Commodity Risk Through the Eyes of an Ag Lender

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1 Commodity Risk Through the Eyes of an Ag Lender Wisconsin Banker s Association April 5 th, 2017 Michael Irgang, Executive Vice President 1 Michael Irgang: Bio Michael Irgang is currently Executive Vice President/Co-owner of Global Risk Management Corp. (GRM), a Minneapolis-based commodity consulting firm. Michael began his career in the Financial Services division of Arthur Andersen & Company in 1987 before joining Bank of America in 1989 where he spent four years in Internal Audit, Economic Research and Global Trading & Distribution. In 1993, Michael began a 20-year career with McDonald s Corporation in the corporate treasury department initially working on the financial markets team. In 1997, he took over responsibility for McDonald s foreign exchange hedging program. Working with McDonald s Supply Chain, suppliers, and owner/operators, Michael provided the vision and leadership behind the growth of McDonald s commodity risk management program from a pilot initiative to a global discipline which covered a multi-billion dollar annual spend in commodity classes including livestock, agricultural, softs, dairy, energy and paper/packaging. Under Michael s leadership the commodity risk program provided McDonald s with a strategic advantage by providing competitive & predictable pricing to the McDonald s system. Michael was recognized with Treasury and Risk Management magazine s Alexander Hamilton Gold Medal Award for his accomplishments in building McDonald s commodity risk management program and was a co-recipient of the Ernst & Young Global Risk Manager of the Year. Michael holds BS degree in Commerce from DePaul University and an MBA from the University of Chicago. Michael also holds a Certified Public Accountant designation as well as a Series 3 license. 2 Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results WBA Agricultural Bankers Conference 1

2 Agenda for Today s Discussion I. Commodity Market Volatility II. Case study: Impact of commodity price volatility on farm-level cash flow (Illinois Farmer Example) III. Futures & Options 101 IV.Commodity Volatility & Loan Quality V. Benefits of a Disciplined Commodity Risk Management Program to Ag Lenders & Borrowers 3 COMMODITY MARKET VOLATILITY 4 WBA Agricultural Bankers Conference 2

3 Our New Reality low interest rates rising risk appetite speculators rising prices La Nina weather risks government intervention rising grain stocks EM demand Chinese still importing food inflation controls 5 Trump Administration rising input costs Stronger US $ What is Volatility? 6 WBA Agricultural Bankers Conference 3

4 Volatility by Asset Class Currencies Interest Rates Equity Indices Commodities 70% 60% 50% 40% 30% 20% 10% 0% 7 Commodity Market Volatility Why are commodities more volatile than other asset classes? 8 WBA Agricultural Bankers Conference 4

5 Commodity Market Volatility Mother Nature Why are commodities more volatile than other asset classes? Institutional and Speculative Investors Government Policy Liquidity Economics 101 as it pertains to inelastic demand 9 CASE STUDY: IMPACT OF COMMODITY PRICE VOLATILITY ON FARM-LEVEL CASH FLOW 10 WBA Agricultural Bankers Conference 5

6 Illinois Farmer: Impact of Volatility on Farm Cash Flow 2017/2018 Corn Crop February 15 th, 2017 Acres: 2,500 Yield/acre (F) Dec17 Corn / bu. (2/15/2017) $3.925 Direct Variable Costs / Acre * $423 Other Non-Land Costs / Acre* $242 Corn Price Volatility 32% * Department of Agricultural and Consumer Economics, University of Illinois 11 Impact of Volatility on Farm Cash Flow Base Case Acres 2,500 Yield Expected Price $ Total Revenue $1,879,094 Total Direct Var. Costs ($1,057,500) Other Non-Land Costs ($605,000) Cash Available for Debt Service (CFADS) $216,594 What impact does Corn Price Volatility have on CFADS? 12 WBA Agricultural Bankers Conference 6

7 Impact of Volatility on Farm Cash Flow Base Case + 1 SD Price Change - 1 SD Price Change Acres 2,500 2,500 2,500 Yield Expected Price $ $ $ Total Revenue $1,879,094 $2,428,012 $1,330,175 Total Direct Var. Costs ($1,057,500) ($1,057,500) ($1,057,500) Other Non-Land Costs ($605,000) ($605,000) ($605,000) CFADS $216,594 $765,512 ($332,325) 13 Impact of Volatility of Farmer Cash Flow Stochastic Modeling $216,594 Conclusion: There is a 38.9% probability CFADS will be below zero. 14 WBA Agricultural Bankers Conference 7

8 RISK MANAGEMENT TOOLS: FUTURES & OPTIONS Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results Futures Definition: A standardized, transferable, exchange-traded contractual agreement to buy or sell a particular commodity, bond, currency, or stock index, at a specified price and quantity, on a specified future date. Food companies typically use futures to hedge market risk in wheat, corn, soybean products, cocoa, dairy, energy, and foreign exchange. 16 WBA Agricultural Bankers Conference 8

9 Basics 17 Chicago Corn Futures Contract Specifications Contract Size: 5,000 bushels Deliverable Grades: Through December 2018: #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium, #3 Yellow at a 1.5 cent/bushel discount; As of March 2019: #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium, #3 Yellow at a discount between 2 and 4 cents/bushel depending on broken corn and foreign material and damage grade factors. Price Quote: Cents/bushel Contract Months: Dec, Mar, May, Jul, Sep Last Trading Day: The business day prior to the 15th calendar day of the contract month. Last Delivery Day: Second business day following the last trading day of the delivery month. Trading Hours: Electronic: 7:00 p.m. 7:45 a.m. and 8:30 a.m. 1:15 p.m. Central Time, Sun.-Fri. (As of May 15 th ). Open Auction: 8:30 a.m. - 1:15 p.m. Central Time, Mon-Fri. Trading in expiring contracts closes at noon on the last trading day. Daily Price Limit: ($0.25) per bushel ($1,250/contract) above or below the previous day's settlement price. No limit in the spot month (limits are lifted beginning on First Position Day). Ticker Symbol: C Initial & Maintenance Margin Initial Margin: The initial amount that must be deposited in your margin account to participate in a futures contract (long or short) Maintenance Margin: The minimum amount of equity that must be maintained in a margin account If the amount of equity in the margin account falls below the maintenance margin level, a margin call is issued to bring the amount in the account back up to the initial margin level Initial & Maintenance margin are the same for hedgers Margin levels usually reflect the historical volatility of futures prices Margin levels will change from time to time as volatility changes to reflect the risk on an open position. Margins will also change in the event of a limit move Failure to meet a margin call could result in the event of liquidation of the positions in your account 18 WBA Agricultural Bankers Conference 9

10 Basics Open Interest Definition: The number of open futures contracts outstanding at a particular moment. i.e. the number of contracts that have not been canceled by a offsetting trade Open interest is the total number of contracts held by both buyers and sellers When a buyer and seller of a contract enter into a new trade, open interest increases by 1. The more open interest in a market, the easier it is to execute a trade 19 Futures Symbol Delivery Months (2017) Calendar Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Grains H17 K17 N17 U17 Z17 Energy F17 G17 H17 J17 K17 M17 N17 Q17 U17 V17 X17 Z17 Oilseeds F17 H17 K17 N17 Q17 U17 X17 December 2017 Chicago Corn CZ17 December 2017 Natural Gas NGZ17 November 2017 Soybeans SX17 20 WBA Agricultural Bankers Conference 10

11 Futures Contract First Notice Day Dates Calendar Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Grains 2/29 4/29 6/30 8/31 11/30 Natural Gas 12/30 / 2015 Oilseeds 12/31 / /28 2/26 3/30 4/28 5/27 6/29 7/28 8/30 9/28 10/28 11/29 2/29 4/29 6/30 7/29 8/31 10/31 First Notice Day The day after which someone who has purchased a futures contract may be required to take physical delivery of the contract's underlying commodity. 21 Delivery Mechanics Shorts who maintain their positions after the last trading day are obligated to deliver the actual commodity against the contract. Similarly, longs who maintain their positions after the last trading day must accept delivery. In the commodity markets, the number of open long contracts is always equal to the number of open short contracts. Most traders have no intention of making or accepting delivery and hence offset their positions before the last trading day. It has been estimated that fewer than 3 percent of open contracts actually result in delivery. A Complete Guide to the Futures Market by Jack D. Schwager 22 WBA Agricultural Bankers Conference 11

12 Futures Strip CBOT Corn Futures Strip March 2 nd, 2017 Source: Reuters 23 Exchange-Traded Futures: Benefits Provides for the transfer of risk from one party to an exchange Liquidity Counterparty Credit Risk Easy to Use 24 WBA Agricultural Bankers Conference 12

13 Options on Futures Call Option - Gives the buyer the right, but not the obligation, to assume a Long Futures contract. Put Option - Gives the buyer the right, but not the obligation, to assume a Short Futures contract. Options = Insurance Cash Flow Considerations Futures & Options Premiums - Paid or Received - Debits & Credits Margin Deposits - Initial & Maintenance Limited vs. Unlimited Access to Open Trade Gains WBA Agricultural Bankers Conference 13

14 Cash Flow Matrix Futures and Options Instrument Limited Unlimited Premium rec d Futures initial and maintenance margin Premium paid Access to trade gains Yes - excess of margin req. Long Call premium paid at time of execution used to offset futures margins Short Call margin req. if market above strike at time of execution used to offset futures margins Long Put premium paid at time of execution used to offset futures margins Short Put Margin req. if market below strike at time of execution used to offset futures margins 27 Illinois Farmer: Options Contract Long / Short * Buy / Sell Quantity - in number of Contracts Futures Delivery Month Strike Price Futures Market Put or Call Premium - in $/cents per unit Buy 96 (~478,750 / 5K) Dec 2017 $3.95 Corn Puts $.22/bu. Language to execute WBA Agricultural Bankers Conference 14

15 Option Premium Components December $3.95 $0.22/bu. December Corn Futures = $3.925/bu. Premium = Intrinsic + Time Value $0.22 = $ $0.195 Intrinsic value is the in-the-money portion of the option's premium. 29 Corn Put Option Example: Illinois Farmer For 22 /bu., our farmer has the right, but not the obligation, to sell corn at $3.95/bu. 30 WBA Agricultural Bankers Conference 15

16 Corn Put Option Example: Illinois Farmer 31 COMMODITY VOLATILITY AND LOAN QUALITY 32 WBA Agricultural Bankers Conference 16

17 Goals of Farmers vs Ag Lenders How can Commodity Risk Management Bridge the Goals of Farmers and Ag Lenders? Maximize Cash Flow Loan Repayment 33 Ag Lending & the Credit Review Process What questions come up during the credit review process regarding a farmer s grain marketing practices? What level of understanding do lenders and credit officers alike have on best practices in managing grain price risks? Is there a requirement that a farmer have a disciplined program in place to reduce grain price volatility? 34 WBA Agricultural Bankers Conference 17

18 Illinois Farmer: Cash Flow Conclusion: There is a 38.9% probability cash flow available for debt service will be below zero. $216, Illinois Farmer: 50% Short Futures Coverage Probability of CFADS below $0 falls to 22.1% Standard Deviation falls from $550.6K to $275.3K Maximum iteration falls from $4.0 Million to $2.1 Million $216, WBA Agricultural Bankers Conference 18

19 Illinois Farmer: 75% Short Futures Coverage Probability of a CFADS below $0 falls to 2.2% Standard Deviation falls from $550.6K to $137.6K Maximum iteration falls from $4 Million to $1.2 Million $216, HOW CAN GRM HELP: BENEFITS FROM A DISCIPLINED COMMODITY RISK MANAGEMENT PROGRAM 38 WBA Agricultural Bankers Conference 19

20 Corn: Ending Stocks Two consecutive years of record yields in the USA. Continued expansion of acres in South America Increased competition from other feed inputs US exports have become less competitive on the global market 39 Corn Balance Sheet: Sensitivity Analysis What If? (Trend -5% ) What If? (Trend) What if? (Record) (Millions) 17/18 17/18 17/18 Planted Acres Harvested Acres Yield (bu./acre.) (Million Bushels) Carryin 2,320 2,320 2,320 Production 12,828 13,728 14,457 Total Supply 15,198 16,098 16,827 Exports 2,225 2,225 2,225 Feed Use 5,550 5,550 5,550 Ethanol 5,400 5,400 5,400 Food/Ind/Seed 1,445 1,445 1,445 Total Use 14,620 14,620 14,620 Ending Stocks 578 1,478 2,207 % Stocks/Use 4.0% 10.1% 15.1% Bullish Supportive Bearish Current % ES/U 15.9% 15.9% 15.9% Production Change vs % -9.3% -4.5% 40 WBA Agricultural Bankers Conference 20

21 Corn Seasonal: Bull Years vs. Bear Years 100% Corn Seasonal: Nearby Monthly Average vs. Previous Dec ( ) Bear Years Range Bear Years Bulls Years Range Bull Years 2017 Percent Change from Prior December 80% 60% 40% 20% 0% -20% -40% -60% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 41 What is the definition of high & low prices for Corn? 42 WBA Agricultural Bankers Conference 21

22 At Global Risk Management we are: Focused on commodity risk of our clients for the past 20 years Skilled staff of 6 professionals with over 150 years of collective commodity purchasing and risk management experience McDonald s, Pillsbury, Kellogg s, General Mills, Bunge, CHS Inc., Mission Foods, Stotler and Co., Bank of America, Andersen Consulting Broad range of U.S. and International clients from Farm to Fork Farmers Processing Packaged foods Food Service Distributors Quick Service Restaurants 43 A Simple Philosophy Our approach at GRM is simple and influences all that we do: disciplined risk management protocols, strategies, and tactics for sourcing raw materials will lead to sound business operations and competitive cost structures. 44 WBA Agricultural Bankers Conference 22

23 GRM: Farmer Solutions GRM will offer a grain merchandising program directly to the farmer base for soybeans, corn and wheat Program will provide guidance on the optimal timing of forward sales for the grains covered in the program GRM s guidance will include objective fundamental analysis and disciplined strategies to optimize farmer cash flow GRM would assume no transactional responsibility for this program 45 Contact Information Chris Morley Ph: cmorley@grmcorp.com Michael Irgang Ph: mirgang@grmcorp.com Brian Harris Ph: bharris@grmcorp.com Global Risk Management, Inc Broadway St. NE, Suite 110 Minneapolis, MN Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results WBA Agricultural Bankers Conference 23

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