Hedging in 2014 Wisconsin Crop Management Conference & Agri-Industry Showcase 01/16/2014 Fred Seamon Senior Director CME Group
Disclaimer Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All references to options refer to options on futures. Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)12 of the Commodity Exchange Act. Swaps are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. Any research views expressed are those of the individual author and do not necessarily represent the views of the CME Group or its affiliates. CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Globex and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. NYMEX, New York Mercantile Exchange and ClearPort are registered trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. KCBOT, KCBT and Kansas City Board of Trade are trademarks of The Board of Trade of Kansas City, Missouri, Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official Exchange rules. Current rules should be consulted in all cases concerning contract specifications. Copyright 2013 CME Group. All rights reserved. 2
CHANGE A transformation or modification (Source: Dictionary.com) Change has a considerable psychological impact on the human mind. To the fearful it is threatening because it means that things may get worse. To the hopeful it is encouraging because things may get better. To the confident it is inspiring because the challenge exists to make things better. -- King Whitney, Jr. Nothing endures but change. -- Heraclitus, from Diogenes Laertius, Lives of Eminent Philosophers! (540 BC - 480 BC) 3
CHANGE A transformation or modification (Source: Dictionary.com) Image From Consumerwarningnetwork.com Image From Apple.com 4
CHANGE A transformation or modification (Source: Dictionary.com) Image from swatek.com Image from fueladditivebenefits.com Image from newcarsinfo.com Image from JohnDeere.com 5
CHANGE A transformation or modification (Source: Dictionary.com) 6
Outline - Change in Market Size & Liquidity - Change in Market Venue Where We Trade - Change in Market Make-up Who Trades - Change in Price Discovery Contract Performance - Change Additional Hedging Tools - What Does It Mean For A Hedger In 2014 7
Market Size & Liquidity
Corn and Wheat Futures Volume Growth 9
Soy Complex Futures Volume Growth 10
Grain and Oilseed Futures Open Interest Growth Corn, Soybean, and Wheat Open Interest 3.5 Corn Soybeans Wheat 3.0 2.5 Millions of Contracts 2.0 1.5 1.0 0.5 0.0 Jan-85 Aug-85 Mar-86 Oct-86 May-87 Dec-87 Jul-88 Feb-89 Sep-89 Apr-90 Nov-90 Jun-91 Jan-92 Aug-92 Mar-93 Oct-93 May-94 Dec-94 Jul-95 Feb-96 Sep-96 Apr-97 Nov-97 Jun-98 Jan-99 Aug-99 Mar-00 Oct-00 May-01 Dec-01 Jul-02 Feb-03 Sep-03 Apr-04 Nov-04 Jun-05 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09 Feb-10 Sep-10 Apr-11 Nov-11 Jun-12 Jan-13 Aug-13 11
Grain and Oilseed Options Volume Growth 12
Market Venue
Corn and Wheat Futures Electronic Trading Growth 14
Soybean Complex Futures Electronic Trading Growth 15
Corn and Wheat Options Electronic Trading Growth 16
Soybean Complex Options Electronic Trading Growth 17
Market Make-up
Speculators are Necessary Liquidity is, in effect, the hostess gift that speculators bring to every market party, and without the capital poured into energy markets by institutional investors, prices may well be far higher and more volatile than they are. -- Philip K. Verleger Owner and President of PKVerleger LLC 19
Speculators are Necessary The warehousemen are large scale operators who have skill and money. Only the professional speculators are equipped to oppose them; the effective competition in the storage market is provided by the large scale speculators. -- Tom Hieronymus Professor Emeritus, The Office for Futures and Options Research, The University of Illinois 20
Market Make-Up - Corn 60% Percentage of Open Interest by Category Corn 3.0 50% 2.5 40% 2.0 Percentage 30% 20% 1.5 1.0 Open Interest in Millions 10% 0.5 0% 0.0 Non-Reportable Non-Commercial Commercial Index OI 21
Market Make-Up - Wheat 60% Percentage of Open Interest by Category CBOT Wheat 800 50% 700 600 Percentage 40% 30% 20% 10% 500 400 300 200 100 Open Interest in Thousands Non-Reportable Non-Commercial Commercial Index OI 0% 0 22
Market Make-Up - Soybeans 60% Percentage of Open Interest by Category Soybeans 1.4 50% 1.2 Percentage 40% 30% 20% 1.0 0.8 0.6 0.4 Open Interest in Millions 10% 0.2 0% Non-Reportable Non-Commercial Commercial Index OI 0.0 23
Index Fund Net Long Positions Have Remained Steady in Corn Futures Market Index Net Long (Short) Positions as % of OI 60% Corn Nearby Price Cents per Bushel 900 Though index fund positions as a percentage of open interest remained constant at around 20% over the last five years, prices increased 48%. Index Net Long Positions 50% 40% 30% 20% 10% 800 700 600 500 400 300 200 100 Cents per Bushel Source: www.cftc.gov 0% Jan-09 Index Net Long Positions as % of Open Interest Nearby Corn Settlements 0 Dec-13 24
Index Fund Net Long Positions Have Remained Steady in Wheat Futures Market Index Net Long (Short) Positions as % of OI 70% Wheat Nearby Price Cents per Bushel 1400 Though index fund positions as a percentage of open interest remained steady over the last four years, prices have been consolidating for most of this time period. index Net Long Positions 60% 50% 40% 30% 20% 10% 1200 1000 800 600 400 200 Cents per Bushel Source: www.cftc.gov 0% Jan-09 Index Net Long Positions as % of Open Interest Nearby Wheat Settlements 0 Dec-13 25
Index Fund Net Long Positions Have Declined in Soybean Futures Market Index Net Long (Short) Positions as % of OI Soybeans Nearby Price Cents per Bushel 60% 2000 Index fund positions as a percentage of open interest has declined over the last four years while prices increased. Index Net Long Positions 50% 40% 30% 20% 10% 1800 1600 1400 1200 1000 800 600 400 200 Cents per Bushel Source: www.cftc.gov 0% Jan-09 Index Net Long Positions as % of Open Interest Nearby Soybean Settlements 0 Dec-13 26
CME Group Most attractive, valuable, diverse franchise in exchange sector Combination of unique assets provide competitive advantages - Balanced portfolio of diverse and benchmark products - Industry-leading trading platform, flexible architecture - World-class clearing, risk management expertise Additional growth opportunities - Early stages of globalization - Over-the-counter (OTC) and exchange-traded markets converging - Non-transaction based businesses Strong financial characteristics - Significant operating leverage - Unique variable dividend philosophy supplementing regular dividend - $1.2B in dividends paid in 2012 27
Do Speculators Cause Distortions? Irwin, Scott H., Sanders, Dwight R., and Merrin, Robert P. Devil or Angel? The Role of Speculation in the Recent Commodity Price Boom (and Bust) Journal of Agricultural & Applied Economics, 41(2009):377-391. There is little evidence that the 2008 boom and bust in commodity prices was driven by a speculative bubble. Economic fundamentals provide a better explanation for the movements in commodity prices. The main factors driving prices up in the energy markets included strong demand from China, India, and other developing nations, a leveling out of crude oil production, a decrease in the responsiveness of consumers to price increases, and U.S. monetary policy. In the grain markets, factors driving up prices also included demand growth from developing nations and U.S. monetary policy, as well as the diversion of row crops to bio-fuel production and weather-related shortfalls. Demand factors reversed in quick order doe to financial market meltdown and world-wide recession, leading to large price drops. The complex interplay between these factors and how they impact commodity prices is often difficult to grasp in real-time and speculators have historically provided a convenient scapegoat. 28
Market Performance
Grain Products Historical Volatility Monthly Historical Volatility Percent Volatility Corn Wheat Soybeans 50 45 40 35 30 25 20 15 10 5 0 30
20-Day Moving Average Correlation on Price Changes Between Nearby Corn Futures and Spot Gulf Cash Prices 1.00 0.80 0.60 0.40 0.20 0.00 Price Difference Correlation 1989 to Apr 2011: 0.86 Price Difference Correlation 1989 to Jan 2008: 0.84 Price Difference Correlation 2008 to Sep 2013: 0.92-0.20-0.40 31
20-Day Moving Average Correlation on Price Changes Between Nearby Soybean Futures and Spot Gulf Cash Prices 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 Price Difference Correla.on 1989 to Apr 2011: 0.92 Price Difference Correla.on 1989 to Jan 2008: 0.92 Price Difference Correla.on 2008 to Sep 2013: 0.92 0.00 32
20-Day Moving Average Correlation on Price Changes Between Nearby Wheat Futures and Spot Gulf Cash Prices 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 Price Difference Correla.on 1989 to Apr 2011: 0.88 Price Difference Correla.on 1989 to Jan 2008: 0.87 Price Difference Correla.on 2008 to Sep 2013: 0.93 0.20 0.10 0.00 33
Basis Levels at Selected Spot Locations 2013 Sep Corn 250 200 Chicago Cash Gulf Cash N. Illinois Cash Central IL Cash 150 Price (cents/bu.) 100 50 0-50 5/1/13 5/8/13 5/15/13 5/22/13 5/29/13 6/5/13 6/12/13 6/19/13 6/26/13 7/3/13 7/10/13 7/17/13 7/24/13 7/31/13 8/7/13 8/14/13 8/21/13 8/28/13 9/4/13 34
Basis Levels at Selected Spot Locations 2013 Sep Wheat 90 60 30 0-30 -60-90 5/1/13 5/8/13 5/15/13 5/22/13 5/29/13 6/5/13 6/12/13 6/19/13 6/26/13 7/3/13 7/10/13 7/17/13 7/24/13 7/31/13 8/7/13 8/14/13 8/21/13 Price (cents/bu.) 8/28/13 9/4/13 9/11/13 Chicago St. Louis Miss River Mt Vernon Ohio River Gulf Toledo Memphis Miss River 35
Basis Levels at Selected Spot Locations 2013 Sep Soybeans Price (cents/bu.) 450 400 350 300 250 200 150 100 50 0-50 Chicago Cash Gulf Cash N. Illinois Cash Central IL Cash 36
New Hedging Tools
Product Innovation CME Group has enhanced Agricultural option suite by successfully launching innovative option products over recent years: - Calendar Spread Options (CSOs) - Weekly Options - Short-Dated New Crop Options (SDNCO) 38
Short-Dated New Crop Options Definition: - The Short-Dated Options on the deferred (new crop) months are early expiring options that reference the December Corn Contract, November Soybean Contract and July Wheat Contract Key Benefits: - Cost-effective: lower premiums due to lesser time value - Facilitate hedging early in the planting and growing season - Manage risk during specific windows of the growing season at reduced costs - Useful for trading around key USDA reports - Allow Greek sensitivity hedging - Can be used to hedge old/new crop Calendar Spread Options (CSOs) positions - Arbitrage opportunities between outrights, CSOs and Short-Dated options 39
Weekly options on Corn, Soybean, and Wheat futures launched on May 23, 2011. Weekly options on Soybean Meal and Soybean Oil launched on September 26, 2011. Since launch through the end of Nov 2013, more than 1.52 million contracts have traded. 2013 YTD ADV=2,102. Corn is the most active, accounts for 86%, Soybean 12%, wheat/ soymeal 2%. Nov 2013 total volume=52,035, 36% higher than Nov 2012. Record high monthly ADV 5,668 was set in Aug 2012, amid the drought. Reduce hedging costs due to low time value, thus low premium. Used to hedge short term events such as USDA crop reports and weather forecasts during growing season. Market familiarity leading to steady volume almost every day. Weekly Options 40
Calendar Spread Options (CSOs) CSOs for Corn, Soybeans, Wheat, Soybean Meal and Soybean Oil launched in June 2009 Since launch through the end of Nov 2013, more than 1.16 million contracts traded. 2013 YTD ADV = 1,520. Nov 2013 total volume=5,812, 45% lower than Nov 2012. A new tool to hedge grain inventory and futures spread risk, especially old/new crop. CSOs are sensitive only to the value and volatility of the spread itself, rather than the price of the underlying commodity. More efficient and precise than combining options on two different months in an effort to replicate the spread. 41
Ramifications
What does it all mean to the hedger in 2014? - Prices are higher and risks are greater than ever. - Futures and Options markets are bigger, deeper, and more liquid than ever. - Markets are more heavily regulated. - Futures trading is more likely to take place on the CME Globex Electronic Trading Platform, typically at less cost than in the past. - You will likely be trading in a market with greater price volatility compared to the past, which also implies greater margin requirements. - The speculator assuming your risk is more likely to be an electronic proprietary trading firm rather than a floor local. - Hedging effectiveness is actually improved in the modern market environment with higher correlations and strong convergence. - Good Luck; Embrace Change; It s a Great Time to Work in Agriculture. 43
Thank you