Buying Futures to Protect Against Rising Prices
Those involved in buying grain and oilseed products are aware of the risks they face from a potential price increase.
Grain processors, feed manufacturers, food companies and importers who are concerned about the impact that a price increase 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 that buyers can employ.
A manufacturer is planning to purchase 15,000 bushels of corn for his feed operation in the spring, but is concerned about an increase in corn prices by the time he is ready to make his purchase in April. The basis in his area in mid-April is typically 5 cents over the May futures price, which is currently $4.25 per bushel.
The manufacturer knows his business will be profitable if he pays $4.30 for corn, so he decides to hedge his upcoming corn purchase by buying, or going long, May Corn futures. Since each Corn futures contract equals 5,000 bushels, he goes long three Corn futures contracts to hedge the 15,000 bushels of corn he will need.
By hedging with May Corn futures, he locks in an expected purchase price level of $4.30, which is the May futures of $4.25 price plus the expected basis.
Assume that in April, the May Corn futures price increases to $4.70. This means that the cash price for corn in April would be $4.75, which is 45 cents higher than cash corn price the feed manufacturer was anticipating back in December.
However, the 45-cent gain he makes when he offsets his long futures position by selling May Corn futures will give him a net purchase price of $4.30 per bushel, which is the cash price of $4.75 minus the 45-cent gain on the futures position. Note that this is 45 cents lower than the corn price in the cash market.
But what if corn prices decline instead? Well, if the price for corn does go down, the feed manufacturer will still pay $4.30 per bushel for corn.
Suppose the May Corn futures price falls from $4.25 to $4.00 by mid-April. With the basis of 5 over, the manufacturer would purchase corn locally at $4.05 and simultaneously offset his futures position by selling May Corn futures at $4.00. Even though he purchased cash corn at a lower price, the feed manufacturer lost 25 cents on his futures position. This equates to a net purchase price for corn of $4.30, which equals the cash price of $4.05 plus the 25-cent loss on the futures position.
In this scenario, where hedging with futures provided protection against rising prices but did not allow the hedger to take advantage of lower prices, it may appear on the surface that hedging was a losing proposition for the feed manufacturer.
However, remember his original goal at the beginning of this process: to lock in a price of $4.30 for his corn purchases. By hedging with futures, he accomplished what he intended when making the decision to hedge.
Relinquishing the chance at a lower price in exchange for securing price protection, knowing that the price could just as easily have increased, is a trade-off that a futures hedger is willing to make.
Of course, the feed manufacturer’s actual purchase price will be affected by what happens to the basis between the time he initiates the hedge and when he makes his corn purchase. Keep in mind that a long hedger will benefit from a weakening basis, or a basis that becomes less positive or more negative.
A basis that is weaker than expected could lower a long hedger’s net purchase price, even in the face of a price increase.
For example, in the earlier scenario, Corn futures increased to $4.70. If the basis weakens from 5 over to 10 under, the manufacturer’s net purchase price would be $4.15, which is the May futures price of $4.70, minus the basis of 10 under, minus the futures gain of 45 cents.
However, if the basis strengthens, in other words, becomes less negative or more positive, it could increase the feed manufacturer’s final purchase price.
If the basis strengthens from 5 over to 10 over, the result would be a net purchase price of $4.35, the May futures price of $4.70, plus the basis of 10 cents, minus the futures gain of 45 cents.
No one can predict the future, but hedgers can take steps to manage it. Buying grain and oilseed futures allows those who need protection against rising prices to have peace of mind of knowing that they have taken steps to manage the risk involved in purchasing these commodities for their business.