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Hedging margins

Last July, Bruce Peterson, who farms with his brothers, Brian and Chris, near Northfield, Minnesota, was getting ready to buy some of his fertilizer for the 2012 corn crop.

“Once we buy fertilizer, we'll hedge a portion of the crop,” he says. The timing, especially this year, can be tricky.

But, as Bruce puts it, “if you're willing to have a significant outlay on one input, you should be willing to put a price floor on corn with hedge-to-arrive contracts, futures, or options.”

There is risk to not doing that. What looks like a positive margin of high-priced corn over high-priced fertilizer could shrink drastically if the Petersons buy fertilizer now and wait to sell 2012 corn later at a lower price.

“It probably makes sense to sell 10%, 15%, or 20% of the crop – maybe not the same day you buy the input but when there's an uptick in the market,” he says.

Bruce and Chris consult once a week with a consulting service, Commodity and Ingredient Hedging, a Chicago-based firm founded in 1999 that specializes in helping producers lock in profitable margins with forward pricing. Chris, who runs the farm's 14,000-head hog-finishing operation makes separate calls to CIH.

The three brothers farm almost 6,000 acres of corn, soybeans, and a small amount of alfalfa in a partnership called Far-Gaze Farms. Bruce calls himself the “point man on fertilizer.” Brian buys diesel fuel for the farm's machinery and propane for drying. Chris buys seed. “We'll kind of bounce ideas off of each other,” Bruce says.

Far-Gaze Farms has been working with CIH for about six years. The firm uses each client's history of yields and costs, as well as historical futures prices to compare potential margins with historical ones, says Jon Greteman, a CIH account executive in West Des Moines, Iowa. It doesn't try to forecast price trends.

For crop farmers, the service costs $3,600 a year for a minimum of 52 sessions of consulting, regardless of farm size. Livestock producers pay $9,000 annually.

Except during busy planting and harvest seasons, most weekly consulting sessions are in front of a computer, using GoToMeeting conferencing software to look at charts and data. Each client has his or her own Web-based dashboard that shows margins. For new clients, entering cost and production records can be time-consuming, Greteman says. “In the long term, it definitely pays off to make good decisions.”

Historical trends in grain futures prices are easy to find. Records for input prices can be more challenging. Greteman says heating oil prices give an approximate history of trends for diesel fuel. Natural gas prices are a proxy for anhydrous ammonia.

His clients rarely use futures in those commodities to hedge their costs, though. The minimum volume can be too big (42,000 gallons for heating oil). And natural gas prices don't track perfectly with anhydrous, creating basis risk.

“We can still make decisions when they're locking contracts in,” Greteman says, “and then they can go to their fuel supplier and lock in the amount they need physically.”

Locking when it works

Donald Lippy is among those who have tried hedging diesel costs.

He and his brother, Ed, are managing owners of Lippy Brothers, Inc., near Hampstead, Maryland. It's a family-run farm that grows more than 8,000 acres of corn, barley, and soft red winter wheat followed by either double-cropped soybeans or snap beans.

The farm also sells eggs from 400,000 laying hens. That supplies the majority of their nitrogen fertilizer, so they haven't used CIH as much for offsetting that input.

“I've actually bought futures on diesel fuel a couple of times,” Lippy says. “I should have kept on.”

About three years ago, they hedged diesel at about $1.30 a gallon, he recalls. The price rose to $2 shortly after that.

“It was about 50¢ to 70¢ a gallon we made off it,” he says.

“It worked well, but then it got high and it never got back down to where we felt comfortable,” he says.

Lippy has worked with CIH for more than 20 years and often follows their advice on forward pricing for the corn planted on about half their acres.

Five years ago, the farm started exporting soybeans in containers through the nearby port of Baltimore, mainly to Taiwan and Malaysia. Consolidated Grain and Barge brokers the cash sales, and Lippy has been relying more and more on CIH to hedge that crop, too.

“It worked most of the time. Last year it didn't work,” he says, because the basis was higher for selling to Perdue Farms, the Maryland chicken producer that dominates the local soybean market.

For much of his hedging, Lippy uses options, which leave an upside in case of unexpected market trends.

Locking in margins but leaving a chance to increase profits “is really one of the cornerstones of what we attempt to do,” says Scott Gerig, business development manager for CIH in Chicago.

After consulting with CIH, Lippy started selling corn in July 2010. By July 2011, he had about 70% of the crop sold, some with hedge-to-arrive contracts, which allow the farm to set the basis later. In his area, the normal basis of 30¢ to 50¢ above futures has been as much as $1.50.

The Peterson brothers have cash sales obligations that affect how they hedge their crops. About a third of their corn is used for hog finishing. And they invested in an ethanol plant where they deliver about a fourth of their corn.

“We're a little more hesitant to sell forward until we have some of our feed needs covered,” says Bruce.

He usually prices about a third of his corn with hedge-to-arrive contracts, a third with futures hedges, and the last third with put options.

The limits of margins

CIH is known for its work with the hog industry. In recent years, its business with crop producers has grown, says Gerig. “With the operating costs and the volatility, we are really seeing a lot more interest in focusing on the crop margin management approach,” he says.

Seed and chemical costs aren't volatile, so producers can't use price swings to improve margins. But there are plenty of other key inputs, including land rent.

“By the time you lock in fertilizer, rent, and fuel, you're taking care of the bulk of your margin,” says Greteman.

The Peterson brothers start negotiating leases in September. In winter, they update cost estimates for the next season. Then during calls with CIH, “they kind of want to know where we're at and how much we're comfortable selling to cover costs,” Bruce says. “By nature, I'm probably more of an incremental seller, where I sell the crop 10% to 20% at a time.” At times CIH encourages sales earlier than he'd like, “but at least we have that discussion,” he says.

Learn More

Commodity and Ingredient Hedging, LLC 312/596-7755 | www.cihedging.com

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