A deferred delivery contract can lock in a profit, but also prevents cashing in on future price increases
Adeferred delivery contract (DDC) is the most popular type of grain-marketing contract provided by grain buyers. A DDC, as they are often called, locks in the price for a certain quantity of a base grade of grain to be delivered to a certain location at some date in the future.
“Advantages of a DDC are that it locks in a price to protect against possible downside price risk, provides certainty for meeting cash flow commitments, and provides a delivery opportunity,” says Neil Blue, market specialist with Alberta Agriculture and Rural Development. “Possible disadvantages are that a commitment for delivery of a certain quantity of a certain grade is made to a buyer, and a higher price than the DDC price cannot be captured on the quantity priced.”
Some farmers, who in past years priced part of their grain production before it was harvested, later questioned that decision. That regret may have been because of a production shortfall, or prices moving higher than their contracted prices, or both.
“Regarding the concern of a production shortfall, it is possible that the farmer may have to buy out the portion of the contract that is not delivered, particularly if the price of the contracted grain rises above the contracted price,” says Blue.
“With regard to the concern of missing out on a higher price than the contract price, it is natural to want the best price, but it is almost impossible to pick the top price in any year. A goal of having the average price for a given year’s crop in the top third of the year’s price range is more realistic.
“Before signing a deferred delivery contract, it is a good idea to get an unsigned copy of the contract, read it and understand it, with the help of legal counsel if necessary. If you have concerns with the contract, have those concerns addressed before signing. An amended contract is still valid if both parties agree to the changes. If the changes that you suggest are not mutually acceptable and those concerns are important enough to you, perhaps you should decide not to sign that contract.”
Some questions that should be answered before signing a forward pricing contract:
- Will the price provide an acceptable margin above the costs of production?
- Will this sales commitment assist in meeting some of the cash flow needs at the time of settlement?
- Is the quantity to be priced consistent with expected production? For example, some farmers price no more than 50 per cent of their expected production before harvest.
- If the contract does not provide an Act of God clause, how will a contract shortfall be handled? Also, how will a different grade from the contract base grade be handled?
- Is the contract price based on the analysis of current market information?
- How will a delay in grain delivery from either party to the contract be handled?
- In case of a dispute over the contract, how will that dispute be resolved?
“For those commodities with a futures market, pricing grain via a sell futures may offer advantages to the producer over a deferred delivery contract, particularly if available basis levels are weak,” says Blue. “A sell futures position locks in the futures part of price without having a physical delivery commitment to a particular buyer. Thus, the producer can still shop around to various buyers for the best basis relating to the grade of grain produced.
“Also, sell futures can easily be offset in the case of a production shortfall or weather-induced downgrading. Disadvantages of sell futures are the need to have a commodity futures account and the possibility of margin calls if the price rises above the entry point. Keep in mind that a higher futures price also implies a higher cash selling price for the commodity being produced.”