New Generation Grain Contracts Decision Contracts MARKET BASED RISK MANAGEMENT FOR AGRICULTURE September 2006 Iowa State University Regis Lefaucheur Decision Commodities, LLC 614 Billy Sunday Rd., Suite 600 Ames, Iowa 50010 515.956.7880 www.decisioncommodities.com
Decision Commodities Based in Ames, IA Provides innovative forward contracts to grain producers to help them take the emotion, stress and guesswork out of grain pricing Customer base: Iowa, Illinois, Minnesota, North Dakota, Wisconsin, Missouri Decision Contracts enable producers to put discipline into grain marketing 2
Decision Commodities What does Decision Commodities do? Take the EMOTION out of selling Take the GUESSWORK out of selling Consistently outguessing or outperforming the market is impossible. 3
Grain Industry Vocabulary Definitions: Futures price Basis Cash Price Spread Relationships 4
Producer Hedging 01 Feb 2006 Harvest Price Decrease Scenario $2.50 Lower $2.10 -$0.40 Futures Sell @ $2.50 Buy @ $2.10 +$0.40 Producer Goal: Lock in an attractive price (higher is better) Protection against lower prices 01 Feb 2006 Harvest Price Increase Scenario $2.50 Higher $2.90 +$0.40 Futures Sell @ $2.50 Buy @ $2.90 -$0.40 5
Elevator Hedging Harvest January 15 sale Price Decrease Scenario $2.90 Lower $2.70 -$0.20 Futures Sell @ $2.90 Buy @ $2.70 +$0.20 Elevator Goal: Lock in the price of the grain he bought to protect his margins (storage, drying, basis, hedging) Harvest January 15 Sale Price Increase Scenario $2.90 Higher $3.10 +$0.20 Futures Sell @ $2.90 Buy @ $3.10 -$0.20 6
End User: feed mill, ethanol 01 Feb 2005 Harvest Price Decrease Scenario $2.50 Lower $2.10 +$0.40 Futures Buy @ $2.50 Sell @ @2.10 -$0.40 End User Goal: Lock in an attractive price (lower is better) Protection against higher prices 01 Feb 2005 Harvest Price Increase Scenario $2.50 Higher $2.90 -$0.40 Futures Buy @ $2.50 Sell @ $2.90 +$0.40 7
Decision Contracts Insurance against low prices Put Option Contract Risk Management Continuum Futures Contract Insurance against high prices Call Option Contract Farmers Price Sensitive Elevator Margin Dependent End-User Price Sensitive 8
Relationship Between Basis And Cash Price Futures Price -Basis = Cash Price (paid to the producer) $2.5475 (Dec 2006) - $0.40 = $2.1475 See: http://www.hoic.com/grain/bids.asp http://www.maxyieldcooperative.com 9
10 Example
11 Example
BASIS What is BASIS? Chicago Board of Trade - Corn Futures Price = $2.75 Processor Bid - $2.70 BASIS = 0.05 under Warehouse Bid - $2.60 BASIS = 0.10 under Producer Bid - $2.50 BASIS = 0.25 under How can a user increase or decrease the movement of grain locally if they can t change the price on the Chicago Board of Trade? 12
What factors contribute to determining the BASIS? BASIS Feed Ethanol River Processing Processing 13
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BASIS Industrial Export Ethanol Dairy Feed Poultry Export 15 What impact does a BASIS change in one area have on other areas? Which markets have the greatest influence on basis, spreads and the futures market?
SPREAD Spread = price difference between various futures reference months The Spread can be Carry or Inverted Spread= + $ 0.1350 + / Carry Spread= - $ 0.025 -/ Inverted 16
STORE or SELL? What decision should a producer make? STORE Wide Carry Basis Spread SELL Narrow Inverted Low Futures price High Result: Decrease in the movement of grain Result: Increase in the movement of grain 17
EFFICIENT MARKET HYPOTHESIS RANDOMNESS 18
Efficient Market Hypothesis According to Fama, an efficient market is one that accurately incorporates all known information in determining price. This is know as the efficient market hypothesis. Although there is considerable disagreement about the degree to which EMH holds, it has become the dominant paradigm used by economists to understand and investigate the behavior of financial and commodity markets. Markets for commodities and products that are widely traded in agriculture and the food industry are a model of efficiency. The compile all the information and knowledge of traders, businesses and producers, and express this data in the form of a price. 19
Efficient Market Hypothesis The daily pricing process in the market is usually referred to as a random walk. A commonly used analogy of a random walk is the flipping of a fair coin. Overtime, the expected change is price is zero. The market is all-knowing. Consistently outguessing or outperforming it is very difficult (if not impossible) 20
Randomness What does randomness looks like? 21
Randomness and Unpredictability Randomness CBOT Corn December Futures 2005 It is easy to see patterns in random events 22
23 300 250 200 150 100 50 0 SOYBEAN Up/Down days Number of trading days up/down Nov 01 to Oct 31-1997-2004 - NOV Soybean CBOT 233 193 268 247 209 195 112 121 74 75 36 39 37 25 0 2 12 5 7 10 11 16 19 10 11 4 9 13 1 ($0.50) ($0.35) ($0.25) ($0.22) ($0.20) ($0.18) ($0.16) ($0.14) ($0.12) ($0.10) ($0.08) ($0.06) ($0.04) ($0.02) $0.00 $0.02 $0.04 $0.06 $0.08 $0.10 $0.12 $0.14 $0.16 $0.18 $0.20 $0.22 $0.25 $0.35 $0.50 Decision Commodities LLC
SOYBEAN Up/Down days By year (days) 1997 Up 126 Down 126 Total 252 SOYBEAN TOTALS Average of up/down Standard deviation 1997-2004 $0.00 $0.08 1998 123 127 250 Minimum Maximum $-0.49 $0.50 1999 114 136 250 Total Days 1994 2000 123 127 250 Up Days Down Days 1010 984 2001 119 129 248 2002 134 115 249 2003 145 104 249 2004 126 120 246 Nov 01 to Oct 31-1997-2004 - NOV Soybean CBOT 24
Randomness and Unpredictability Another way to view markets is that while prices can t be predicted, prices aren t all that random either. While we can t guarantee that the pattern depicted below will be repeated in the future, this 25 year frequency histogram tends to suggest that there is some central tendency around $2.15 to $2.95 range. Frequency of Closing Prices in CBOT December Corn 1979-2004 400 350 300 250 200 150 100 50 0 $1.60 $1.75 $1.90 $2.05 $2.20 $2.35 $2.50 $2.65 $2.80 $2.95 $3.10 $3.25 $3.40 $3.55 $3.70 $3.85 $4.00 25
BEHAVIORAL FINANCE AND EMOTIONS 26
Behavioral Finance and Emotions 2004 December Corn Futures 06-2003 to 09-2004 27
Behavioral Finance Regret: Regret management is probably a more accurate term for risk management. There is a very natural tendency to avoid regret. In grain marketing, this is often embodied into a decision not to decide. Regret is the more powerful behavioral issue. Obviously, regret can significantly impair our ability to make rational choices. Risk aversion: Most people are risk averse and seek to avoid risk. However, there tends to be identifiable biases in human behavior that lead to irrational decision making. One of these biases is the tendency to accept increases risk over a guaranteed loss. It reflects a tendency to underestimate the chances of extreme market situation occurring. In grain marketing, this tendency leads some to accept price risk rather than pay for insurance such as a put option purchase or guaranteed minimum price contract. Why don t producers want to pay 5 cents to protect 50 cents? 28
Long Term Corn Prices 2004 December Corn Futures 06-2003 to 09-2004 29 Reference price anchoring: It is the tendency for a person to fix a specific figure in their mind as the perceived value. An example of driving with eyes fixed on the rear view mirror is establishing a target price based on last year s market price. Bull or bear forecasts coming from newsletters, magazines, market advisors, radio shows Reality takes a long time to soak in, and when it does, it is usually too late as opportunities are long gone.
Behavioral Finance Escalation: too much invested to quit. A situation where a person enters a transaction hoping for a favorable outcome but after circumstances change to unfavorable, the person finds it difficult to escape or even adds to it. Endowment: Associated with the fear of giving up something. It is more painful to give up an asset than it is pleasurable to obtain. Ownership as a positive feeling. Producers have a tendency to store grain beyond economic justification, because when it is sold, there is no opportunity to gain anymore. For grain under storage, the perceived value increases with the duration of ownership. 30
Behavioral Finance Which one of the following would you choose? A. Winning a guaranteed $3,000 B. Taking an 80% chance of winning $4,000 Now consider this option A. Lose $3,000 B. Take an 80% chance of losing $4,000 31
Behavioral Finance Results: You are not alone if you said you would take the $3,000 but roll the dice and risk losing the $4,000 As human being, we don t deal with losses the same way we do with gains We will ride a loss to the bitter end while cutting a gain short Contributing to this mindset is a condition known as the Gambler s fallacy, which is the belief that a successful outcome is due after a run of back luck. But chance or the randomness of an efficient market is not self-correcting. Flipping 10 consecutive heads does not increase the chance that the eleventh toss will yield a tails, any more than a trend of lower grain prices ensures an up- or downswing in tomorrow s market. 32
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Agricultural Market Advisory Services AGMAS Agmas study (U of I Urbana): provide a neutral evaluation of the performance of market advisory services for corn, soybean and wheat. Tracking about 25-35 advisory programs per year since 1994 Paid subscriptions obtained for each services Recommendations recorded in real-time Two important issues:. Market advisory service performance relative to appropriate benchmarks. Predictability of market advisory service from yearto-year Result data available for the period 1995-2003 34
Agricultural Market Advisory Services Benchmarks: average of two-year marketing window (24 months) : price offered by the market USDA producer average : an indicator of marketing performance of farmers 35
Performance relative to Benchmark Performance of Market Advisory Services Corn - Average of 1997-2003 AgResource Utterback Marketing Services Brock (hedge) Ag Review AgriVisor (aggressive cash) Allendale (futures only) AgLine by Doane (hedge) Progressive Ag AgriVisor (basic cash) AgLine by Doane (cash only) AgriVisor (aggressive hedge) AgriVisor (basic hedge) Top Farmer Intelligence Brock (cash only) Risk Mgmt Group (futures & options) Risk Mgmt Group (cash only) Risk Mgmt Group (options only) Co-Mark Northstar Commodity Allendale (futures & options) Freese-Notis Steward-Peterson Advisory Reports Pro Farmer (cash only) Pro Farmer (hedge) Ag Financial Strategies $1.85 $2.30 $2.28 $2.27 $2.27 $2.22 $2.21 $2.20 $2.19 $2.19 $2.18 $2.17 $2.16 $2.16 $2.16 $2.14 $2.13 $2.11 $2.10 $2.09 $2.09 $2.07 $2.02 $1.99 $1.99 24 Month Average: $2.15 USDA Producer Average: $2.05 $1.70 $1.80 $1.90 $2.00 $2.10 $2.20 $2.30 $2.40 $2.50 36
Predictability from year-to-year Ranking of Market Advisory Services - Corn Rank 1999 2000 2001 2002 2003 1 AgResource AgResource Progressive Ag Brock (hedge) AgResource 2 Allendale (futures only) Utterback Marketing Services Top Farmer Intelligence Brock (cash only) Progressive Ag 3 AgLine by Doane (hedge) Top Farmer Intelligence Ag Review Ag Review AgLine by Doane (cash only) 4 AgriVisor (aggressive cash) Brock (hedge) Utterback Marketing Services Risk Mgmt Group (futures & options) AgLine by Doane (hedge) 5 Ag Review AgLine by Doane (hedge) Co-Mark AgriVisor (basic hedge) Ag Review 6 Top Farmer Intelligence AgriVisor (aggressive cash) Steward-Peterson Advisory Reports AgriVisor (aggressive hedge) Freese-Notis 7 AgriVisor (basic cash) AgriVisor (aggressive hedge) Risk Mgmt Group (cash only) AgriVisor (basic cash) Northstar Commodity 8 Risk Mgmt Group (cash only) AgriVisor (basic cash) Allendale (futures only) AgriVisor (aggressive cash) Brock (cash only) 9 Allendale (futures & options) AgriVisor (basic hedge) Risk Mgmt Group (options only) AgResource AgriVisor (basic hedge) 10 Brock (cash only) Risk Mgmt Group (cash only) Risk Mgmt Group (futures & options) Progressive Ag AgriVisor (aggressive hedge) 11 Utterback Marketing Services Risk Mgmt Group (futures & options) Allendale (futures & options) Risk Mgmt Group (options only) AgriVisor (basic cash) 12 AgLine by Doane (cash only) AgLine by Doane (cash only) AgriVisor (aggressive cash) Risk Mgmt Group (cash only) AgriVisor (aggressive cash) 13 AgriVisor (basic hedge) Allendale (futures only) AgriVisor (aggressive hedge) Freese-Notis Brock (hedge) 14 Brock (hedge) Risk Mgmt Group (options only) AgLine by Doane (cash only) Co-Mark Allendale (futures & options) 15 AgriVisor (aggressive hedge) Progressive Ag AgLine by Doane (hedge) Steward-Peterson Advisory Reports Co-Mark 16 Risk Mgmt Group (options only) Freese-Notis AgriVisor (basic cash) Utterback Marketing Services Risk Mgmt Group (futures & options) 17 Risk Mgmt Group (futures & options) Co-Mark Pro Farmer (cash only) AgLine by Doane (hedge) Risk Mgmt Group (options only) 18 Progressive Ag Ag Review Northstar Commodity Northstar Commodity Steward-Peterson Advisory Reports 19 Steward-Peterson Advisory Reports Brock (cash only) AgriVisor (basic hedge) AgLine by Doane (cash only) Allendale (futures only) 20 Freese-Notis Allendale (futures & options) Pro Farmer (hedge) Top Farmer Intelligence Pro Farmer (cash only) 21 Pro Farmer (hedge) Pro Farmer (cash only) Brock (cash only) Allendale (futures only) Risk Mgmt Group (cash only) 22 Pro Farmer (cash only) Pro Farmer (hedge) Brock (hedge) Pro Farmer (cash only) Top Farmer Intelligence 23 Steward-Peterson Advisory Reports Freese-Notis Allendale (futures & options) Pro Farmer (hedge) 24 Ag Financial Strategies Pro Farmer (hedge) Utterback Marketing Services 25 AgResource Ag Financial Strategies Ag Financial Strategies Agmas Study released on 03/2005 37
Agricultural Market Advisory Services Limited evidence that advisory services outperform market benchmarks, particularly after taking risk into account Substantial evidence that advisory services outperform farmer benchmarks, even after taking risk into account Little evidence that past performance can be used to predict future performance 38
Decision Contracts Farmers continue to identify price and income risk as their greatest management challenge 39
Setting goals Corn Prices 1998-2005 (Dec CBOT) $3.50 $3.40 $3.30 $3.20 $3.10 $3.00 Upper Third $2.90 $2.80 $2.70 $2.60 Average Price $2.50 $2.40 $2.30 $2.20 Lower Third $2.10 $2.00 $1.90 $1.80 2005 2005 2004 2004 2004 2003 2003 2003 2002 2002 2002 2001 2001 2001 2000 2000 2000 1999 1999 1999 1998 1998 1998 $1.70 Decision Commodities LLC 40 Price series for CZ contract : Average Price = $2.37 Upper Third = $ 2.44 and above Lower Third = $ 2.27 and below
Daily Average Corn Prices 1998-2005 Based on December Corn (CZ) In the last 22 years for corn: Marketing at harvest was high price point = 3 years (93, 95, 02) High price point was spring/summer = 7 years (84, 87, 88, 90, 94, 96,04) High price point was before spring = 12 years (85,86,89,92,94,97,98,99,00,01,03,05) $2.70 December CBOT Corn Average Prices 1998-2005 (Jan 1 to November 30-23 months) $2.60 12 7 3 $2.50 $2.40 $2.30 HARVEST $2.20 $2.10 PLANTING $2.00 41 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Corn - High Low Average Historical Prices DEC Corn Historical Price ranges (Full length of contract) High Top third Average Bottom third Low $4.00 $3.80 $3.84 $3.60 $3.40 $3.37 $3.37 $3.20 $3.00 $2.80 $2.60 $3.08 $2.99 $2.91 $2.83 $2.73 $2.93 $2.69 $2.87 $2.87 $3.17 $2.47 $2.40 $2.39 $2.36 $2.38 $2.29 $2.20 $2.04 $2.11 $2.00 $2.00 $1.99 $1.88 $1.93 $1.87 $1.86 $1.80 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Last Update: 08/24/2006 Decision Commodities LLC 42
Decision Contracts Decision Commodities automated pricing models : Index Rally Accelerator Topper 43
Decision Contracts...a tool that delivers execution discipline without major time requirements Example You want to pre-harvest market 20,000 bushels of corn for Fall delivery, starting in January. The Index pricing model can, for example, price an even increment of bushels every day between January and September, achieving an average price for that time period. Assuming 100 (market) days between January and September, 200 bushels will be priced every day at the price of the underlying futures contract. You sign a forward contract with local grain elevator (specifying Decision Contracts as pricing mechanism), and deliver grain in same manner as usual. 44
Decision Contracts Producer Cash Contract Grain Elevator Ethanol Plant Basis Forward futures price Decision Contracts provides pricing mechanism for the futures price 45
Decision Contracts Index Pricing Model Index: Average Price Contract Prices an even increment of bushels each day for a given pricing period. Producer settings: Pricing period beginning Pricing Period end Delivery Period Bushels Example: 10,000 bu 100 days 100 bu would be priced each day 2006 The Index price model will result in the average price for the specified time pricing period. 46
Decision Contracts Rally Pricing Model Rally: Bushels price on days during the pricing period when: 1) the day s closing price is above the floor price and 2) the one day price change is less than the sensitivity level. Producer Settings: Pricing period beginning Pricing period end Bushels Bushels price if one Price Floor day price change UpPoint less than UpPoint Throttle $2.36 60 $2.35 $2.34 $2.33 $2.32 $2.31 $2.30 $2.29 $2.28 Floor 50 40 30 20 10 Bushels Bushels to Price = Remaining Bu Remaining Days If UpPoint = 0 pricing occurs when price goes down. X Throttle $2.27 Day 1 2 3 4 5 0 47
Rally Example 10,000 bu = 100 X 5 (Throttle) = 500 bu 100 days 500 bu on the first day 48
Decision Contracts Accelerator Pricing Model Accelerator: The daily amount of bushels priced accelerates as the futures prices increase, and vice versa Bushels price on days during the pricing period when: 1) the day s closing price is above the floor price 2) pricing factor increases (decreases) as futures prices go up (or go down) Producer Settings: Pricing period beginning Pricing period end Bushels Floor and Pivot Bu priced = (remaining bushels) X Throttle remaining days 49
Decision Contracts Accelerator Pricing Model December Corn Range (CZ) Min Max Throttle Pivot $2.60 $2.50 $2.40 $2.30 > $2.59 $2.49 $2.39 10 4 3 1 Very Aggressive Aggressive Moderate Slow Throttle acts as a multiplier of daily bushels priced PF =10 Floor PF =6 PF = 4 PF = 1 0 50 100 150 200 Daily bushels priced 50
Decision Contracts Accelerator Pricing Model December Corn 2003 Accelerator (red) = $2.41 Bu priced = 90.37 % Floor price (purple) = $2.30 Daily bushels sold increase when futures prices move into upper ranges, and vice versa 51
Decision Contracts Topper Pricing Model Topper: Bushels will price on days when grain prices close up sharply from the previous day, during the pricing period. Producer Settings: Pricing period beginning Pricing period end Bushels Price Floor Trigger Throttle Number of trading days up/down Dec 01 to Nov 30-1998-2005 - DEC Corn CBOT 450 400 407 350 300 250 200 218 242 256 198 188 150 100 81 86 75 66 23 20 15 14 50 0 0 0 14 5 8 10 26 34 5 8 2 ($0.20) ($0.15) ($0.10) ($0.09) ($0.08) ($0.07) ($0.06) ($0.05) ($0.04) ($0.03) ($0.02) ($0.01) $0.00 $0.01 $0.02 $0.03 $0.04 $0.05 $0.06 $0.07 $0.08 $0.09 $0.10 $0.15 $0.20 52 Decision Commodities LLC
What are producers saying? I only sell one time per year, that way the check is bigger I only sell grain when prices are in the top third of the market 53
What are producers saying? forward contracts are always terrible ways to market 20% of the time I sold too soon, and 80% of the time I didn t market enough 54
What are producers saying? I hope I made the right hum Well I guess I should have bought more decision 55
Thank you. Decision Commodities, LLC 614 Billy Sunday Rd., Suite 600 Ames, Iowa 50010 515.956.7880 www.decisioncommodities.com 56