Within a margin management context, profitability is ultimately determined by the costs and revenues that are realized in one’s local marketplace. In this respect, the cash price is important as it truly reflects the profitability of a crop, livestock, or dairy operation at any given point in time. In projecting forward margins, the futures market is used as a price discovery mechanism to estimate costs and revenues in deferred time periods. While this is a reasonable way to gauge future profitability, there is obviously room for error given that local prices may be more or less than what the futures market is projecting. This difference or basis between cash prices and futures prices can have a significant impact on profitability and one’s overall margins in any given year or period within a year depending on what is happening in the cash market.
In contracting prices to secure forward profit margins, producers have a choice of using their local cash market or derivative contracts including futures and options on the exchange. When prices are favorable and contracting is available, it is typically better to contract for purchases and sales in the cash market as this provides greater certainty to an operation’s bottom line. The basis, or the difference between the cash market price and the futures market price, is typically used as a gauge of when it would be favorable to contract for purchases and/or sales in the local market. A weak basis from a historical or seasonal perspective may trigger a purchase decision to realize a cost; likewise, a strong basis may similarly trigger a sale decision to secure revenue. In some cases, this basis is something that can only be contracted for in a spot transaction. In other cases however, the basis may be set in advance of delivery and be secured over a period of time. This is typically true on the crop side as basis can often be contracted in forward time periods.
In the current environment, crop prices have been under a great deal of pressure due to the large supplies expected to be harvested this fall and the growing stocks that will accompany this increased supply. This dynamic typically results in a weak basis as cash prices come under pressure relative to futures prices. Because of this, feed purchases may be favorable for hog, dairy and cattle operations not only on a spot basis, but potentially on a forward basis as well. To the extent that basis values are offered at attractive levels in deferred periods, it may well be worthwhile to secure these costs in order to achieve greater visibility on forward margins. Clock soybean meal contracts, forward corn and DDG purchases, and forages may very well be secured into 2015 at costs that pencil out favorably relative to the value of hogs, milk and cattle for livestock feeders.
Given the dynamics of basis the past few years following short crops and supply deficits relative to demand, it might be prudent to contract in the local cash market for feed purchases to the extent that basis is offered at a level which translates into favorable forward margins. While using forward contracts in the cash market provides greater certainty to deferred margins given that basis is included in the transaction, a disadvantage often cited with using the cash market is the lack of flexibility those contracts provide around the price being secured. While it may be the case that feed prices can be locked in at levels that pencil favorably for forward margins, it still might be advantageous to retain flexibility for margins to improve. The futures market can assist in this process though as complimentary positions may be built to add flexibility to a cash purchase or sale in one’s local market.
As an example, let’s say that I am being offered a clock contract on soybean meal for 2015 at basis levels which appear attractive relative to past years and much closer to normal from a historical perspective. I like the fact that I can lock in this supply for my protein needs, and having the peace of mind knowing that the supply will be available when needed at my operation following some of the dislocations that have taken place recently. While locking in a delivered price on a clock basis sounds good from a margin perspective, I still may have pause given the recent increase in price due to concern that I might be booking an inflated value. What I could consider doing in this instance is going to the exchange to purchase a put option or put spread in order to participate in lower prices following my purchase should the market begin to move down again. Combined with a fixed purchase price in the cash market, a put option or put spread would allow me to essentially re-price my soybean meal purchase in a declining market for the cost associated with the option’s premium.
If prices do in fact decline, the put option or put spread will gain in value to offset the depreciated inventory that was purchased at a higher price. In a similar way, if a sale price is contracted in the local cash market such that basis is secured against forward margins, flexibility may be added by complimenting that sale with the purchase of a call option or call spread. This would allow a producer to participate in higher prices following the cash sale, as the call option or call spread will gain in value to offset the opportunity cost of having previously sold at a lower price level. Other strategies could also be considered around either a cash purchase or sale on a forward contract in one’s local marketplace to achieve added price flexibility. In general, if basis levels are attractive as they compare to historical ranges and factor favorably to forward margins, it would typically be advantageous to contract those in one’s local cash market; however, this does not necessarily mean that a producer must forgo flexibility. Understanding how the cash market and futures market can work together to protect forward margins will ultimately put you in greater control of your operation’s profitability and improve the effectiveness of your overall margin management.