- - AGRICULTURE CORE CURRICULUM - - (CLF1000) Advanced Core Cluster: AGRICULTURAL BUSINESS MANAGEMENT (CLF1450) Unit Title: AGRICULTURAL MARKETING ______________________________________________________________________________ (CLF1453 Topic: MARKETING STRATEGIES: Time Year(s) HEDGING AND SPECULATION 2 hours 3 / 4 _____________________________________________________________________________ Topic Objectives: Upon completion of this lesson, the students will be able to: Learning Outcome #: (M-5) Distinguish between hedging and speculation. (*-*) Compare various marketing strategies. Special Materials and Equipment: Daily newspaper, preferably the WALL STREET JOURNAL. References: Luening, R. A., Klemme, R. M., & Mortenson, W. P. (1991). THE FARM MANAGEMENT HANDBOOK (7th ed.). Danville, IL: Interstate Publishers. Resources: Deere & Company. (1987). FARM AND RANCH BUSINESS MANAGEMENT (2nd ed.). Available from: John Deere Technical Services, Department F, John Deere Rd., Moline, IL 61265. Chicago Mercantile Exchange (1990). AN INTRODUCTION TO COMMODITY MARKETING (Teacher Guide). Available from: FFA Supply Services, P.O. Box 15160 Evaluation: Commpletion of activity assignments, final marketing plan, and marketing plan presentation. TOPIC PRESENTATION: MARKETING STRATEGIES: HEDGING AND SPECULATION ______________________________________________________________________________ Note to Instructors: The material in this topic is covered in detail on pages 7-20 to 7-30 in Deere's FARM AND RANCH BUSINESS MANAGEMENT. ______________________________________________________________________________ A. Marketing Strategies 1. There is generally more than one way to market a given product. a. Different agricultural commodities are marketed in different ways. The number of options open to a producer depends largely on the requirements for storage and processing of the product. b. Some products are easily and cheaply stored for long periods of time. Corn, wheat, soybeans, and cotton can be stored for over a year. Product held over from one year to the next is called carryover. c. Other products need to be processed or consumed shortly after production. Storage and processing are more expensive and are generally not easily done on the farm. Examples of products requiring either immediate processing or consumption are fresh fruit and vegetables, milk, and fresh meats. __________________________________________________________ ACTIVITY: 1. Discuss the marketing options for a number of different commodities. How do storage considerations affect the marketing of peaches as compared to wheat? Discuss local commodities and the marketing options available in the area. 2. Read and discuss the beef marketing example on pages 7-18 and 7-19 of Deere's FARM AND RANCH BUSINESS MANAGEMENT. __________________________________________________________ 2. If on-site storage is impossible or very limited, the producer is forced to sell the crop when it is ready at whatever price is offered by the buyer. In this case the producer is said to be a "price taker." a. Firms that process and warehouse agricultural commodities can "build in" an operating markup to cover their costs. 3. The price the producer receives is generally determined by supply and demand forces beyond his control. Marketing strategies center on methods of dealing with unpredictable changes in price. 4. Information is an important resource in making marketing decisions. The more the producer knows about the supply and demand for a product, the more likely the marketing strategy will lead to a favorable outcome. a. For example, if a producer has good reason to expect a higher than average price in a given year, then production can be increased in order to realize greater returns. b. Likewise, if lower prices are expected, the producer can reduce production in order to lower expenses. B. The major goal of a marketing plan is to select a marketing strategy that minimizes risk while at the same time obtaining the best possible price for the product. 1. The two primary risk factors for producers are: a. Risk of physical destruction or deterioration of the product due to bad weather, or due to pests or spoilage in production, storage, or transport. b. Risk of changes in supply or demand which negatively affect price. 2. Marketing strategies must be evaluated in terms of the amount of risk involved, the costs involved, and the potential for profits. C. The ability to store products and supplies and to use commodity futures and forward contracting is shared by both producers and users of agricultural commodities. Six major strategies are available for use: 1. The producer can take market price and sell the product on the cash market when it is harvested. a. The producer is totally at the mercy of the market in this situation. If the market fluctuates significantly this can entail substantial risk. b. It is important to consider a number of possible buyers and compare the prices offered. c. Buyers of agricultural commodities can also suffer from price fluctuations if they have limited storage capability and must buy on the cash market when the product is needed. Livestock producers with limited storage capacity and an ongoing need to purchase feed are often in this situation. 2. If the product can be stored, the producer has the option to store some or all of the product for sale at a later date. a. If the producer holds a commodity in storage in anticipation of a higher price, the producer is said to be speculating. b. The strategy of storing a commodity and selling over a period of time helps to minimize the effect of changing prices. c. In the long run, the increase in the value of a commodity in storage will equal the cost of storage, hence storage is helpful only when prices can vary for reasons other than storage costs. 3. Sometimes a producer can deliver a commodity and defer payment and establishment of price until a later date. a. The product is delivered and payment is delayed until a specified date. b. The main advantage of this strategy over store-and-sell is that the producer does not have to pay storage costs. However, the buyer may add a service charge to cover storage. c. As in store-and-sell, the producer is betting that the.price will increase. d. There is risk in this situation that the purchaser will go bankrupt and fail to pay for the product on the spcified date. 4. A forward contract is one in which the price is fixed before delivery of the commodity. a. This strategy reduces risk by locking in a price. b. The buyer pays storage cost. c. The contract price can wind up being either lower or higher than the market price at the time of sale. d. In this situation the buyer must negotiate compensation for risk taken on. 5. A price can be locked in using a futures contract. a. Commodity futures are financial instruments like stocks and bonds. They are traded on commodity exchanges such as the Chicago Board of Trade. They are promises or contracts to buy or sell a specified quantity and quality of a commodity on a given date. Hundreds of contracts are traded every day for large quantities of wheat, corn, soybeans, cattle, cotton, hogs, and pork bellies. b. Futures trading is designed to help both producers and users of agricultural commodities control risk by locking in prices through hedging. c. Speculators in commodity futures buy and sell on the basis of the direction they think the price will go. They are in the market to make money. d. Hedgers use commodity futures to protect themselves from adverse price changes. Both buyers and sellers of agricultural commodities can hedge. e. Participants in the futures market can buy (go long) or sell (go short) whether or not they have any product to sell. Once a contract is bought or sold the purchaser is in the market (has an open interest). The participant must then make an opposite transaction in order to exit the market. For example: A speculator who thinks pork belly prices are going to fall can sell (or short) pork belly futures. If the price falls as anticipated, the speculator will buy out the sell contract at the new lower price. The difference between the sell price and the buy price is the speculator's profit. Whether speculators or hedgers, all participants must make two opposite transactions in order to exit the market. f. To lock in a price, the hedger takes a position in the futures market opposite the position held in the cash market. For example: A wheat producer anticipates a harvest of 50 tons of wheat in June of the following year. In November, the producer sees that June wheat futures are priced at $3.50/cwt (hundredweight). The producer decides to lock in a price and sells 50 tons of wheat futures on the following day for $3.52/cwt. In June, wheat prices are $3.25/cwt on both the futures and cash market. The grower receives $.25/cwt less than he would have liked on the cash market. However, he buys a futures contract to offset his earlier sale and makes $.25/cwt offsetting the loss, and resulting in a net, realized price of $3.52/cwt. Date Cash Market Futures Market Nov. 15 Sell June futures $3.52/cwt June 15 Sell Weat 3.27 Buy June futures 3.27 Net gain or loss 0.25 Pricing Results Local wheat price $3.27 Futures profit or loss .25 Net realized price 3.52 This type of hedge is sometimes called a short hedge. This example is simplified as it does not consider changes in the local basis. The example works out so the producer realizes the exact price he wanted. This is termed a perfect hedge. 6. Sell on the cash market and speculate with a futures contract. a. This strategy allows the producer to take advantage of price changes without having to pay for storage. __________________________________________________________ ACTIVITY: 1. Visit with local producers to determine the marketing strategies used to market commmon local commodities. __________________________________________________________ D. Hedging 1. There are two types of hedges, the producer hedge and the consumer hedge. 2. In a producer hedge, the producer sells a futures contract for future delivery of the commodity. At the time the commodity is actually sold, the producer buys a futures contract to complete the trade. If the price of the commodity falls, losses on the cash market are offset by gains on the futures market. However, if the price rises, losses on the futures market offset profits on the cash sale of the commodity. This is why the price is said to be locked in. a. The difference between the local market price and the futures market price must be considered in evaluating futures prices. The local basis is the term for this difference in price. The local basis can and does vary over time. However, good estimates of the local basis for a given commodity in a given area for each month of the year are generally available from commodity brokers and local traders. b. All or part of a crop can be hedged. To lock in a price for an entire crop, the amount of product held on the futures market must equal the amount of product to be sold on the cash market. 3. In a consumer hedge, the user of an agricultural product buys a futures contract, and when the commodity is actually bought the consumer sells a futures contract to complete the futures transaction. Once again, the price is locked in. E. Interpreting Futures Quotes in the Newspaper 1. Below is a typical listing for pork bellies: PORK BELLIES (CME) 40,000 lb; cents per lb. -- Season -- Open High Low High Low Close Change Interest 63.00 39.25 Feb 40.62 40.00 40.40 +.25 8,683 61.00 39.00 Mar 40.40 39.80 40.30 +.33 2,177 58.20 40.05 May 41.57 40.90 41.52 +.37 1,437 57.00 41.00 Jul 42.25 41.85 42.15 +.18 451 51.00 40,00 Aug 40.50 40.25 40.37 +.37 177 2. Each contract is designated by the month in which it comes due. Traders must complete their trading by the end of the month given. (CME stands for Chicago Mercantile Exchange.) 3. The seasonal high and low give the price extremes for the contract thus far. 4. The high and low prices of the day are quoted, along with the closing price and the change from the closing price of the day before. 5. Open interest is the number of contracts for 40,00 Pounds of pork bellies which are outstanding. __________________________________________________________ ACTIVITY: 1. Review the hedges presented on pages 7-23 to 7-26 of Deere's FARM AND RANCH BUSINESS MANAGEMENT. 2. Track the price of commodity futures. Let students speculate using play money. There is computer software available which links up with market feeds via modem and can keep track of accounts and transactions for many players. __________________________________________________________ 12/11/91 EEZ/sg #%&C