Those involved in producing or selling grain and oilseed products are aware of the risks they face from a potential decline in prices. Farmers, merchandisers, grain elevators and exporters, who are concerned about the impact that a price decrease could have on their business, are constantly seeking ways to mitigate this risk and protect their bottom line.
Fortunately, due to the availability of CME Group grain and oilseed futures and options, there are many strategies you can employ. This module will discuss selling futures as a hedge against declining prices, including how changes in the basis could affect the final outcome.
For the purpose of our discussion, say that the seller is a soybean producer, it is May and he has just planted his crop. Due to uncertain weather patterns, the producer is concerned that soybean prices could decline before he harvests his crop in October. The basis in his area in mid-October is typically 10 cents under the November futures price, which is currently trading at $8.85 per bushel.
The producer knows he will be profitable if he sells his soybean at the current futures price, so he decides to hedge his crop by selling, or going short, November soybean futures.
By hedging with November Soybean futures, he locks in an expected selling price of $8.75, which is the November futures price of $8.85 price minus the expected basis of 10 under.
Look at what happens to his short futures hedge if soybean prices actually do decline, or if they increase.
Assume that in October, the November Soybean futures price declines to $8.50 and the basis is 10 under as expected. This means that the cash price for soybeans in October is $8.40, which is 35 cents lower than cash soybean price the producer was anticipating back in May.
However, there is a 35 cent gain when he offsets his short futures position by buying November Soybean futures. This will give him a net selling price of $8.75 per bushel, which is the futures price of $8.50, minus the basis of 10 under, plus the 35 cent gain on the futures position. Note that this is 35 cents higher than the soybean price in the cash market.
If the price for soybeans goes up rather than down, the producer will still receive $8.75 per bushel for his soybeans.
Suppose the November Soybean futures price rises from $8.85 to $9.15 by mid-October. With the basis at 10 under, the producer would sell soybeans locally at $9.05 and simultaneously offset his futures position by buying November Soybean futures at $9.15.
Even though he sold his cash soybeans at a higher price, the producer lost 30 cents on his futures position. This equates to a net sell price of $8.75, which is the futures price of 9.15, minus the basis of 10 under, minus the 30 cent loss on the futures position.
Under this scenario, where hedging with futures provided protection against falling prices, but it did not allow him to take advantage of a higher price, it appears on the surface that hedging was a losing proposition for the producer.
However, remember his original goal at the beginning of this process: to lock in a selling price of $8.75 for his soybeans. By hedging with futures, he accomplished what he intended when making the decision to hedge. Relinquishing the chance at a higher price in exchange for securing price protection, knowing that the price could just as easily have declined, is a trade-off that a short futures hedger is willing to make.
The producer’s actual sell price will be affected by what happens to the basis by the time he harvests and sells his soybeans. Keep in mind that a short hedger will benefit from a strengthening basis, or a basis that becomes less negative or more positive.
A basis that is stronger than expected could increase a short hedger’s net selling price even in the face of a price decline. In the earlier scenario, soybeans fell to $8.50. If the basis strengthens from 10 under to 5 under for example, his net sell price would be $8.80, which is the November futures price of $8.50, minus the basis of 5 under, plus the futures gain of 35 cents.
However, if the basis weakens, becomes less positive or more negative, it could lower the producer’s final selling price. If the basis weakens from 10 under to 15 under, for example, the result would be a net selling price of $8.70—the November futures price of $8.50, minus the basis of 15 under, plus the futures gain of 35 cents.
No one can predict the future, but hedgers can take steps to manage it. Selling grain and oilseed futures allows those who need protection against falling prices to have peace of mind knowing that they have taken steps to manage the risk involved in producing or selling these commodities for their operations.