Client:

Bullish grain producers at harvest.

Challenge:

Physical grain storage has costs depending on if it is in commercial or on farm storage, as well as the risk that prices will decrease.

Solution:

Sell the physical grain and replicate the ownership with a call spread. 

Overview

A corn producer has harvested 50,000 bushels of corn and still believes prices will increase.  The producer is looking at his best alternative to benefit from a post-harvest rally. If he puts the grains in storage, there are costs associated with storing the grain, either if in commercial storage or on farm.   

  • Commercial storage involves a minimum and monthly storage charge. Additionally, a producer may incur drying charges and interest charges on working capital until they can sell the grain and pay back the loan.
  • On-farm storage does not involve a storage charge, but there are variable costs associated with storage, quality risk, and interest costs on working capital until the producer can sell the grain.

In both cases, the producer would also benefit from post-harvest basis appreciation.

Approach

At harvest, a producer who believes prices will rally post-harvest is evaluating their marketing alternatives. The grain can be sold off the combine for nearby delivery. Some of the grains can be stored on farm or stored at the local co-op. Current prices at the co-op are:

 

New Crop

Jan

March

Futures

$5.10

$5.20

$5.20

Basis

-$0.20 Z

-$0.05 H

$0.05 H

Cash

$4.90

$5.15

$5.25

Additionally, for commercials storage, the co-op charges a flat $0.20 unit (20 cents) January 1 and then 3 cents a month thereafter. As storage costs are evaluated, the math is broken down below:

 

New Crop

Jan

March

On farm storage

 

-$0.00

-$0.00

Commercial storage

 

-$0.20

-$0.26

Interest

 

-$0.03

-$0.06

Net in on farm storage

 

$5.12

$5.19

Net in commercial storage

 

$4.92

$4.93

Looking at other marketing alternatives, call option premium is evaluated.

March call options

Strike price

Premium

$5.20

$0.23

$5.30

$0.18

$5.40

$0.15

$5.60

$0.10

$5.70

$0.08

$5.80

$0.06

$5.90

$0.05

$6.00

$0.04

Based on premiums, the producer considers selling to the local elevator at harvest at $4.90, and then through their futures broker, buying a $5.30-$6.00 call spread. Using this strategy, the producer can only lose their premium and their profit is limited to the difference in the call strike prices, in this case $ 0.70, or 70 cents.

Sell at harvest, buy $5.30 / $6.00 March call spread

Cash

$4.90

Premium

-$0.14 ($0.18-$0.04)

Net

$4.76

Results

The cash sale, call spread strategy provides the producer with the best outcome if prices decline and allows the producer to participate in 70 cents of price improvement if the market rallies. 

If March Corn falls $1, the call spread has the best outcome with a net cash sale price of $4.76. On farm storage would lose 57 cents and commercial storage would lose 83 cents in terms of spot prices.

If March Corn futures rally $1 in the next three months, all scenarios participate. The call spread adds 70 cents of profit to the New Crop sale given the fact that participants have the right to be long Corn at $5.30 from the long call position. On farm and commercial storage perform better than the call spread, but all three are participate in the rally.

In three months, if March futures are unchanged, the premium paid for the call spread expires worthless and on farm and commercial storage outperform.

Conclusion

Looking across all three scenarios, the call spread performs the best on a large move down, participates on a large move up, and is slightly worse in an unchanged market.   

14 cents/bushel

14 cents per bushel is only at risk of protecting a producer from an advise move down. It still provides upside potential and zero storage cost.

70 cents/bushel

Potential added profit on a price increase with a cash sale/call spread strategy in the example

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