Cross Hedge Effectiveness of CME Group Contracts on Agricultural Commodities

Background

CME Group offers futures contracts for many grain and oilseed products, but there are several commodities grown domestically that do not have a corresponding futures contract. The growers of these commodities do not have a direct way in which to manage price risk. However, market participants often use CME Group’s existing contracts to hedge these commodities through cross hedging.1 Growers, processors, and commercials already using CME Group contracts or looking for a new way to hedge risk for products without futures contracts can in many cases still use the current slate of grain and oilseed futures contracts to effectively manage their price risk. This paper will examine how much price risk is reduced when using a CME Group futures contract to hedge against cash price movements of commodities without a direct futures contract.

This paper looks at seven commodities (sorghum, sunflower seed, alfalfa meal, corn gluten feed meal, distiller’s dried grains, corn gluten feed, and wheat middlings) that do not have futures contracts and measures the hedge effectiveness and hedge ratios of cross hedging with a variety of CME Group’s contracts, including Corn, Soybean Meal, and Soybean Oil futures. Hedge effectiveness is the variation in cash commodity price explained by the futures price, or more simply, how much price volatility or price risk is diminished when using a futures contract to hedge against movements in cash prices. This paper will examine how much price risk is reduced when using a CME Group futures contract to hedge against cash price movements of commodities without a direct futures contract – for example, using CBOT Corn futures to hedge cash sorghum. The hedge ratio is the percent of the cash commodity that should be hedged using the futures contract to reduce price risk to the greatest degree.

Methodology

Data Used

Determining hedge effectiveness and hedge ratios requires both cash prices for each commodity and futures settlement prices for the contract being used to manage risk. For the purposes of this paper, United States Department of Agriculture (USDA) Agricultural Marketing Service (AMS) daily reported commodity prices were used over the five-year period of 2010 through 2014. When daily prices were not available for a given location, as was the case with corn gluten feed and wheat middlings, weekly cash price data were used.

CME Group daily settlement prices for old-crop and new-crop futures contracts were used, with the roll between the new-crop month and the old-crop month taking place on the business day prior to the nearby contract going into delivery. For example, the July 2010 Corn futures contract settlement prices were compared with sorghum cash prices from the last business day of November 2009 through the second to last business day in June 2010, and then the December 2010 Corn futures contract settlement prices were used from the last business day in June 2010 through the second to last business day of November 2010. 

Cointegration, Ordinary Least Squares, and the Engle-Granger Test

In order to determine the hedge effectiveness and hedge ratio, the method of ordinary least squares (OLS) was used to regress futures prices on cash prices. The regression can be run on either price levels or price differences. To determine whether or not levels can be used, the variables were tested for cointegration. Time series data, and particularly price data, are often random and non-stationary. However, if there is a linear combination between two nonstationary sets of cash and futures price data that is stationary, then the two price series are cointegrated. Cointegration ultimately means that there is something moving both cash and futures price data together, and the relationship between the cash and futures series is real and not simply by chance (not spurious). Because of that real relationship, regression on price series data that are cointegrated may be conducted with price levels rather than price differences, and all of the accompanying regression statistics are valid. All of the results presented here were cointegrated based on Engle-Granger tests, and price level data were used to determine hedge effectiveness and hedge ratios for the seven commodities in this paper.

To determine the presence of cointegration among multiple dependent variables – such as when a combination of the Corn futures contract and the Soybean meal futures contract are used to hedge distiller’s dried grains (DDGs) – the residuals produced from the two OLS regressions were tested for cointegration using the Engle-Granger method and found to be cointegrated. Regardless of whether a single futures contract or multiple futures contracts were examined, the resulting coefficient of determination (R2) is the measure of hedge effectiveness (i.e., the percentage reduction in price risk or price volatility compared to outright cash price volatility) and the resulting beta coefficient(s) is (are) the measure of hedge ratio. 

Cross Hedging Results

Sorghum

Sorghum is a cereal that is grown globally and has several different uses. In the United States, sorghum is mainly used as a livestock feed, though it is also found in some finished food products. The United States is the largest global producer of sorghum, which is grown primarily in the southern Plains states, and production has been growing at a rapid pace in recent years. In 2015, the United States produced almost 575 million bushels of sorghum.2

CBOT Corn futures prices are closely correlated with cash sorghum prices, and therefore provide an extremely useful cross hedge. Using data from 14 locations, the hedge effectiveness of cross hedging sorghum with the Corn futures contract ranges from 0.91 in Buffalo, Oklahoma to 0.95 in both Kansas City, Missouri and Shattuck, Oklahoma (Table 1). Across all locations, a sorghum grower can expect a reduction in price risk of over 90 percent by cross hedging their sorghum crop using CBOT Corn futures

Hedge ratios for sorghum are also similar despite the location, ranging from 80 percent in Memphis, Tennessee to just over 100 percent in multiple locations, which suggests that growers should hedge the vast majority of their sorghum crop using Corn futures for optimum risk coverage.

Table 1: Hedging Sorghum With The Corn Futures Contract

  Corn
Hedge Effectiveness (R2) Hedge Ratio
Alva, OK 0.93 0.99
Buffalo, OK 0.91 0.98
Central Kansas 0.94 0.96
Hooker, OK 0.92 1.02
Kansas City, MO 0.95 1.01
Keyes, OK 0.92 1.02
Manchester, OK 0.93 0.98
Medford, OK 0.94 0.97
Memphis, TN 0.93 0.80
Mt. Vernon, IN 0.94 0.91
Ponca City, OK 0.92 0.95
Rural Nebraska 0.93 0.97
Southeast Colorado 0.92 1.01
Shattuck, OK 0.95 0.97

Sunflower

Sunflower is one of the largest oilseed crops in the world, and in the United States, grows predominately in the northern Midwest. Sunflower seed is used in a variety of products, including birdseed, sunflower oil, and consumer snacks. Domestic production of sunflower seed peaked in the 1970s; since then other crops such as soybeans have gained significant acreage in traditional sunflower growing areas. In 2014, the United States produced over 2 billion pounds of sunflower seed valued at approximately $475 million.3

Sunflower seeds are divided into two types: oiltype and non-oil-type. Oil-type seeds account for the majority of sunflower production in the United States, generally between 70 percent and 90 percent depending on the crop year. Sunflower seed can be successfully hedged using the CBOT Soybean Oil futures contract, with a hedge effectiveness of 0.68 in West Fargo, North Dakota and 0.71 in East Colorado (Table 2). A sunflower grower can reduce price risk by up to 70 percent by hedging their sunflower seed crop with the Soybean Oil futures contract.

Table 2: Hedging Sunflower Seed with the Soybean Oil Contract

Soybean Oil
  Hedge Effectiveness (R2) Hedge Ratio
West Fargo, ND 0.68 0.61
East Colorado 0.71 0.59

The hedge ratio for sunflower seed is approximately 0.60 in both locations. Sunflower seed farmers can improve their risk coverage by hedging 60 percent of their sunflower crop with the Soybean Oil futures contract.

Alfalfa Meal

Alfalfa is a type of hay and is grown in the northern and western United States. The predominate growing states include California, South Dakota, and Idaho.Domestically, the United States produced just over 60 million tons of alfalfa hay in 2014, a slight increase from previous years.5 Alfalfa can be turned into feed in the form of either meal or pellets. Alfalfa is fed to livestock, poultry, and horses.

As it is also used as a livestock feed, alfalfa meal can be hedged using the CBOT Soybean Meal futures contract. The Soybean Meal futures contract provides a hedge effectiveness of 0.48 for alfalfa meal in Enderlin, ND (Table 3), meaning alfalfa growers can reduce their risk by approximately 50 percent by hedging some of their crop with soybean meal futures. The hedge ratio is 0.69, meaning that to obtain ideal risk coverage, a producer should hedge about 70 percent of their alfalfa meal production with Soybean Meal futures.

Table 3: Hedging Alfalfa with the Soybean Meal Contract

Soybean Meal
  Hedge Effectiveness (R2) Hedge Ratio
Enderlin, ND 0.48 0.69

Corn Gluten Feed Meal

Corn gluten feed meal (CGM) is a byproduct of wet corn milling, and is used as an animal feed. CGM is approximately 60 percent crude protein, whereas soybean meal used as animal feed generally has a protein content of around 44-48 percent.

CGM can be hedged using the CBOT Soybean Meal futures contract. Using Kansas City prices, the Soybean Meal futures contract provides a hedge effectiveness of 0.57 for corn gluten feed meal (Table 4). The hedge ratio is 1.29, so the data suggest that corn gluten feed meal producers should hedge over 100 percent of their supply with the Soybean Meal futures contract for optimal risk coverage.

Table 4: Hedging Corn Gluten Feed Meal with the Soybean Meal Contract

Soybean Meal
  Hedge Effectiveness (R2) Hedge Ratio
Kansas City 0.57 1.29

Distiller’s Dried Grains

Distiller’s Dried Grains (DDGs) are a byproduct of ethanol production, and are used as a high-protein animal feed source. Production is concentrated in the corn-producing Midwestern states. Production of DDGs has increased significantly in recent years, mirroring the growth in ethanol production. In 2014/2015, DDG production was estimated at over 44 million short tons.6 The export market has also grown substantially, from only 1 million tons less than 10 years ago to over 11 million tons in 2014. China is the largest market for U.S.- produced DDGs.

DDGs can be hedged using the CBOT Corn futures contract, the CBOT Soybean Meal futures contract, or – for the best results – a combination of both contracts. When hedging DDGs, Corn futures provides hedge effectiveness of between 0.56 in East Iowa and 0.65 in Nebraska; Soybean Meal futures provide hedge effectiveness of between 0.55 in Nebraska and 0.63 in Iowa; while a combination of the two delivers hedge effectiveness of just over 0.80 in all locations (Table 5). Whether the Corn or Soybean Meal contract provides better risk coverage depends on location, but a combination of the two results in a more effective hedge regardless of the production state.

Table 5: Hedging Distiller's Dried Grains with the Corn and Soybean Meal Contracts

  Corn Soybean Meal Combination
Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio – Corn Hedge Ratio – Soybean Meal
East Iowa 0.56 0.68 0.62 0.68 0.81 0.44 0.49
South Dakota 0.64 0.73 0.56 0.65 0.82 0.53 0.42
Illinois 0.57 0.68 0.63 0.68 0.82 0.45 0.49
Minnesota 0.58 0.69 0.60 0.67 0.81 0.47 0.46
Nebraska 0.65 0.81 0.55 0.71 0.83 0.59 0.45
West Iowa 0.60 0.71 0.61 0.68 0.83 0.49 0.47

The hedge ratio can help growers or producers determine how much of their DDGs to hedge using each contract. If hedging with only the Corn contract, the hedge ratio varies from 0.68 in Illinois and East Iowa to 0.81 in Nebraska. When only the Soybean Meal contract is used, the hedge ratio varies from 0.65 in South Dakota to 0.71 in Nebraska. The hedge ratios vary slightly across locations when both Corn and Soybean Meal futures are used to hedge DDGs, but are close to hedging half of DDG production with Corn futures and half with Soybean Meal futures in most states.

Corn Gluten Feed

Corn gluten feed (CGF), like corn gluten feed meal, is a byproduct of corn milling and is used as an animal feed. However, it is lower in protein, generally around 20 percent protein content. Production of CGF is highest in states with large corn wet milling operations. From one 56 pound bushel of corn, approximately 6 pounds of CGF can be produced.7

Like DDGs, CGF can be effectively hedged with Corn futures, Soybean Meal futures, or a combination of both. Though CGF is a direct derivative of corn, Soybean Meal futures actually provide a better individual hedge, with a combination of both contracts eclipsing either Corn or Soybean Meal futures independently (Table 6). Hedging with Corn alone produces hedge effectiveness between 0.40 and 0.52 depending on location, whereas hedging with Soybean Meal alone provides hedge effectiveness between 0.61 and 0.55; hedging with a combination of both Corn and Soybean Meal futures delivers hedge effectiveness between 0.70 and 0.73.

Table 6: Hedging Corn Gluten Feed with the Corn and Soybean Meal Contracts

  Corn Soybean Meal Combination
Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio – Corn Hedge Ratio – Soybean Meal
Kansas City, MO 0.40 0.47 0.61 0.56 0.70 0.26 0.45
St. Louis, MO (Weekly) 0.52 0.50 0.55 0.50 0.73 0.34 0.35

Analysis also suggests that a producer should hedge more of their CGF using soybean meal as opposed to corn. The hedge ratio for Corn futures was between 47 percent and 50 percent of CGF production, compared to between 50 percent and 56 percent for Soybean Meal futures. When using both the Corn and Soybean Meal futures contracts in tandem to hedge CGF, data suggests that in Kansas City, Missouri, 26 percent of CGF production should be hedged with Corn futures and 45 percent should be hedged with Soybean Meal futures, and in St. Louis, Missouri, 34 percent of CGF production should be hedged with Corn and 35 percent with Soybean Meal.

Wheat Middlings

Wheat middlings, also known as wheat midds, are made from milling wheat and are used as a feed additive for livestock, horses, and domesticated pets. Wheat midds contain protein and fiber that is particularly beneficial for ruminants. Generally, states that produce most of the nation’s wheat are also large producers of wheat midds; Kansas is the largest producer of wheat midds in the United States.8

Similar to the other animal feeds discussed, wheat midds can be hedged using CBOT Corn and/or Soybean Meal futures. In contrast to CGF, however, Corn generally provides a better hedge for wheat midds (Table 7). The hedge effectiveness using Corn futures ranges from 0.60 to 0.68 depending on the location, while Soybean Meal futures afford a hedge effectiveness between 0.28 in Kansas City, Missouri and 0.44 in Chicago, Illinois. However, when both contracts are used, hedge effectiveness rose to between 0.64 and 0.76, greatly increasing risk coverage for producers of wheat midds.

Table 7: Hedging Wheat Middlings with the Corn and Soybean Meal Contracts

  Corn Soybean Meal Combination
Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio Hedge Effectiveness (R2) Hedge Ratio – Corn Hedge Ratio – Soybean Meal
Chicago, IL (Weekly) 0.61 0.64 0.44 0.53 0.73 0.49 0.31
Kansas City, MO 0.60 0.62 0.28 0.40 0.64 0.54 0.17
Minneapolis, MN (Weekly) 0.68 0.69 0.38 0.50 0.76 0.57 0.25
St. Louis, MO (Weekly) 0.64 0.64 0.39 0.49 0.72 0.52 0.25

Conclusion

The above analysis describes several commodities with significant production in the United States that do not have a direct futures market but which can be effectively cross hedged using existing CME Group agricultural contracts. For example, sorghum growers can use the Corn futures contract and DDG producers can use a combination of the Corn and Soybean Meal futures contracts to effectively reduce price risk. The hedge effectiveness reported in these two commodities is above 0.90 and 0.80, respectively. Hedge ratios reported in this paper show how much of the cash commodity should be ideally hedged to mitigate risk. Even low hedge ratios indicate that some of the inherent risk in agricultural production can be offset by use of an existing futures contract. The existing contracts, specifically Corn and Soybean meal futures, offer deep liquidity, making it easier for buyers and sellers to enter and exit the market. Though it would be theoretically possible to develop new futures contract for each commodity discussed in this paper, the benefit of current contract liquidity outweighs any potential benefit of greater hedge effectiveness (R2) with the new contracts.

Footnotes

1 Cross hedging is defined as taking an offsetting position in another good with correlated price movements in the futures market.

USDA, ERS, Feed Grains Database.

3 USDA, ERS, Oil Crops Yearbook, Table 20 —Sunflowerseed: Acreage planted, harvested, yield, production, and value, U.S., 1980-2014.

4 USDA, NASS, Alfalfa Hay (Dry) 2014 County Map.

5 USDA, NASS, Crop Production 2014 Summary, January 2015.

6 Iowa State Extension, Agricultural Marketing Resource Center, Estimated U.S. Dried Distillers Grains with Solubles (DDGS) Production & Use.

7 Kansas State University, Corn Gluten Feed, Composition and Feeding Value for Beef and Dairy Cattle.

8 Kansas State University, Wheat Middlings, Composition, Feeding Value, and Storage Guidelines.

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