Price Risk Management for Canola
Producers in the Northern Plains - Continued
EB-74,
November 2000
Price Risk Management
for Canola
Producers
in the Northern Plains - Continued
The objective of this study is to analyze price
risk management strategies for canola growers in the
U.S. Northern Plains. Specific objectives include:
- Describe the features and details of each of the
major marketing alternatives including spot and forward
cash transactions, hedging on the Winnipeg
Commodity Exchange, cross-hedging in soybeans and soybean
oil, and storage.
- Analyze various time series of prices to identify
patterns and relationships useful for developing
marketing strategies.
- Evaluate preharvest and harvest/postharvest
marketing strategies.
Definitions
Futures Market
Futures contracts are legally binding
standardized agreements where a buyer and seller agree to deliver
or take delivery of a specific quantity and quality of grain at
a specific place and time in the future. The price in
the contract is established through open outcry bidding in
pits on a trading floor. While there are several futures
markets for grain in the U.S., canola is not traded on a U.S.
futures market. It is traded on the Winnipeg Commodity
Exchange (WCE). Contract specifications and other information
on canola futures can be found at www.wce.mb.ca.
Characteristics of the contract are presented in Table 1.
Table 1. Canola futures contract specifications on the Winnipeg Commodity
Exchange.
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Pricing Basis Free on Board in the Par region
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Currency Canadian dollars
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Delivery Months January, March, May, July, August, September, November
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Delivery Non-commercially clean Canadian canola with maximum
Specifications dockage of 8 percent; all other specifications to meet
No. 1 Canada canola.
Deliverable at a $5.00/net tonne premium: commercially
clean No. 1 Canada canola.
Deliverable at an $8.00/net tonne discount:
commercially clean No. 2 Canada canola.
Deliverable at a $13.00/net tonne discount:
non-commercially clean Canadian canola with maximum
dockage of 8 percent; all other specifications to
meet No. 2 Canada canola.
Varieties derived from GMOs are deliverable.
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Delivery Regions Par -- Par area in Saskatchewan.
Central -- Non-par locations in Saskatchewan at a
$2.00/tonne discount (as of January, 1999).
Eastern -- Non-par locations in Manitoba at a
$2.00/tonne discount (as of January, 1999).
Western -- Non-par locations in Alberta at a
$6.00/tonne premium (as of January, 1999).
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Contract Size 1 contract -- 20 tonnes
5 contracts -- 1 board lot
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First Notice Day One business day prior to the first delivery day
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First Delivery Day First business day of the delivery month
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Last Trading Day Seven clear business days prior to the end of the
delivery month
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Final Notice Day Second last business day of the delivery month
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Trading Hours 9:30 a.m. to 1:15 p.m. CT
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Minimum Price $0.10/tonne
Fluctuation
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Daily Price Limit $10.00/tonne above or below previous settlement
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The contract months for canola are January,
March, May, July, August, September and November. The size
of the contract is 20 metric tons (tonne). Five
contracts make up a board lot. The contract price is for a par
region, which is an area around Saskatoon, Saskatchewan.
Price quotations are in Canadian dollars per metric ton.
Trading hours on the exchange are 9:30 a.m. to 1:15 p.m. CT.
Converting price quotations to dollars per
hundredweight requires knowing the exchange rate and
the relationship between a metric ton and hundredweight.
A metric ton is equal to 2204.6 pounds or 22.046
hundredweight. The price quotation for November
Canola was $254 on August 14, 2000. In U.S. dollars
per hundredweight, this quotation would be $7.77
($254 times .674 divided by 22.046 = $7.77). Canola
futures prices are converted to U.S. dollars per hundredweight in this publication. Basis and all examples are
illustrated using canola futures prices that have been converted.
Using the canola futures market to establish a hedge
in a distant futures contract means that the hedge is
subject to uncertainty about changes in the exchange rate.
The exchange rate could be hedged just as the canola price
is hedged. But, the price analysis presented in the
"Price Analysis"section shows that exchange rate variability is
low over the usual life of a hedge. In addition, including
an exchange rate hedge would increase the transaction
cost. For these reasons, hedging the exchange rate
appears unnecessary at this time.
Basis
Basis is the difference between a cash and
futures price. It is calculated as the cash price minus the
futures price. In North Dakota, the basis is usually negative
for most commodities, so it is described as being a number
of cents under a particular futures contract price. If it
is positive, it is described as being over the futures
contract price.
The nearby basis for canola is presented in this
publication. It is derived by subtracting the nearby futures
contract price from corresponding local cash prices. Prices from
the nearby futures contract month are used until the
last Thursday in the month before the futures contract
month. After that Thursday, prices from the following
futures contract month are used. Futures prices during the
futures contract delivery month are not used since
distortions between the futures and cash markets during that
month can occur and work to the disadvantage of the hedger.
Suppose that the nearby basis is being calculated
for canola beginning in July. The August futures price
is subtracted from the local cash price until the last
Thursday in July. Then the September futures price is
subtracted from the local cash price until the last Thursday in
August. After that, the November futures price is subtracted
from the local cash price until the last Thursday in October,
and so on.
The calculated basis is summarized in this
publication as monthly averages of the weekly basis values.
The averages are presented in graphs.
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Cash Price
Selling in the spot cash market is taking the cash
price offered for canola at a particular time and
location. The price received is sometimes called the flat price
or spot price. Information on the cash price is readily
available from elevators that handle canola.
The commodity futures market can be used to derive
a potential local cash price. To do this the futures
market price must be adjusted to reflect the relationship
between the futures price and the local cash price. In effect,
the futures price must be adjusted by the local basis.
The basis can be projected by comparing the
recent basis level and pattern to previous basis levels and patterns for the same time of the year. Subtract the
proper basis number from the nearby futures contract price
to derive an estimate of the cash price. For example,
an estimate of the nearby basis for August might be a
minus $1.00. A converted canola futures price of $7.77
would indicate a potential cash price in August of $6.77 at Velva.
Cash Forward Contract
The cash forward contract (CFC) is the most
frequently used marketing tool for locking in a price prior to
harvest. The use of this contract would be appropriate on
that portion of the canola crop that can be safely produced,
and where a reasonable basis is being offered in the contract.
The basis can be evaluated by comparing the
contract price to the expected cash price. A somewhat
lower contract price can be expected due to the uncertainty
of the basis. Suppose that the canola cash forward
contract price is $6.52 for harvest delivery at Velva when
the converted canola futures price is $7.77. The contract
price is $.25 below the expected cash price ($6.77) in
this example.
A farmer may choose to speculate that the basis will
be better than the contract price reflects. But, that requires
the use of a different marketing tool such as cash sale,
futures hedge, or put option.
Two steps are needed to determine the profitability
of storage once an expected price has been established.
The first is to determine the cumulative variable cost
of storage per month.
If the canola is stored in the elevator, the variable cost
of storage per month is the rate specified by the
elevator plus an interest cost. The monthly interest cost is
the current cash canola price times the interest rate per
month. If the canola is stored in existing on-farm bins,
variable storage costs also need to be considered. The
variable costs of existing on-farm storage can be divided into
two categories.
The first category is comprised of costs
primarily associated with the canola going into and out of
storage. Many farmers feel that they need at least $.20-$.25
per hundredweight to justify using existing on-farm storage
for canola to cover the costs of operating and repairing
the equipment, handling shrink, insurance,
management, labor and trucking. The $.20-$.25 charge would be specified as a cost during the first month of storage only.
Once the canola is in the bin, this cost is not important
to the storage decision since part of it has already
occurred and the remainder will occur regardless of whether
the canola is hauled out immediately or later.
The second category of variable costs includes a
cost per month for interest on investment in the canola
in storage and storage shrink; both are based on the
current cash price. A canola price of $6.20 per hundredweight
was used for this study. The cost for shrink is very small
for properly designed storage facilities, probably about
the same as for wheat, approximately .05 percent per month.
Interest on investment, in this publication, was based
on a bank loan annual interest rate. An alternative rate
of interest would be applicable for those producers with
no debt. It would be the potential rate of return from
an investment of the proceeds of a canola sale.
The final step in determining the profitability of
storage is to determine the month with the highest net
expected price by subtracting the variable storage costs from
the expected prices. The month with the highest net
expected price is the month during which sales should be planned.
It must be emphasized that this procedure is only a
tool for planning sales. If the differences (spreads)
between futures prices change and/or expectations of the
basis change, then the plan changes too.
An example of timing sales is provided in Table 2.
The example is for Velva, North Dakota. In this
example, the market is indicating that storage until March should
be profitable. The highest net price occurred in March when
it was 31 cents per hundredweight higher than at harvest.
Table 2. Profitability of storing canola at Velva, N.D., in U.S. cents per
hundredweight.
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Nearby Nearby Velva Velva Expected
Calendar Futures Canola Nearby Expected Storage Net
Month Month Price Basis Price Costs Price
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Aug Sep 758 -60 698 698
Sep Nov 777 -62 715 26 689
Oct Nov 777 -80 697 32 665
Nov Jan 795 -62 733 38 695
Dec Jan 795 -58 737 44 693
Jan Mar 813 -40 773 50 723
Feb Mar 813 -50 763 56 707
Mar May 829 -38 791 62 729
Apr May 829 -37 792 68 724
May Jul 844 -50 794 74 720
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To be sure of capturing the expected net price for
March delivery, however, it would be necessary to establish
a storage hedge by selling the May futures. The risk
in holding unhedged inventory until March is that cash
prices may not actually increase enough to cover the cost
of storage and may decrease. The risk in a storage hedge
is limited to the basis.
Basis Contract
There may be times when it is advantageous to fix
a favorable basis but not the futures or price. This can
be done at elevators through a basis contract,
sometimes called a basis fixed contract.
In this contract, the basis is fixed relative to a
specific futures month at the time of the contract. The farmer
then just watches the futures price. When a price objective
is reached, the farmer can fix the futures price too. At
this point, the basis contract is equivalent to a CFC.
Delayed Price Contract
Grain can be delivered to the elevator and the
pricing decision can be delayed until later with a delayed
price (DP) contract. When the producer decides to price
the grain, the decision is based on the cash price posted in
the local elevator rather than on the futures price.
Knowledge of the basis is needed to determine if the posted cash
price is appropriate given current futures prices.
Service charges specified in the contract would
reflect anticipated changes in the basis. This type of
contract leaves the producer exposed to both price level and
basis risk, but service charges may be less than storage
costs. Hence, it is often used as a substitute for storage.
Futures Hedge
Hedging is the process of buying or selling a
futures contract as a temporary substitute for buying or selling
a commodity at some later time. For example, a price prior
to harvest is "locked-in" by selling a futures contract, which
is bought back at harvest when the actual commodity is
sold for cash. Gains on the futures contract are
approximately offset by losses in the cash market value and visa-versa.
Futures contracts are typically offset; that is, a
sold contract is offset by a purchase. A producer who sells
a futures contract he does not own is in a short
futures position. A producer who buys a futures contract that
he has not sold is in a long futures position.
Delivery can be made during the contract month but
it is an uncommon practice for the majority of
traders. When delivery occurs, it is usually done by an
experienced trader (Purcell, 1991). Delivery points are specified at
the WCE for the canola futures contract.
The expected price from a hedge is the futures
price adjusted by the typical basis less brokerage fees
and interest cost on the margin money held by the
brokerage firm on the futures hedge. The transaction (fees
and interest) cost may total $.07 per hundredweight for
canola. Thus, the expected hedge price in the example would
be $6.70 ($7.77 less $1.00 and $.07).
Suppose the basis improves so that in August it is
minus $.75 instead of minus $1.00, but the converted futures
is still $7.77. Subtracting the 75 cents basis and 7
cents hedge cost from the $7.77 futures price yields an
actual hedge price of $6.95. This price would be $.18 better
than the expected cash price of $6.77, $.43 better than the
cash forward contract price of $6.52, and $.25 better than
the expected hedge price of $6.70 because of the better
than expected basis.
There are risks in hedging canola as there are in
any hedge. If the basis is weaker than expected at the time
the hedge is completed, the hedge price would be lower
than expected. Suppose the basis weakens so that in August
it is minus $1.50 instead of minus $1.00. Subtracting
the $1.50 basis and 7 cents hedge cost from the $7.77
futures price yields a hedge price of $6.20. This price would
be $.32 worse than the cash forward contract price of
$6.52 and $.50 worse than the expected hedge price of
$6.70 because of the weaker than expected basis.
The hedge is also based on the assumption that
the crop will be produced. If production is less than the
amount hedged and the futures price increases, losses in
the futures market will not be offset by gains in the
cash market.
A third risk is margin risk. Margin is the money
deposited with a broker's firm to keep the account in
good standing. It serves as a performance bond. If
the futures price increases after a short hedge has
been established, an additional security deposit (margin) may
be needed to support the futures position. Cash
flow budgets of the hedger need to reflect the possibility
of increased margin payments.
Hedge Ratios and Cross Hedging
A hedge ratio is the proportion of the futures
position required to minimize the risk associated with a
cash position (production, inventory, and so on). Note that
the emphasis is on minimizing risk, not maximizing
returns. Hedging price risk for a commodity with both cash
and futures markets is generally portrayed as taking equal
and opposite positions in cash and futures markets.
This implies a hedge ratio of one and is used in
most examples of hedging.
For example, in the case of wheat, which trades in
5,000 bushel units, a hedge ratio of one would indicate that
to hedge 10,000 bushels of production, an opposite
position of two contracts (5,000 bushels times two) would be
taken in the futures market. However, in cases where there is
no futures market (as in the case of barley), or more
refined estimates of optimal hedge ratios are required, it should
be noted that optimum hedge ratios are not equal to one in many cases and can vary widely over time.
A hedge ratio of 1:1 will be used in the hedging
examples using canola futures. Several examples
of more refined hedge ratios will also be presented.
A marketing alternative that allows the canola
producer to use the futures market of a different commodity
for hedging is called cross hedging. Cross hedging may
be desirable for canola producers disinclined to use the
WCE for a futures hedge or for options.
For cross hedging to be effective, there must be
a predictable relationship between both commodities.
The predictable relationship is referred to as a hedge
ratio. Optimal hedge ratios can be found in the "Price
Analysis" section of this publication.
A hedge ratio of 1.56 was derived between 5,000 bushels or 2,500 hundredweight of Velva canola
and soybean oil futures in the "Price Analysis" section.
This means that 1.56 contracts of the soybean oil futures
should be traded for each 2,500 hundredweight of canola to
be hedged.
Suppose that production of 15,000 hundredweight
of canola is expected and that one-third of that amount
or 5,000 hundredweight is to be hedged. For each
2,500 hundredweight, 1.56 oil contracts are to be sold.
This means that 5,000 hundredweight should be hedged
with three contracts of soybean oil futures.
Hedged-to-Arrive Contract
The hedged-to-arrive (H-T-A) contract may be useful in a situation where the futures price is considered
acceptable but the local cash forward contract price appears
too low relative to the futures. Sometimes called a futures
fixed or basis open contract, the H-T-A contract
accomplishes the same purpose as a regular futures hedge.
The futures price is fixed when the contract is
initiated and the basis is established later. The basis can be
fixed when it becomes more attractive or when the
contract matures. The risk with this contract is that the basis
may weaken instead of strengthen.
The elevator handles the futures position, including
any margin money. The elevator may or may not charge a
fee for this service. In return, the producer is committed
to delivering the contracted bushels to the elevator.
Options
An option offers the producer more flexibility and
safety than the futures market. Option buyers will benefit
when prices move in their favor, losses are limited to the cost
of an option, and the buyer of an option will never receive
a margin call (see Minneapolis Grain Exchange
publication for definitions and a complete explanation of options).
Producers who buy put options have the right to
sell futures at a specific (strike) price but not the obligation,
and they do not have a delivery obligation. Profit on
a purchased put option is generally achieved by
offsetting (selling) the put option at a later time for a higher
premium than when it was purchased. At least the amount by
which the price is below the strike price can be captured
when the put option is offset. The amount could be greater if
time value remains.
Call options are the right to buy futures at a
specific (strike) price instead of to sell as in put options. A
profit would be achieved in the same manner, in effect,
by offsetting (selling) for a higher premium than when it
was purchased. At least the amount by which the price is
above (instead of below) the strike price can be captured
when the call option is offset. As with put options, a
greater amount can be captured if time value remains.
Minimum Price Contract
Cash contracts based on the options market may
be available through local elevators. Referred to as a
minimum price contract (MPC), they offer about the same
price flexibility as put and call options. They differ from options
in that a producer has a delivery obligation with the
MPC. Another difference is that the relationship between
the cash price and the futures price is fixed.
The basis fixed portion of the contract is calculated
as the difference between the minimum selling price and
the strike price. The producer can execute the basis
fixed portion of the contract any time before the contract expires.
Selection
Selection of a marketing alternative is discussed in
the "Example Marketing Plan" section. The direction of
futures prices and basis is a key factor in selecting a
marketing tool. Familiarity with marketing alternatives,
storage availability, production risk, and control of the crop are also important factors.
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EB-74,
November 2000
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