across the year so postharvest periods are excess demand periods. Again, wheat needs to move from excess supply to excess demand periods. Storing grain is a marketing service and that service must cover its economic costs. Start with the harvest price. Suppose KCBOT wheat JUL contract is $5.00/bu. The economic costs of moving wheat from harvest to post-harvest periods is 6 /bu of fixed costs and 4 /bu/mo of variable costs again, economic costs are not just accounting costs but include normal profits. Profits are required to attract capital to an industry. So what is the price one month after harvest? If it is lower than $5.10 then no wheat will be stored and this will cause the price to be bid lower. If it is higher than $5.10 then pure profits will be earned by elevators and this will cause the price to be bid up. So $5.10 is just right. Make the same argument two, three, and four months after harvest... Next, look at the actual data in the remaining figures to see if the real world supports theory. For a given location, evaluate basis across the calendar months relative to the harvest month AREC 412 Lec F Grain Basis & Yield Risk 4

5 Calculating Average Returns to Storage from a Basis Table These are LR returns to storing every year used to calculate the basis. ex) Store wheat from July to November using MAR contract. Basis MAR July November So if, MAR futures in July = $5.86/bu. then the Forward Price for November cash wheat FP = = $5.28/bu. and the July cash wheat = = $5.00/bu. So marginal returns to storage from July to November MR = = $0.28/bu. Do you see the easier method to calculate MR to storage? Subtract what two numbers? AREC 412 Lec F Grain Basis & Yield Risk 5

6 So, cash markets are linked through transportation costs, futures contracts are linked through storage costs, delivery point cash market is linked to nearby futures contract price through delivery costs, thus markets are linked across space and time. This is the Law of One Price. AREC 412 Lec F Grain Basis & Yield Risk 6

7 Grain Basis Summary Prices MAR (deferred) DEC (deferred) SEP (deferred) JUL (harvest) (-) Surplus Regions Par Market (+) Deficit Regions 1) Par delivery cash markets under nearby futures by delivery costs. 2) Transportation costs surplus areas under par location (KS, OK, CO) deficit areas over par location (Gulf & River east coast & west coast) 3) Storage costs futures contracts priced to reflect storage costs basis widest at harvest and narrows reflecting storage costs AREC 412 Lec F Grain Basis & Yield Risk 7

8 Factors affecting long-run average basis levels 1) Fundamental changes in the production and consumption: Ethanol and corn... Round-Up Ready soybeans soybean rust... 2) Changes in the transportation system structure: long-run fuel costs competitive uses of the system changes on transportation technology or management entry or exit of transportation firms and facilities changes in regulations and deregulation 3) Changes in the storage system structure: long-run interest rates changes in storage technology or management entry or exit of storage firms or facilities changes in government programs AREC 412 Lec F Grain Basis & Yield Risk 8

9 Storage Hedges We are not interesting in storing grain based on LR returns. We want to know if it pays to store grain this year. If it does then we will and if it doesn t then we won t. We are exploiting variations in basis around the average levels. ex) Cost of storing wheat in a commercial elevator. Variable cost (elevator charge) $0.040/bu./mo. insurance, maintenance, portion of fixed costs, & profit Interest/Opportunity cost $0.025/bu./mo. $5.00/bu. x (10% / 12 mo.) Total Costs $0.065/bu./mo. AREC 412 Lec F Grain Basis & Yield Risk 9

10 ex) Harvest wheat in July. Evaluate a storage hedge from July to January (tax purposes) using the MAR or MAY contract. Hard Way Price Basis Forward Price MAR $5.85 Cash $5.00 MR = MC = 6.5 /bu./mo. for 6 mo. = 39 MC >=< MR? Price Basis Forward Price MAY $5.99 MR = MC >=< MR? AREC 412 Lec F Grain Basis & Yield Risk 10

11 ex) Harvest wheat in July. Evaluate a storage hedge from July to January (tax purposes) using the MAR or MAY contract. Hard Way Price Basis Forward Price MAR $ $5.30 Cash $5.00 MR = $ $5.00 = 30 MC = 6.5 /bu./mo. for 6 mo. = 39 MC > MR. Do not store grain, sell cash. Price Basis Forward Price MAY $ $5.39 MR = $ $5.00 = 39 MC = MR. Do not store grain, sell cash. AREC 412 Lec F Grain Basis & Yield Risk 11

12 Easy Way Cash $5.00/bu. MAR $5.85 MAY $5.99 Expected Basis less Current Basis Expected MR to Storage less MC of Storage MAR (-0.85) MAY (-0.99) Profit or Loss Narrow or Strong Basis: do not store, sell cash grain. AREC 412 Lec F Grain Basis & Yield Risk 12

13 ex) Evaluate a storage hedge from July to October. Cash $5.00/bu. DEC $5.98 MAR $6.12 MAY $6.01 Expected Basis less Current Basis Expected MR to Storage less MC of Storage Profit or Loss Risk Wide or Weak Basis: store and hedge grain. DEC MAR MAY Which contract is best? Don t forget the risk-return tradeoff. AREC 412 Lec F Grain Basis & Yield Risk 13

14 ex) Evaluate a storage hedge from July to October. Cash $5.00/bu. DEC $5.98 MAR $6.12 MAY $6.01 DEC MAR MAY Expected Basis less Current Basis (-0.98) (-1.12) (-1.01) Expected MR to Storage less MC of Storage Profit or Loss Risk Wide or Weak Basis: store and hedge grain. Which contract is best? Don t forget the risk-return tradeoff. AREC 412 Lec F Grain Basis & Yield Risk 14

15 Store grain or not? Examine: MC of storage versus MR of storage. Continue storing grain or sell out of storage? Examine: MC of continued storage versus MR of continued storage. Are fixed costs important? Planning on storing grain from July to October. Hedge with DEC and expected profit 18.5 /bu. Expected basis in October Suppose basis in September (Cash - DEC futures in September) is -0.65? Sell now or keep grain one more month until October? AREC 412 Lec F Grain Basis & Yield Risk 15

16 Store grain or not? Examine: MC of storage versus MR of storage. Continue storing grain or sell out of storage? Examine: MC of continued storage versus MR of continued storage. Are fixed costs important? Planning on storing grain from July to October. Hedge with DEC and expected profit 18.5 /bu. Expected basis in October Suppose basis in September (Cash - DEC futures in September) is -0.65? Sell now or keep grain one more month until October? Sell now! MC > MR of continued storage. MC = 6.5 > MR = 5 = [-0.60 (-0.65)] AREC 412 Lec F Grain Basis & Yield Risk 16

17 What are the causes of weak basis? Large crops Quick harvest (good weather) Shortage of rail cars or barges Light government program participation Little on-farm storage Tax-related marketings Producers need cash What are the causes of strong basis? Small crops Slow harvest (poor weather) Well-functioning transportation system Heavy government program participation Much on-farm storage Tax-related holdings Prospects of higher prices in the future However, very tough to see in the HRW wheat price data since 2006 AREC 412 Lec F Grain Basis & Yield Risk 17

18 Yield Risk ex) Corn grower in Nebraska with 1000 acres and 200 bu./ac. typical yields. Rising prices Date Cash Futures Basis 4/15 FP = = 3.95 DEC $4.25/bu. Sell 40 contracts expected 11/15 Sell cash $4.70/bu. DEC $5.00/bu. Buy 40 contracts actual Net Price = Cash Price + Gain or Loss in Futures $3.95/bu. = But the T-Account is missing something AREC 412 Lec F Grain Basis & Yield Risk 18

19 Suppose the drought reduced yields to 150 bu./ac. Calculate returns and net price on 150,000 bushels. Cash receipts = $ ,000 = $705,000 Futures receipts = -$ ,000 = -$150,000 Total receipts = $555,000 Net Price = $555,000 / 150,000 bu. = $3.70/bu. < FP This is yield risk. Yield risk is present when future marketings are 1) uncertain and 2) the uncertainty is negatively correlated with changes in futures contract prices. AREC 412 Lec F Grain Basis & Yield Risk 19

20 Falling prices Date Cash Futures Basis 4/15 FP = = 3.95 DEC $4.25/bu. Sell 40 contracts expected 11/15 Sell cash $3.20/bu. DEC $3.50/bu. Buy 40 contracts actual Net Price = Cash Price + Gain or Loss in Futures $3.95/bu. = Again, too simple AREC 412 Lec F Grain Basis & Yield Risk 20

21 Suppose the good weather increased yields to 225 bu./ac. Calculate returns and net price on 225,000 bushels. Cash receipts = $ ,000 = $720,000 Futures receipts = +$ ,000 = $150,000 Total receipts = $870,000 Net Price = $870,000 / 225,000 bu. = $3.87/bu. < FP It s the yield uncertainty and the negative correlation between yields/quantities and price changes that causes NP < FP. AREC 412 Lec F Grain Basis & Yield Risk 21

22 Yield Risk Summary Yield Prices Revenue Bad weather below avg. yields Good weather above avg. yields cash futures cash futures cash & futures NP < FP cash & futures NP < FP Yield risk is not like basis risk. Basis risk sometimes helps and sometimes hurts. Yield risk always hurts. One case is worse than the other... But partly due to the numbers used. Also, what is happening to the $/bu. break-even costs under the two scenarios? (Production costs are usually per acre, incurred at planting, and then the yield per acre is changing.) We also zeroed out basis risk. What would the basis outcomes likely be in the two examples? Because you are going to have both in the real world. AREC 412 Lec F Grain Basis & Yield Risk 22

23 How does a hedger manage yield risk? 1. Establish partial price protection when production is unknown. Execute scaleup hedges. ⅓, ⅓, ⅓ Rule. ⅓ before planting, ⅓ between planting and when production is well known, and ⅓ between when production is well known and harvest. 2. Crop Insurance. 3. Crop yield futures contracts. (Which are written but are not traded.) AREC 412 Lec F Grain Basis & Yield Risk 23

24 How do you figure out exactly how much to hedge when there s yield risk? Revenue = P X + X f ( P fs - P fb ) = Cash Revenue + Futures Gain/Loss where P = Cash Price $/bu. X = Cash Yield bu./ac. P fs = Futures Sell Price P fb = Futures Buy Price X f * = ρ μ p ( σ x / σ p ) + μ x ρ = Corr(P,X) X f * = Optimal Hedge bu./ac. For wheat in Colorado: (-0.25) (4.50) (6.0 / 0.75) + 35 = (-9.0) + 35 = 26 bu./ac. or hedge (26 bu / 35 bu = ) 74% of expected crop. The negative correlation between price and yield is a natural hedge. What about wheat in Kansas or corn in Iowa? (ρ?) What about corn in Colorado? What about farm yields versus state yields? (σ x?) What about livestock? AREC 412 Lec F Grain Basis & Yield Risk 24