The old saying goes “you’ll never go broke selling crops for a profit,” — but you could be in a financial pickle if you don’t deliver what you sold.
That hard financial reality has put the long tradition of forward pricing contracts under the microscope this year. It’s prompting questions about the responsibility farmers and grain companies have to honour them and what alternatives there are for farmers to lock in good prices while limiting production risk.
On one of them is futures options — a type of price insurance.
It’s unclear how many farmers can’t fill their contracts, but there are some following the worst drought in years.
In most cases those farmers are obliged to buy crops from another source and deliver them, or buy their contracts back. Either way is expensive, especially this year because crop prices have risen a lot since many farmers priced.
Why it matters: It make sense to lock in profitable prices, but forward contracts trade price risk for production risk. Futures options are a different way to capture a ‘floor price.’
In August the Keystone Agricultural Producers (KAP) wrote the Western Grain Elevator Association (WGEA) asking its members — Canada’s major grain companies — to reduce their “administrative fees” for farmers who can’t fill their delivery contracts because of low yields.
That prompted some social media posts about farmers’ contractual obligations and ways to reduce farmers’ risk in volatile markets. One came from Warren Ellis, past owner of Ellis Seeds at Wawanesa.
Ellis posted on Facebook farmers can use futures options.
“There are tools out there that farmers can use so that they don’t have that risk,” Ellis later said in an interview Sept. 15. “All organizations, ag related, should be educating farmers to those opportunities because we spend so much time on the production side of things and we do very little on the marketing side and farmers need to know as much about marketing as we do about growing crops.”
A futures option is a type of security that grants the trader the right, but not the obligation, to buy or sell a futures contract at a specific price by a specific date.
- Read more: Futures options by the numbers
Options have been around for decades. But according to some experts they are expensive and thinly traded making them at times hard to exercise. But Ellis said he didn’t experience either issue and used options often.
Options are an alternative to forward selling to an elevator with no production risk.
With options, for a fee, a farmer can lock in a minimum price on as many bushels as they want, still capture price increases, and if there’s a crop failure, not have to buy back their contract or buy the crop from someone else and deliver it.
“It’s strictly (price) insurance,” Ellis said. “You just walk away from the insurance policy basically.”
The fee is akin to an insurance premium. The cost is connected to the floor price the farmer wants to insure. The higher the insured price, the higher the fee.
Options costs vary, but locking in a minimum $10 a bushel for canola might cost 30 cents a bushel, he said. Locking in $16 might cost $1 a bushel.
“That ($1 a bushel) might seem pricey but you’ve got to remember what you’re insuring,” Ellis said.
“It costs you a lot more to insure a million-dollar home as opposed to a $300,000 home. But if farmers want to insure 40 bushels an acre and it’s costing them $1 a bushel that becomes one of your major expenses on your balance sheet. But at the same time you’ve got to look at what you’re insuring and if it costs you $1 to get $16, hmm, I think that’s a pretty good trade.”
And if the price goes to $20 the farmer simply doesn’t exercise the option and gets that price when they deliver to the elevator (example).
And if the farmer doesn’t have the grain to deliver they don’t have to buy the grain from somewhere else or buy back their contract.
KAP’s appeal to grain companies seems like something a farm organization would do. But it rubbed some farmers the wrong way — something KAP president Bill Campbell acknowledged.
“We’ve had calls on both sides of the fence, but those that are impacted feel that it is a significant issue for them,” he said in an interview Sept. 15.
As one farmer put it in a document obtained by the Manitoba Co-operator “a contract is a contract and has to be honoured by both parties (farmers and grain companies).”
If grain companies cancelled contracts with farmers to take advantage of lower crop prices farmers wouldn’t like it, Homewood, Man. farmer Warren McCutcheon said in an interview Sept. 16.
“It kind of irks me when I hear farmers complaining, ‘they won’t let me out of my contract,’” he said. “That was a marketing risk that you took on. Some years it works, some years it doesn’t.”
It was hard watching crop prices rise to historical highs this summer and not take advantage of them, McCutcheon said. He’d already sold some crop before seeding.
“But this year when we put the drill in the ground there was no moisture… so I wasn’t about to make that decision of selling a bunch,” he said. “It’s not worth the risk. But everybody is different and everybody’s area is a little bit different too.”
McCutcheon doesn’t know how many farmers aren’t able to fill their contracts. He knows a few sold more oats than they grew, and because prices are up since they locked in, face extra costs to replace them.
“Oats have been sort of a foolproof sell that usually always pays to move off the combine, but guys just didn’t seem to have them here,” he said. “There were lots of 30- and 40-bushel oat crops. Now you’re having to go find the other half of your production, but everyone is in the same boat.”
Some crops are in such short supply it’s tough coming up with a price, McCutcheon said. He heard of a farmer asking a seed grower for 10,000 bushels of winter wheat.
“The guy says, ‘wow, you’re planting a lot of winter wheat.’ The farmer said, ‘no, I’m not planting winter wheat, I am trying to fill a contract that I am $5 a bushel offside on,’” McCutcheon said.
In more normal years a farmer would buy from a farmer a few miles away where crops yielded better, McCutcheon said. Not this year because the drought was so widespread.
Farmers have used elevator contracts for years and understand the risks, University of Manitoba agricultural economist Derek Brewin said in an interview Sept. 13.
“Agriculture is risky,” he said. “It’s a risk to price it before you’ve produced it, but you… face downward price risk as well. I personally favour not pricing until you’ve got most of it, or at least have a really good idea of how well the season is going.”
Most students taking a degree or diploma agriculture take a basic marketing course that explains the risks, Brewin said.
But universities should still research contracts and encourage farmers to read the fine print, he added.
While some farmers can’t fill their contracts, grain companies need it because they’ve sold it, Brewin said.
Most years forward pricing works well for farmers, said MarketsFarm’s senior market analyst Mike Jubinville.
“It generates some cash flow in the fall and sometimes if it’s a big crop just getting some delivery in September can be a big challenge because you have so much grain coming in at one time,” he said in an interview Sept. 15.
The age and experience of a farmer may have played a role in the risk they took this year, especially after so many good crops in a row, Campbell said.
“I’m not sure if it’s the right term to use, but this is a huge learning curve for the industry with regards to things that can and will happen under the right environmental circumstances,” he said.
KAP is planning a marketing seminar for farmers in the new year.
“We need to have the conversation to the downside of these production contracts and make the producer aware of their obligations and what the elevators’ expectations are and the risk,” Campbell said. “I’m not sure that was fairly understood by everyone.”
Grain companies are looking at their contracts too, elevator association executive director Wade Sobkowich said in an interview Sept. 15.
“I don’t know if there will be contract changes, but I do know this whole contracting process is going to be going under the microscope with each and every company,” he said
“Nobody wants to be in a situation like this in the future. If you can’t take a look at a situation like this and try to learn from it you’re not doing it right.”
For more content related to drought management visit The Dry Times, where you can find a collection of stories from our family of publications as well as links to external resources to support your decisions through these difficult times.