In some parts of Western Canada, flooding and weather conditions have meant disappointing crop losses that have led to some difficult contract positions. As part of an initiative to help farmers get the best value for their crop, the Canadian Canola Growers Association investigated some possible next steps for farmers who find themselves in a “short situation” with their forward-priced delivery contracts.
Here are some options to consider:
CANCEL THE CONTRACT AND PAY THE BUYOUT COST
When you signed a deferred delivery contract, the company you contracted with either sold the futures or the cash commodity. Now, if you come up short on your obligations so will the company. If the market has risen since you signed the contract, as is likely the case this year, there will be a cost to the grain company to either replace the grain it expected to get from you or buy itself out of its futures position.
In most cases, this replacement cost will be charged back to the farmer if the contract is cancelled. That said, there are a few things to consider if you decide cancelling your contract is your best option.
BE UP FRONT WITH THE COMPANY
Speak to the grain company as soon as you are aware of a potential shortfall. Some contracts include a clause making it the farmer’s responsibility to inform the company of possible difficulties in fulfilling contract obligations. Beyond that, there are likely other farmers facing a similar situation. So being the first to come in and discuss your options means there’s a better chance of negotiating a workable solution.
Often there is an administration fee associated with cancelling a contract. You may be able to negotiate a reduction or a waiving of this fee, especially if adverse weather is the reason for cancelling.
BUY GRAIN FROM A NEIGHBOUR
If you do have to pay the administration fee, buying grain from a neighbour to deliver against your contract might be an option to consider.
Contract buyout costs may be eligible expenses under AgriStability. If you anticipate making an AgriStability claim this crop year, check with your accountant on the eligibility of these costs.
Familiarize yourself with the cancellation clause in the contract to ensure the buyout cost is calculated by the company in accordance with the contract terms.
When giving instructions to cancel a contract, provide clear instructions to the grain company to avoid any misunderstanding or confusion around what should be done.
ROLL DELIVERY TO THE NEXT CROP YEAR
This may be more of a feasible alternative if your delivery period is later in the crop year. It avoids any immediate cash payments to close out the original contract, but it may result in a price discount to the deferred market.
Be prepared for the basis to be much wider on a new crop contract due to carrying charges and other forces in the market and be aware of the price risk associated with staying in the market.
BUY A CALL OPTION
If the market price has gone up, a call option can help offset the cost of cancelling a contract by giving you the right to buy the underlying futures at a certain strike price potentially below the current market price.
One expert calls options a “phenomenal way to manage price risk” because you know the costs up front. With options, you pay a premium to purchase them, but their costs and risks are very limited beyond that. You do need an account with a broker to purchase options.
If you didn’t buy a call option in the spring, it isn’t necessarily too late. Anytime you have priced volume and are uncomfortable with your crop production potential as well as a significant portion of the national crop, you may be able to benefit from purchasing a call option. Since the futures market needs to go up for you to benefit from a call option, localized events such as hail probably wouldn’t affect the market enough. On the other hand, a wide-spread early frost or rained-out harvest could affect the market in this way.
CONSIDERATIONS FOR FUTURE YEARS
If the risk (or reality) of being short on a forward priced grain contract made you uncomfortable this year, there are a few things you can do to help reduce this risk in your grain marketing plan for future years.
Review the contract buyout clauses from the various companies to determine which is best for you.
Understand your obligations and risks in any contract you sign.
Educate yourself on the alternatives that help mitigate the risk of being short on contracted volume. One alternative is to purchase a call option when signing forward priced contracts.
Another alternative is utilizing a type of contract that provides extra protection against changes in futures prices between the time of contracting and delivery. In the event of crop failure, the value of these contracts can be used to offset contract cancellation costs. Speak to your grain company(s) about how this type of contract might fit in your grain marketing plan.
Whether this year’s conditions are repeated again or not, taking the time to thoroughly understand the risks in your grain marketing plan and the alternatives available to mitigate them is a good investment in the future of your operation.