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Featured Article

13 January 2022

Case Study: Hedging Downside Risk in Corn Under Rising Input Costs with a Min-Max Contract

By CME Group

CLIENT:

Grain producers

CHALLENGE:

Navigating market volatility in an uncertain economy

SOLUTION:

Min-Max contract via elevator agreement or options spread

Overview:

Supply chain disruptions, unpredictable weather, labor shortages, variable export demand, and foreign supply have all contributed to corn volatility since the onset of the Covid-19 pandemic. Although bullish grain markets are generally favorable to producers, commodity price increases are expected to be derived in large part from higher input costs, thus producing higher break-even costs estimated for the 2022 crop year. With significant increases expected among almost all input costs to grain producers in the coming year, the need to protect profit margins is strong.

Table 1 below shows the University of Illinois Crop Budget inputs for direct, overhead, and power costs over the period 2020 through 2022 (projected) for corn acreage planted after soybeans. Total direct costs are expected to see a year-on-year increase of 20% for 2022 compared to the 2021 crop year, to $428 per acre. Fertilizer, comprising the plurality of direct costs, is expected to increase 40% this coming year, after a 6% increase in the year prior. Drying, which is generally powered by natural gas, is expected to see a 33% increase in cost next year. Driven by low labor supply and increasing wages; building repair, general hired labor, and machine repair are each expected to see double digit increases in cost 2021 over 2022 as well.

Table 1: University of Illinois Crop Budget Input Costs, 2020-2022*

Input Type Input 2020 2021 2020/2021 2022 2021/2022
Direct costs Crop insurance $ 23.00 $ 25.00 9% $ 27.00 8%
  Drying $ 15.00 $ 15.00 0% $ 20.00 33%
  Fertilizers $ 125.00 $ 132.00 6% $ 185.00 40%
  Pesticides $ 60.00 $ 61.00 2% $ 66.00 8%
  Seed $ 112.00 $ 114.00 2% $ 121.00 6%
  Storage $ 10.00 $ 10.00 0% $ 9.00 -10%
Total direct costs   $ 345.00 $ 357.00 3% $ 428.00 20%
 
Overhead cost Building depreciation $ 17.00 $ 17.00 0% $ 18.00 6%
  Building repair and rent $ 9.00 $ 9.00 0% $ 10.00 11%
  Hired labor $ 23.00 $ 23.00 0% $ 26.00 13%
  Insurance $ 10.00 $ 10.00 0% $ 10.00 0%
  Interest (non-land) $ 26.00 $ 27.00 4% $ 17.00 -37%
  Misc $ 9.00 $ 9.00 0% $ 10.00 11%
Total overhead costs   $ 94.00 $ 95.00 1% $ 91.00 -4%
 
Power cost Fuel and oil $ 17.00 $ 17.00 0% $ 21.00 24%
  Light vehicle $ 2.00 $ 2.00 0% $ 2.00 0%
  Mach. Depreciation $ 58.00 $ 59.00 2% $ 64.00 8%
  Machine hire/lease $ 26.00 $ 26.00 0% $ 30.00 15%
  Machine repair $ 27.00 $ 27.00 0% $ 35.00 30%
  Utilities $ 6.00 $ 6.00 0% $ 7.00 17%
Total power costs   $ 136.00 $ 137.00 1% $ 159.00 16%
 
Grand Total   $ 575.00 $ 589.00 2% $ 678.00 15%

*Northern Illinois Region for corn after soybeans, prices in dollars per acre

The sum of direct, overhead, and power costs is expected to increase 15% year-on-year 2021/2022 to $678 per acre. Breakeven prices are generally calculated per bushel, as the total of input costs divided by the expected yield, necessitating that crop revenue increase by an amount exceeded by input costs for harvests to remain profitable. Such high input costs simultaneously beg a bull market in terms of corn pricing and demand caution of producers and merchandisers alike. 

Scenario:

A min-max contract can provide price stability for producers amidst rising input costs and uncertain volatility. Also known as a “floor-ceiling” or “collar” contract, a min-max contract can be procured through an agreement with the grain elevator in the cash market.

A min-max contract establishes both floor and ceiling prices, which are the respective minimum and maximum prices that will be received at expiration. If the market settles between the floor and ceiling prices, the participant will receive the market price (often minus a few cents per bushel as commission paid to the elevator). The delivery location, date, and specifications are set at the onset of the contract.

Min-max contracts benefit market participants with cautious but ultimately (at least slightly bullish) market sentiment. To these participants who are confident in the viability of their harvest and delivery timing, stability is more important than catching waves of extreme price volatility. Additionally, a min-max contract allows opportunity to lock in profit margin if the floor price of the contract is greater than the cost of production. Min-max contracts do have exposure to a margin call when futures move past the call strike.

Example:

On October 6, 2021, the cash corn price is 532c per bushel. General market expectation is for the price of corn to rise over the next six months, though unexpected headwinds could arise. The producer arranges a min-max contract with his elevator establishing a ceiling of 598'4, a 12.5% increase from the current price, and a floor of 505'4, or a 5% decrease, at an April 1, 2022 expiration. If a bull market prevails where corn reaches 617'4 by April 1, 2022, the producer will have been able to capture the majority of the upward move while still protecting himself from downside risk.

Figure 1: Min-Max Contract Example

Conclusion:

Our optimistic yet cautious producer is able to protect himself from unexpected headwinds in an environment of rising input costs and bullish price expectation.

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