Hedging Against Falling Wheat Prices using Wheat Futures

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No Wheat Shortage, but Prices May Rise

The price of wheat had been falling since the last great spike in 2008, but in April, Guy Lapointe seeded 2,200 acres of hard red spring wheat anyway on his rolling land in Alberta.

Now, as prices jump skyward, he is about to send his two John Deere combines into his fields and relishes the higher price he will reap.

“It is looking up,” said Mr. Lapointe, 46. “One farmer’s misfortune is another’s fortune.”

The drought afflicting Russia’s plains and the Kremlin’s sudden decision Thursday to halt exports of wheat will undoubtedly have unexpected consequences across the globe. Farmers from the Midwest to France will fill the void left by Russian exporters, but food processors could get caught by rising costs. The higher prices could be passed to consumers of foods including pizzas, bread and bagels.

If prices rise further, the situation could resemble 2008, when drought in Australia and embargoes across Asia in foodstuffs like rice disrupted the global food supply and prompted some rioting.

But there is an important difference between the current situation and that last price spike: the Russian drought and ban on wheat exports, in contrast to the global shock in 2008 that drove wheat prices up to nearly $13 a bushel and created tensions in Indonesia and Pakistan, are occurring when global wheat production is plentiful and stocks in the United States are at a 23-year high, analysts said.

“This is still going to be the third-largest wheat crop in world history, even with the Russian shortfall,” said Daniel W. Basse, president of AgResource, an agricultural consultant firm in Chicago. “The question becomes, Will the drought persist, and will there be problems elsewhere, in other big producers like Argentina or Australia?”

Wheat prices have risen by about 90 percent since June because of the Russian drought and other factors like floods during the planting season in parts of Canada. As the price shock ripples through the supply chain, small food producers may be unprotected because they tend to buy flour on the spot market.

Larger companies, like Piantedosi Baking Company of suburban Boston, have hedged against cost inflation.

“Now that we are hitting the storm here, we are locked down fairly far, to the end of the year practically,” said Joseph A. Piantedosi Jr., who runs the company with two cousins.

Papa John’s Pizza said it had locked in its wheat purchases through the first quarter of 2020, and Domino’s Pizza said it had also hedged.

The drought this summer had already pushed the price of wheat futures to their highest level since 2008. Amid growing nervousness on Monday, the number of wheat futures and options contracts traded on the Chicago Board of Trade reached record highs, beating the previous record set in 2008, and more than double the daily average so far this year.

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Then on Thursday, the announcement of the embargo by Prime Minister Vladimir V. Putin caused a further sharp swing — prices hit their upper limits on all three of the exchanges where wheat futures are traded in the United States, in Chicago, Kansas City and Minneapolis.

“It was a really crazy day,” said Frank Stone, 55, of the Kansas City Trading Group.

On Friday, the futures prices fell again, this time hitting the lower limits on all three exchanges, on tentative reports that Russia might honor some of its export contracts after all or at least postpone the embargo until after its wheat harvest.

According to Interfax, First Deputy Prime Minister Igor Shuvalov said on the Ekho Moskvy radio station, “The decision to ban exports could be adjusted, depending on the harvest.”

By close of trading on Friday, wheat futures for September delivery on the Chicago Board of Trade had dropped 60 cents, to $7.25 a bushel, still sharply higher than a few weeks ago.

Cash prices for wheat have risen less significantly than futures prices, traders and analysts said, reflecting the fact that wheat is in healthy supply around the world.

“We do have a lot of wheat in the U.S.,” said Erica Olson, marketing specialist at the North Dakota Wheat Commission, a trade group. “We have wheat left over from last year and a good harvest this year.”

This is in contrast to the big supply shock in 2007 and 2008. In 2007, for example, worldwide stocks had already fallen sharply. By 2008 they had fallen to the lowest level in 30 years because of falling production and higher consumption, Ms. Olsen said, quoting Department of Agriculture data. Stocks had recovered by May 2020, she said.

Maximo Torero, at the International Food Policy Research Institute, said the market reaction was overdone. Russia represents only 11 percent of the world’s wheat exports, he said, and any shortfall could be met by major wheat exporters like the United States, Australia or Canada.

The real concern, he said, was that other countries would follow Russia’s lead and stop exporting, a domino reaction around the world similar to the one in 2008 that could cause a sharper increase in prices.

Jack Scoville, vice president of Price Futures Group, a futures brokerage in Chicago, said importers around the world who had agreed to buy wheat from Russia and now faced the prospect of broken contracts would have to look for more expensive supplies elsewhere.

“There will be higher prices for them,” he said.

Technical Analysis #C-WHEAT : 2020-12-30

Falling long bets in agricultural commodity futures weigh on wheat prices

Speculators cut net long position in futures and options in agricultural commodities, including grains, last week. However early next year rebalancing of index funds is expected to result in buying of grains futures. Will the wheat price continue falling?

According to the Commodity Futures Trading Commission data managed money, a proxy for speculators in commodity futures contracts or commodity options, cut their net long position in futures and options in the top 13 US-traded agricultural commodities in the week to last Tuesday. The selling was led by grains in which the net long was cut by 44259 contracts to less than 29000. At the same time analysts note that many index funds are poised to start buying grains in early-year rebalancing of portfolios. For Chicago soft red winter wheat and Kansas City hard red winter this rebalancing process is expected to result in buying equivalent to 8.9% and 14% respectively of daily trading volumes during January 9-13 rebalancing period, according to Societe Generale estimates. This may be bullish for wheat prices.

On the daily timeframe WHEAT: D1 has been trading with negative bias after hitting sixteen-month high in mid-June. The price failed to breach above the 50-day moving average MA(50) on Tuesday after rallying 3.5%, the biggest one day gain in over two and half months.

  • The Donchian channel gives a neutral signal: it is flat.
  • The Parabolic indicator has formed a sell signal.

Note: This overview has an informative and tutorial character and is published for free. All the data, included in the overview, are received from public sources, recognized as more or less reliable. Moreover, there is no guarantee that the indicated information is full and precise. Overviews are not updated. The whole information in each overview, including opinion, indicators, charts and anything else, is provided only for familiarization purposes and is not financial advice or а recommendation. The whole text and its any part, as well as the charts cannot be considered as an offer to make a deal with any asset. IFC Markets and its employees under any circumstances are not liable for any action taken by someone else during or after reading the overview.

How to Use Commodity Futures to Hedge

Futures are the most popular asset class used for hedging. Strictly speaking, investment risk can never be completely eliminated, but its impacts can be mitigated or passed on. Hedging through future agreements between two parties has been in existence for decades.

Farmers and consumers used to mutually agree on the price of staples like rice and wheat for a future transaction date. Soft commodities like coffee are known to have standard exchange-traded contracts dating back to 1882.

Key Takeaways

  • Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security.
  • In the world of commodities, both consumers and producers of them can use futures contracts to hedge.
  • Hedging with futures effectively locks in the price of a commodity today, even if it will actually be bought or sold in physical form in the future.

Hedging Commodities

Let’s look at some basic examples of the futures market, as well as the return prospects and risks.

For simplicity’s sake, we assume one unit of the commodity, which can be a bushel of corn, a liter of orange juice, or a ton of sugar. Let’s look at a farmer who expects one unit of soybean to be ready for sale in six months’ time. Assume that the current spot price of soybeans is $10 per unit. After considering plantation costs and expected profits, he wants the minimum sale price to be $10.10 per unit, once his crop is ready. The farmer is concerned that oversupply or other uncontrollable factors might lead to price declines in the future, which would leave him with a loss.

Here are the parameters:

  • Price protection is expected by the farmer (minimum $10.10).
  • Protection is needed for a specified period of time (six months).
  • Quantity is fixed: the farmer knows that he will produce one unit of soybean during the stated time period.
  • His aim is to hedge (eliminate the risk/loss), not speculate.

Futures contracts, by their specifications, fit the above parameters:

  • They can be bought or sold today for fixing a future price.
  • They are for a specified period of time, after which they expire.
  • The quantity of the futures contract is fixed.
  • They offer hedging.

Assume a futures contract on one unit of soybean with six months to expiry is available today for $10.10. The farmer can sell this futures contract (short sell) to gain the required protection (locking in the sale price).

How This Works: Producer Hedge

If the price of soybeans shoots up to say $13 in six months, the farmer will incur a loss of $2.90 (sell price-buy price = $10.10-$13.00) on the futures contract. He will be able to sell his actual crop produce at the market rate of $13, which will lead to a net sale price of $13 – $2.90 = $10.10.

If the price of soybeans remains at $10, the farmer will benefit from the futures contract ($10.10 – $10 = $0.10). He will sell his soybeans at $10, leaving his net sale price at $10 + $0.10 = $10.10

If the price declines to $7.50, the farmer will benefit from the futures contract ($10.10 – $7.50 = $2.60). He will sell his crop produce at $7.50, making his net sale price $10.10 ($7.50 + $2.60).

In all three cases, the farmer is able to shield his desired sale price by using futures contracts. The actual crop produce is sold at available market rates, but the fluctuation in prices is eliminated by the futures contract.

Hedging is not without costs and risks. Assume that in the first above-mentioned case, the price reaches $13, but the farmer did not take a futures contract. He would have benefited by selling at a higher price of $13. Because of futures position, he lost an extra $2.90. On the other hand, the situation could have been worse for him the third case, when he was selling at $7.50. Without futures, he would have suffered a loss. But in all cases, he is able to achieve the desired hedge.

How This Works: Consumer Hedge

Now assume a soybean oil manufacturer who needs one unit of soybean in six months’ time. He is worried that soybean prices may shoot up in the near future. He can buy (go long) the same soybean future contract to lock the buy price at his desired level of around $10, say $10.10.

If the price of soybean shoots up to say $13, the futures buyer will profit by $2.90 (sell price-buy price = $13 – $10.10) on the futures contract. He will buy the required soybean at the market price of $13, which will lead to a net buy price of -$13 + $2.90 = -$10.10 (negative indicates net outflow for buying).

If the price of soybeans remains at $10, the buyer will lose on the futures contract ($10 – $10.10 = -$0.10). He will buy the required soybean at $10, taking his net buy price to -$10 – $0.10 = -$10.10

If the price declines to $7.50, the buyer will lose on the futures contract ($7.50 – $10.10 = -$2.60). He will buy required soybean at the market price of $7.50, taking his net buy price to -$7.50 – $2.60 = -$10.10.

In all three cases, the soybean oil manufacturer is able to get his desired buy price, by using a futures contract. Effectively, the actual crop produce is bought at available market rates. The fluctuation in prices is mitigated by the futures contract.

Risks

Using the same futures contract at the same price, quantity, and expiry, the hedging requirements for both the soybean farmer (producer) and the soybean oil manufacturer (consumer) are met. Both were able to secure their desired price to buy or sell the commodity in the future. The risk did not pass anywhere but was mitigated—one was losing on higher profit potential at the expense of the other.

Both parties can mutually agree with this set of defined parameters, leading to a contract to be honored in the future (constituting a forward contract). The futures exchange matches the buyer or seller, enabling price discovery and standardization of contracts while taking away counter-party default risk, which is prominent in mutual forward contracts.

Challenges to Hedging

While hedging is encouraged, it does come with its own set of unique challenges and considerations. Some of the most common include the following:

  • Margin money is required to be deposited, which may not be readily available. Margin calls may also be required if the price in the futures market moves against you, even if you own the physical commodity.
  • There may be daily mark-to-market requirements.
  • Using futures takes away the higher profit potential in some cases (as cited above). It can lead to different perceptions in cases of large organizations, especially the ones having multiple owners or those listed on stock exchanges. For example, shareholders of a sugar company may be expecting higher profits due to an increase in sugar prices last quarter but may be disappointed when the announced quarterly results indicate that profits were nullified due to hedging positions.
  • Contract size and specifications may not always perfectly fit the required hedging coverage. For example, one contract of arabica coffee “C” futures covers 37,500 pounds of coffee and may be too large or disproportionate to fit the hedging requirements of a producer/consumer. Small-sized mini-contracts, if available, might be explored in this case.
  • Standard available futures contracts might not always match the physical commodity specifications, which could lead to hedging discrepancies. A farmer growing a different variant of coffee may not find a futures contract covering his quality, forcing him to take only available robusta or arabica contracts. At the time of expiry, his actual sale price may be different than the hedge available from the robusta or arabica contracts.
  • If the futures market is not efficient and not well regulated, speculators can dominate and impact the futures prices drastically, leading to price discrepancies at entry and exit (expiration), which undo the hedge.

The Bottom Line

With new asset classes opening up through local, national, and international exchanges, hedging is now possible for anything and everything. Commodity options are an alternative to futures that can be used for hedging. Care should be taken when assessing hedging securities to ensure they meet your needs. Bear in mind that hedgers should not get enticed by speculative gains. When hedging, careful consideration and focus can achieve the desired results.

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