Informed Storage: Understanding the Risks and Opportunities

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1 Art Informed Storage: Understanding the Risks and Opportunities Randy Fortenbery School of Economic Sciences College of Agricultural, Human, and Natural Resource Sciences Washington State University

2 The objective of marketing is: NOT to make money in the futures market. NOT to sell at the highest price of the year. NOT to generate accurate price forecasts. TO minimize the risk associated with achieving a target level of income.

3 Futures Market Sends price signals to the entire system Actively used at all levels of the grain market chain EXCEPT the farm Is unique in its application of financial leverage

4 Soft Red Winter Wheat Futures

5 The Objective of Storage Earn a profit over and above storage costs. There are two ways to profit from storage: Futures prices rally and cash price follow Cash price improves even if futures don t i.e. the basis strengthens. If you are simply speculating on higher prices without the market telling you to expect better cash prices, there are often less expensive (or lower risk) ways to do that

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9 July 2018 Futures Prices for Soft Red Winter Wheat

10 July 2015 Futures Weekly Prices $4.75 $5.00 $5.25 $5.50 $5.75 $6.00 $6.25 $6.50

11 2015 July Wheat Futures Prices $5.00 $5.50 $6.00 $6.50

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14 Dice 70.00% 60.00% 50.00% Probability 40.00% 30.00% 20.00% 10.00% 0.00% Value of Rolling Two Dice

15 July 2018 Soft Red Wheat Futures

16 July Futures 70.00% 60.00% 50.00% Probability 40.00% 30.00% 20.00% 10.00% 0.00% $3.40 $3.60 $3.80 $4.00 $4.20 $4.40 $4.60 $4.80 $5.00 $5.20 $5.40 Value of Rolling Two Dice

17 What Really Matters for Storage is what Happens in the Cash Market If cash and futures prices do not move in lock step, then what happens in the futures market may not reflect your actual return on storage. Further, even if we anticipate the direction of price movement accurately, we also need to be convinced that the magnitude of movement will; cover all storage costs and risk. Fortenbery rule of thumb you need almost 5 cents per month expected return to justify risk.

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21 Basis and Price Formation Basis is the difference between a cash price at a specific location and the price of a particular futures contract. The cash price offered to a grain producer for any given marketing strategy is a function of local basis.

22 Basis Changes The lower the cash price relative to futures prices, the weaker the basis. A weak basis is good for cash buyers,and bad for cash sellers The higher the cash price is relative to futures, the stronger the basis. A strong basis is bad for cash buyers,and good for cash sellers.

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24 2012/13 Crop Year White Wheat Cash Prices $6.75 $7.00 $7.25 $7.50 $7.75 $8.00 $8.25

25 Recording Basis To record historical basis levels, collect closing futures prices for the contract closest to maturity (but not expiring in the current month) each Wednesday, and the corresponding cash price (collected later Wednesday or Thursday morning). Subtract the futures price from the cash price. Average the Wednesday basis calculations for each month to arrive at the average monthly basis level.

26 Clarkston Soft White Wheat Basis Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 2014/15 $1.38 $1.58 $1.53 $1.74 $1.66 $1.43 $0.99 $1.36 $1.56 $1.66 $1.47 $ /16 $1.07 $0.67 $0.73 $0.70 $0.62 $0.60 $0.65 $0.59 $0.56 $0.38 $0.50 $ /17 $0.65 $1.00 $0.86 $0.78 $0.67 $0.68 $0.57 $0.36 $0.38 $0.47 $0.55 $ yr Average $1.03 $1.08 $1.04 $1.07 $0.98 $0.90 $0.73 $0.77 $0.84 $0.83 $0.84 $ yr Average $0.86 $0.84 $0.80 $0.74 $0.64 $0.64 $0.61 $0.48 $0.47 $0.42 $0.52 $0.61

27 Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 3 yr Average $1.03 $1.08 $1.04 $1.07 $0.98 $0.90 $0.73 $0.77 $0.84 $0.83 $0.84 $ yr Average $0.86 $0.84 $0.80 $0.74 $0.64 $0.64 $0.61 $0.48 $0.47 $0.42 $0.52 $ /18 $0.47 $0.49 $1.00 $0.90 $1.03

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30 Clarkston Basis Forecast

31 April Forward Actual Offer for April 2018: $5.22

32 July Futures Probability 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% #3.40 $3.60 $3.80 $4.00 $4.20 $4.40 $4.60 $4.80 $5.00 $5.20 $5.40 Value of Rolling Two Dice December Cash Price: $5.12 June Basis Forecast: $ Dice: 1-2 Basis is $0.20 weaker then expected 3-4 Basis is as expected 5-6 Basis is $0.20 stronger then expected

33 Calculating the Expected Return to Storage Compare the current market price with price expectations for later months. Expectations of later cash prices are calculated using the current quote for futures contracts of different delivery dates adjusted for the expected basis in your area each month. This expectation may come from historical experience, or a more sophisticated forecast model.

34 Factors that Determine Returns to Storage Futures Market Spreads: The greater the premium between a futures price for nearby delivery and one for distant delivery, the greater the expected return to storage. In general, a spread the equates to about 5 cents per month is desired. Basis Improvement: Basis is the difference between the current cash price at a specific location, and the futures price for the contract closest to maturity (cash futures = basis). If the basis gets stronger, it means the cash price is rising relative to futures price. A strengthening basis rewards storage.

35 Futures Market Spreads The futures market spreads are reflected in the regularly quoted prices for various delivery dates. If the March contract for wheat is $4.14, and the July contract is $4.42, then the futures market is bidding 7 cents per bushel per month as a national average return to storage.

36 Basis Appreciation Basis appreciation happens when the cash price moves higher relative to the futures price. Basis levels are generally seasonal. When a local basis is abnormally weak (cash price is lower relative to futures than is normally the case) storage becomes more attractive. When a basis is abnormally strong storage becomes much more risky.

37 Potential returns to storage are maximized when the futures market exhibits a positive spread and basis is expected to strengthen. Combining the current market spread with the expected basis appreciation gives an expected return to storage.

38 Using basis information to evaluate a wheat storage position December 12, 2017 Today's cash price $ March futures price $ May futures price $ July futures price $ Expected cash prices on December 12 for delivery in 2018 Store Until: February March April May June Futures Price $ $ $ $ $ Expected Basis Expected Cash Price $ $ $ $ $ Storage Return Expected Cash Price $ $ $ $ $ minus Today's Price $ $ $ $ $ minus Storage Costs $ $ $ $ $ Total Return $ $ $ $ $ Per Month Return $ $ $ $ $

39 Using basis information to evaluate a soybean storage position December 12, 2017 Today's cash price $5.14 March futures price $4.11 May futures price $4.24 July futures price $4.37 Expected cash prices on June 21 for delivery in 2018 Store Until: February March April May June Futures Price $4.11 $4.24 $4.24 $4.37 $4.37 Expected Basis $0.90 $0.85 $0.85 $0.83 $0.81 Expected Cash Price $5.01 $5.09 $5.09 $5.20 $5.18 Storage Return Expected Cash Price $5.01 $5.09 $5.09 $5.20 $5.18 minus Today's Price $5.14 $5.14 $5.14 $5.14 $5.14 minus Storage Costs $0.06 $0.09 $0.12 $0.15 $0.18 (assume 3 cents per month) Total Return -$0.19 -$0.14 -$0.17 -$0.09 -$0.14 Per Month Return -$ $ $ $ $0.023

40 Commodity Options Market A market in which producers purchase the opportunity but not the obligation to sell or buy a commodity at a certain price anytime during a pre-specified period of time. INSURANCE

41 INSURANCE Substitution of a small but certain loss (insurance premium) for the possibility of a large uncertain loss.

42 Two Options Markets Insuring a selling price PUT OPTION Insuring a buying price CALL OPTION In both cases the underlying commodity is a futures contract, not the physical commodity

43 OPTIONS TERMS Strike Price price at which the futures contract can be bought or sold. Premium cost of the option. The buyer loses the premium regardless of whether the option is used.

44 INTRINSIC VALUE + TIME VALUE OPTION PREMIUM Plus a brokers commission of about ½ cent per bushel

45 Wheat Option Premiums: Dec 11 Delivery Futures Price Call Option Month Soft Red Winter Strike Price Premium (cost to buy) 1 March 2018 $4.14 $4.20 $0.09 May 2018 $4.27 $4.30 $0.16 July 2018 $4.42 $4.50 $0.20 September 2018 $4.51 $4.60 $0.26 1This is the cost to buy a call option for a futures contract expiring in each month. They are in cents per bushel, and each option, like each futures contact, is for 5000 bushels.

46 July Futures 70.00% 60.00% 50.00% Probability 40.00% 30.00% 20.00% 10.00% 0.00% $3.40 $3.60 $3.80 $4.00 $4.20 $4.40 $4.60 $4.80 $5.00 $5.20 $5.40 Value of Rolling Two Dice

47 July option vs. 6 months storage

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50 Summary Store for a return over storage costs, not simply to speculate on higher prices. Hold cash inventory when futures market have a strong carry, and basis is expected to strengthen. Consider locking in storage returns for at least part of your inventory. In low volatility markets where option costs match storage costs, consider replacing storage with call options if there is not a strong opportunity for additional basis strength.