Marketing: Unimaginable prices- ‘Put’ protection in place
By Matt Mattke
The overwhelming herd mentality towards grains prices is bullish, and in some cases euphorically bullish. The consensus expectation is that grain prices are going to continue moving higher, and many market analysts/traders have gone one step further, saying supply-side effects of the drought will keep grain prices high for the next year.
There are many reasons to be bullish: Demand is still high relative to supply, and therefore inventory is tight; and the bulk of the grain belt is still experiencing drought conditions. These and other factors continue to suggest there is a very real risk of higher corn prices. If this year’s drought continues into next year, the risk of substantially higher prices increases dramatically.
The questions dairy producers have been asking are:
• How high can the price of corn go?
• How long can these high prices last?
Both questions are difficult to answer, because emotions and irrational exuberance can take prices to levels well beyond what fundamentals justify. There is the old adage: “expect the unexpected,” and that is especially true with the current commodities markets.
Recent cotton futures prices are a reminder that anything is possible. Back in March 2010, the cotton futures price was about $80.00/ton; by March 2011 the price hit an all-time record high of almost $230.00/ton, a move nearly everyone would have said was impossible.
The point is dairy producers must prepare and protect themselves – both on the feed side, as well as on the milk side – from the unexpected/unimaginable types of market scenarios. Those unimaginable market scenarios apply to both UP markets and DOWN markets.
Going forward, open-minded producers must take the stance that either $12/bushel or $4/bushel corn is possible, and be protected against the first scenario, but also able to participate in the second scenario.
This does not require psychic powers. It requires planning and strategies to accomodate many market scenarios.
For example, right now the trend is still up for corn prices, so there is still the risk of seeing higher prices. On the other side of the coin, $7.00/bushel and higher corn prices have not lasted long in the past. There is the other old adage that “high prices cure high prices,” and $7.00/bushel and higher corn have done a good job fixing supply/demand imbalances in the past. Every rally over $7.00/bushel has eventually been followed by a selloff down at least into the $5.00/bushel range.
Thus, there are dollars per bushel of risk and opportunity in both directions from the current price of about $7.50/bushel. For a producer who still must buy 2012/13 corn needs, a strategy must be implemented to protect against unimaginable upside risk, while still providing participation in the unimaginable downside opportunity. A strategy to accommodate both is buying the physical corn and protecting the purchase with put options.
Buying the physical corn protects against higher prices. If a dairy producer has $7.50/bushel corn bought and corn goes to $12.00/bushel, they are locked in at $7.50/bushel. However, if corn goes to $5.00/bushel, they are still locked in at $7.50/bushel. The latter scenario is where the put option coverage comes into play. If $7.00 put options are purchased at 35¢/bushel and corn drops to $5.00/bushel the put options would provide $1.65/bushel of downside price protection. That would effectively reduce the purchase price on the physical corn from $7.50/bushel to $5.85/bushel.
Bottom line, complementing cash market purchases of corn feed or protein feed with put option protection can give a dairy producer a feed hedge position that protects them no matter what unimaginable price development comes in 2013. That’s an attractive position to be in.