Understanding Commodity Markets
Overview
A brief overview of what commodities and cash commodity markets are. Contains a brie description of different cash marketing opportunities that exist and begin to introduce the concept of futures markets.
What is a Commodity?
Commodity Markets
Producers (farmers, ranchers), merchandisers, processors, retailers, and consumers rely on each other. Producers need to be able to sell the raw products they produce to processors. Processors then use these raw materials to create goods that are sold to retailers. Producers and processors both require a place to negotiate prices and either buy or sell their agricultural products. But how are prices for commodities determined? The answer is commodity markets.
What is a Commodity?
A commodity is a raw product. Examples of commodities include grains, like corn, wheat and soybeans; livestock like cattle and hogs; metals like gold and silver, and energy sources like crude oil and natural gas. This raw product is typically sold, and then processed and/or packaged in some way. So corn may be sold to a processor who makes ethanol; gold is sold to a processor making jewelry; and crude oil is sold to a processor who makes plastic. These processed goods are then shipped to retailers, who then sell a finished product to consumers.
To make it easier to buy and sell these raw goods, the quality of the commodity must be uniform from all producers. So all the bushels of corn, all the bales of cotton, and all the barrels of crude oil are essentially the same, regardless of who produced them.
Marketing Commodities and Managing Risk
Farming is full of risk. In any year, growers can face weather perils that include droughts and floods. Even when producers escape those extremes, conditions must be favorable at key periods during planting, growing, and harvesting. And even after crops are grown and harvested, producers still encounter risk. Changes in consumer demand, unforeseen international events, costs for fuel, and other circumstances can all influence profit. But the greatest risk of all may not be associated with producing commodities, but in marketing, or selling, them for a profit. Two methods that are commonly used to market commodities are cash marketing and forward contracting.
Cash Marketing
Cash Marketing
Cash marketing takes place when a farmer sells his commodity for cash. For a grain farmer, this is usually done at a local cooperative or elevator. The farmer has not entered into any kind of contract to deliver the commodity at a certain time or at a certain price. In fact, cash marketing can take place any time after harvest, and can be delayed by months if the producer stores his/her crop. The farmer's primary risk is if prices move lower while holding the commodity, he or she will have missed the opportunity to sell at the higher price.
A trade on the cash market always involves transfer of the actual commodity. The farmer delivers their grain to the elevator after harvest or from storage, and receives the current price. Every grain marketing transaction, involving price protection, results in the sale of the physical commodity in the cash market. In other words, all spot, forward cash, futures hedges, options, basis, hedge-to-arrive contracts, etc., are not considered complete until the cash sale is made. This is a key point to remember when we discuss the mechanics of alternatives that employ more than one transaction in the cash, futures, or options markets.
The majority of all cash sales do not require any further action in terms of using additional marketing alternatives. Once the cash sale is complete, any further action taken regarding previously sold grain results in the "speculative" use of grain marketing alternatives, futures or options. We will be covering the ideas of “speculation”, hedging and options in later chapters. It is important to remember that the cash sale often represents the best sale that can be made at a given point in time. Deciding when to use the cash sale as the primary pricing method for a given unit of grain, instead of other marketing alternatives, depends on many factors. Most of the factors are quite similar to those used in making all grain sales decisions.
Cash Sale/Spot/Daily to Arrive
The cash sale of the physical commodity is the most common sales method used by farmers, and is ultimately involved in all grain sales. At times, it is used as a stand-alone transaction; at other times, it represents the completion of a hedge or other strategy.
How Does the Spot Sale Work?
•The price for the spot sale is based on the nearby futures contract plus or minus the basis and is stated as a cash price ($/bu. or, in some cases, $/lb. or $/cwt.).
•The farmer agrees to sell a specific quantity of grain at the spot price on the day that the grain is delivered. Note that premiums may be available for special qualities or large volumes. These premiums are negotiated between the seller and the grain merchant.
•Payment for the grain sold may be taken immediately or deferred to a later date.
Advantages of the Spot Sale
•Exact price is known.
•Further downside price risk is eliminated for the quantity sold.
•Carrying charges are eliminated on the quantity sold.
•The sale may be for any quantity of grain.
Disadvantages to the Spot Sale
•Since the price is fixed on the quantity sold, flexibility in pricing is eliminated or greatly reduced.
•Because title and control change hands, USDA's Commodity Credit Corporation (CCC) loan and loan deficiency payment (LDP) are no longer available on the grain.
Best Time to Use the Spot Sale
•When the price represents an acceptable profit.
•When the basis is stronger than normal (in most regions, a positive basis is highly indicative that the spot price represents a good sales opportunity).
Forward Contracting
Forward Contracting
A forward contract is a way to minimize the risk that the price of a commodity might go down before a farmer sells. A forward contract is an agreement to deliver a specific amount of a specific commodity at a specific time in the future. Because no one really knows whether prices will go up or down, a forward contract "locks-in" a price that is higher than the current cash price.
A farmer who forward contracts with the local elevator is guaranteed a known price for a specific amount of his crop, however, the arrangement doesn't offer much flexibility. If prices move higher before the delivery date, the farmer is still obligated to deliver the contracted grain at the lower, previously agreed to price. Also, the farmer is obligated to deliver the contracted amount of the commodity, even if his yields are lower than expected.
Example: In July, a farmer contracts to deliver 5,000 bushels of corn to a grain elevator operator in November. The contract price is $4.00 a bushel. The cash price of corn could go higher or lower between July and November. In November, even if the market price for corn is only $3.60 a bushel, the elevator operator is obligated to pay the farmer $4.00 a bushel. Likewise, if corn sells for $4.75 a bushel, the farmer still receives only $4.00 a bushel.
The forward contract is the second most common way to sell grain. This is a cash contract that allows the farmer to sell a specific quantity of grain for a specified cash price for delivery at a later date. It allows the farmer to set a price for a crop that is to be grown, growing in the field, harvested, or being held for later delivery.
How does the Forward Contract Work?
•Forward contracts can be made with a local grain dealer (or end user) any time—before planting, during the growing season, at harvest, or after harvest.
•The contract can be written to allow the seller to take payment at the time the grain is delivered or to defer payment until a later date (see section on "Cash Sale with Deferred Payment").
•Forward contracts are made for a specific price, quantity, and delivery date.
Advantages of Forward Contracting
•The exact price is known.
•The exact quantity is known.
•The date of delivery is known
•Downside price risk is eliminated for the quantity contracted.
•Any quantity can be contracted.
•Premiums can be negotiated for large-volume contracts or special qualities.
•Generally, farmers who irrigate can safely contract up to 100% of intended production.
Disadvantages to Forward Contracting
•The seller is obligated to fill the contract, even in the event of a production shortfall, depending on price and local conditions.
•Upside price potential is eliminated on the quantity contracted.
•You give up flexibility in choosing your delivery point.
•The seller must fill the contract even in the case of a production shortfall. As a result, farmers who produce crops on dry land generally limit the amount they contract to 50% of intended production; crop insurance or the use of options may boost this amount.
Best Time to Use the Forward Contract
•When the contract price represents an acceptable profit.
•When basis is stronger than normal.
•When you expect prices to fall.
The Cash Sale with Deferred Payment
The Cash Sale with Deferred Payment
The cash sale for deferred payment—whether a spot sale or forward contract—is generally used for tax management, to defer income into the next tax year.
Advantages of the Cash Sale with Deferred Payment
•The exact price is known.
•Payment is taken in the tax year the seller chooses.
Disadvantages of the Cash Sale with Deferred Payment
•Deferred income can present a tax problem in the event production and commodity prices are higher—or income is up for other reasons—in the following year.
•Credit risk: Should the buyer go out of business, the seller may have trouble collecting his or her payment. Some, but not all, states have indemnity funds to protect farmers in the case of elevator bankruptcy, but coverage often is not 100% and the protection does not apply to direct sales to end users such as livestock producers. The credit risk with this contract is less, however, than one with "deferred pricing"—in which the price is not determined at time of delivery.
What are Commodity Markets?
What are Commodity Markets?
A commodity market is a place where you can buy, sell, or trade these raw products. But imagine having to transport all of the world's grain, gold, crude oil and other commodities to a single place in order to sell them. It would be unwieldy and costly to have a huge central location, to which all the sellers would deliver their commodities and from which all the buyers would haul them away. So, instead of trading the physical commodity, buyers and sellers in a commodity market trade contracts representing specific amounts of each commodity. For example, a producer could sell a contract to deliver 5,000 bushels of grain at a set price at a certain time. In exchange for payment, the contract would require the producer to deliver the grain to a specific location by a certain date. A processor could then use the market to purchase the contract for 5,000 bushels of grain at a set price and time.
It is in the commodities market that the prices of raw commodities, such as grain and livestock, are set. In the example of a grain farmer, it is these markets that set the price a farmer will receive when she sells her grain at the local elevator. By understanding how the markets work, processors attempt to buy their raw goods at the lowest price, and producers attempt to sell their commodity for the highest price.
There are many commodities markets around the world. Regardless of their names or locations, these trading centers all provide the same thing: a central location for buyers and sellers to negotiate prices and execute trades. The world's largest commodities market is the CME Group, which is the combination of the two largest commodity exchanges in the world, the CBOT (Chicago Board of Trade) and the CME (Chicago Mercantile Exchange).
There are a variety of participants in the commodities market. Traders are anyone who buys or sells a contract—also known as “taking a position" in the commodities market. Speculators are those traders who buy or sell in an attempt to profit from price movements. Hedgers are traders who "hedge their bets" for favorable prices in one market by buying or selling a commodity in another.
Market Prices & Decision Making
Commodity markets are big business, and for farmers the rise and fall of commodity prices can have a significant impact on the bottom line. Keeping up to date on prices and factors influencing the market helps producers make informed business decisions. Things that can impact the price of many commodities include the weather, government policies, international events, consumer preferences, shifting input costs, and general supply and demand for the commodity.
Because of all of the different factors that influence prices, buying or selling contracts in a commodity market requires detailed data-gathering, critical thinking, and an ability to tolerate and manage risk. There are many sources a producer or trader can use for this data, including industry publications, weather forecasts, news headlines, and government reports. Many traders rely on personal experience and an understanding of market history and trends to help make decisions.
With so many sources for commodities data, how does a producer gather information and data to help make the most informed marketing choices for their business? With all of this uncertainty, how can a farmer ensure the best price for a commodity?
Key Terms and Definitions:
Key Terms and Definitions:
Producers – The firms, businesses or people that actually produce the product in its raw state, for our class it will generally signify farmers and ranchers.
Processors – The firms, businesses or people that purchase the raw material and process it into something more usable. For example the ethanol producer in Richardton – Red Trail Energy, purchases corn (the raw material) from producers (farmers) or the elevator (merchandisers) and processes the product into ethanol that can be used to fuel your vehicle, or at least 10% of it!
Merchandisers – The firms, businesses or people that are the middlemen between the producers and the processor. Typically merchandisers attempt to earn a profit by transporting grain or other raw materials between those that have it or produce it and those that need it. Your local elevator would be an example of a merchandiser.
Retailer – The firms, businesses or people that get the finished product into the hands of consumers. Either through a storefront, or a website. They are the link between the processor and the consumer.
Consumer – You and everyone like you that needs to buy products that they cannot produce themselves, or do not want to produce themselves.
Commodity – A raw product. Grains – corn, soybeans, hard-red spring wheat, soft-white winter wheat, etc. Livestock – feeder cattle (700 lb steer), live cattle (fat steer ready for slaughter), lean hogs (hog carcass skinned and on the “rail” – which means the animal is already slaughtered, had its “offal” (hide and guts) removed and is hanging on the rail – the line that moves the carcass through the slaughterhouse as it gets cut up into specific cuts of meat. Metals and energy are also considered to be commodities.
Risk – All the bad things that can happen throughout a year. Risk is everywhere and can take many forms. Weather, liability, etc. For our purposes we will focus on price and market risk in this class.
Marketing – In this class we use the term marketing to represent “selling”. We call it marketing however, because we may “market” the product (lock in a price) but retain ownership until the contract comes due.
Cash Marketing – When a producer sells his product for cash, receives the cash payment and gives up the physical possession of the item at that time.
Transaction – The process that occurs when money and physical possession change hands between buyer and seller.
Physical commodity – The actual product or commodity. When I take a truckload of corn to the elevator to sell, and I dump the corn into the pit in exchange for payment, I am sell corn in the cash market and giving up my ownership rights to the physical commodity.
Spot (spot market) – Another term for the “cash market”.
Basis – The difference between the cash price and the futures price. Basis = Cash Price – Futures Price. We will have a whole chapter on Basis – Chapter 2.
Forward Contract – A “contract” is a legally binding agreement that spells out the terms of a transaction. A “forward contract” is a legally binding agreement that spells out the terms of a transaction where the trade of the physical commodity will occur at some point in the future.
Deferred Payment – Payment is withheld after the trade of the physical commodity. Generally occurs at the end of the year (Decemberish) in order to avoid paying taxes on the income until the next year.
Commodity Market – A place where commodity prices are established. We will cover commodity markets in depth in Chapter 3.
Traders – Firms, businesses or people that trade (buy or sell) commodities in the commodity market.
Speculators – Traders that will not actually own the physical commodity, rather they attempt to make money by betting on the direction of price movements in the commodity markets.
Hedgers – Traders that will have to buy or sell the physical commodity and are looking to “hedge” or lock in their prices in order to remove risk.
Additional Terms to Know:
Bullish – The attitude of traders that price is going to increase. Usually supply will be tightening, or demand will be increasing. The “market” may be referred to as “bullish” when the price is going up on a commodity. Individuals in the market may be referred to as “bullish” when they place a bet that the price is going to increase. For example, a farmer that holds corn in storage after harvest to sell in the spring or summer would be considered to be “bullish” since she/he did not sell earlier. A speculator would be considered “bullish” if he bought a futures contract at a low price and is expecting to be able to sell it at a later date for a higher price. Individuals with a bullish attitude are known in the trade as “bulls”.
Bearish – The attitude of traders that price is going to decrease. Usually supply will be increasing, or demand is falling. The “market” may be referred to as “bearish” when price is going down on a commodity. Individuals in the market may be referred to as “bearish” when they place a bet that the price is going to decrease. For example, a farmer that sells grain directly out of the field rather than placing it in storage would be considered to be “bearish” since she/he sold early. A speculator would be considered “bearish” if he sold a futures contract at a high price and is expecting to be able to buy it back at a later date for a lower price. Individuals with a bearish attitude are known in the trade as “bears”.
Long – A “long” trade is when the trader purchases an asset first and then sells it later. A successful long trade makes money when the price of the asset (commodity for our purposes) increases in price between the time that the asset is purchased and when it is sold. All cash grain farmers (so pretty much all farmers since they all produce grain and sell it in the cash market at some point) have taken a long position in the cash market since they are purchasing the inputs first and then selling the finished product at a later date. The expectation is that the cost of producing the commodity will be less than the price that the framers is able to sell it for. Speculators are considered to be long when they purchase a futures contract first and then sell it at a later date. If price increases, the speculator makes a profit. If the price decreases, the speculator will lose money on the trade.
Short – A “short” trade is when the trader sells an asset first and then buys it later. A successful short trade makes money when the price of the asset decreases in price between the time that the asset is sold and when it is purchased. The concept of “shorting” the market is a difficult concept for many to understand. How can something be sold, when you don’t already have it? The stock market also has the concept of the short, except there you have to borrow the asset, or stock from someone else first, pay the lender of the asset interest, then you can sell the asset at a high price. You then need to buy it back at a lower price at a later date and return the asset to the original owner. When it works the profit you receive from the sale, covers the cost of the interest payment to the lender and all is good.
In the futures market the act of “shorting” is much simpler. You do NOT need to borrow the asset from anyone. You can simply go in to the futures market and sell a futures contract on a commodity that you do not have, or own. In order to exit the trade you need to make sure that you buy it back prior to expiration. Once you buy the futures contract back, the trade is done, and it essentially no longer exists. If you sell high and buy it back at a lower price you profit! We will be covering the idea of long and short in more detail later in the semester, but this will help to make sense of some of the videos that we watch and other material that we will cover.
Old crop – Grain that is stored in the bin. Could have been harvested last year or the years prior. The old crop contracts are the contracts that occur after harvest.
New crop – Grain that has yet to be planted, being planted or is in the ground. New crop contracts are those that expire after harvest of the next year. Currently –January 2016 – the new crop contract in corn would be Dec 2016.
Stocks – These represent the amount of grain that is left over or projected to be left over when the new harvest begins. The fear is running out of grain. As stocks get smaller and smaller or get projected to get smaller, this is considered bullish news. In order to keep he stocks from running out, the price will rise in order to ration the remaining grain. As well as encouraging farmers to produce higher levels of grain in the future to cover the dwindling stocks.
Rally – Prices have a sustained increase. If prices increase for a full day or more, it is considered to be a rally.
Unpriced/Gambling bushels – Bushels that have not been sold, or hedged in the futures market.
Carry in the market – This means the difference in prices from one futures contract month to the next. If the March 2016 Corn contract is at $3.55 and the May 2016 Corn contract is at $3.62, we would say that the market will pay $0.07 to carry the corn for the next 2-3 months. It is the premium paid for holding on to your grain into the months when the stocks get lower.
Carry-out – Carry actually has two meanings – carry in the market (see above) and carryout, which is basically the same as stocks (see above)