Extremely volatile commodity prices due to high energy costs have led to the suspension of forward price cash contracts - a marketing tool used among farmers to reduce price risk and increase profits each year, according to Texas AgriLife Extension Service economists.
The suspension of forward contracts is a result of grain elevator operators' and merchants' inability to cover margin spreads, said Mark Welch and John Robinson, economists in College Station.
Corn, wheat, cotton, soybeans and other commodities have eclipsed record prices this year as a result of increased biofuel demand, acreage adjustments, production shortfalls, tight carryover stocks, and speculative investment, Welch said.
“Many farmers wanting to lock in prices at these historic levels are turning to forward price contracts,” he said.
Forward price contracts of a growing crop establish a “price and delivery provision,” Welch said, which transfers price risk from the producer to the writer of the contract.
“(This is) usually a grain elevator or cotton merchant,” Welch said. “The elevator or merchant may then transfer this price risk to speculators by hedging in the futures market.”
A contract hedge consists of selling an equivalent amount of cotton or grain in the futures market to cover inventory or forward contracted commodities that they hold, he said.
“If prices are lower at harvest, gains in the futures market offset the price difference between the higher contract price and the current cash price, protecting the elevator or merchant's price margin,” Robinson said. “If prices go up at harvest, losses in the futures market are offset by the ability to sell the forward contracted grain or cotton at a higher price.”
Those participating in the futures market must have enough margin money deposited to cover potential losses. The margin is balanced daily and those profits accrued in excess of the margin requirement may be withdrawn.
“Any losses that draw the margin account below the minimum maintenance level must be offset by additional deposits to restore the account to its initial balance,” Welch said.
Those that fail to bring the account up to the initial required level result in liquidation of the position and the holder of the account must absorb all losses.
As a result of rapid escalation of commodity prices, elevators and merchants who wrote forward price contracts are facing “enormous proportions,” Welch said.
“Wheat that was hedged at planting last October for a then all-time record high price of $7 a bushel has incurred margin calls of $6 per bushel or $30,000 per contract.”
Forward-contracted corn last fall has increased in price by more than $2 a bushel, he said.
“The margin requirement to maintain each of those contracts is now around $10,000,” he said. “For a medium to mid-sized grain elevator to maintain their hedged positions, they have had to deposit millions of dollars in margin money. Add to this the interest cost of funds required to maintain margin requirements and the financial burden of offering and maintaining forward contracts is considerable.”
Farmers are now left with the option of either hedging their crops by selling futures contracts, buying options or a combination of the two, Welch said.
“The impact of severe margin calls on the commercial sector should give growers renewed pause about the margin risks of hedging via selling straight futures,” he said. “Many producers are uncomfortable or unfamiliar or had unprofitable experiences with these marketing alternatives. It's important that prospective hedgers learn all they can about these markets and understand the risks and rewards before initiating a hedging program.”
In order for producers to stay updated on changing market conditions, Welch and Robinson advised them to have ongoing communication with lenders and the grain or cotton merchants.
“Working together, it's possible to forge an effective strategy to manage price risk even in these volatile markets,” Welch said.
Commodity organizations representing grain and cotton industries have complained to the Commodity Futures Trading Commission that the markets are no longer working as intended.