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Using risk management tools
The volatility in crop prices during the last few years has made it essential to have a marketing plan. But that same volatility can knock you off your game if margin calls lead you to abandon your plan.
It's hard enough to ride the risks that are a natural part of producing a crop, but the futures exchanges have raised your risks again when you market the crop by requiring larger margin deposits on futures. It increases your costs and requires a larger capital pool – whether your own money or a lender's – to place an initial hedge. And even more when margin calls start coming.
Chicago corn futures maintenance margins have risen from 8¢ a bushel in May 2006 to 35¢ this past summer. Soybean margin calls have climbed from 15¢ a bushel in May 2006 to 65¢ during the summer. Initial margins to place a futures hedge also have risen commensurately.
Why raise margins? If you ask the industry, almost everyone will say, “To wring excessive speculation out of the market.” The decade-long rise of hedge funds and other big-money speculators has left them with a lot of cash to put to work, looking for a hot market to trade. Some of that money, which sometimes originates overseas, has made its way to the Chicago grain futures exchanges.
But the CME Group, which owns the corn and soybean exchange, denies that it is targeting any class of trader with its margin increases. In a May memo, Kim Taylor, head of the division that determines margins, said, “Margins … aren't a means to move a market one way or the other, or to encourage or discourage participation from one kind of market participant or another. As part of our overall risk-management program, margins are adjusted frequently across all our products based on market volatility,” she wrote.
How to manage margin calls
For farmers, staying in the game without getting knocked out by margin calls basically involves just two approaches: Either have a large credit line or bank account to meet margin calls, or avoid taking a futures position.
And, indeed, for years many farmers have taken advantage of grain dealers' hedge-to-arrive contracts, placing the futures risk with the elevator. A farmer agrees to deliver grain at a certain date, and the elevator hedges the deal with a short futures contract. Any margin calls come to the elevator.
Another place to transfer futures risk is to your lender. An example is Rabo AgriFinance's commodity swap, an over-the-counter derivative tied to a line of credit. The hedge is initiated by Rabo, so no margining is required by the farmer throughout the life of the transaction, essentially eliminating the farmer's margin call risk.
But Rabo's commodity swap is not the standard among farmers. Most still pay their own margin calls, often with a line of credit from their lender. “If a farmer is paying the margin calls, he has to have a banker who understands that if he has a margin call, it has to be met in order to maintain the hedge,” says Rabo AgriFinance north-central managing director Shawn Smeins. He warns that some rural bankers who don't specialize in agriculture may not grasp the importance of maintaining that hedge.
Indeed, there have been reports that even some bank boards of directors (often made up of farmers) have questioned why they must keep funding numerous margin calls. You keep paying the margin calls until you can sell the cash grain for enough profit to cover the futures loss.
“Our (bank) board members had to be educated,” says Illinois crop producer Mike Zinke.
Margin calls on short hedges can be steep in a fast-rising grain market, such as the one seen in 2008. Farm Credit Services tells of a mid-South rice producer who borrowed $10 million as part of his 2008 needs, which included hedging. But by the time the books were closed out, the debt was $70 million as FCS covered the farmer's margin calls.
This chart shows how the amount of margin money required to hold a corn futures contract fluctuated between 2008 and 2011.
FCS AgriBank chief credit officer Ross Anderson says his bank makes every effort to stick with a farm borrower and fund every margin call, because to abandon the marketing plan can be disastrous. If, instead of meeting the margin call, a hedge is either lifted prematurely or forced into liquidation, the farmer doesn't get his margin money back should prices retreat. And in many cases, that margin money is the bank's money.
“In these volatile markets, we find ourselves providing additional credit to producers to meet their increased hedging requirements,” says Minneapolis-based Anderson, who runs one of five wholesale banks that provide money to local FCS branches.
In an internal company memo last June, Anderson specifically expressed this concern by saying, “The rise in grain prices, particularly in corn, began in the July/August 2010 time frame, creating large demands for capital to cover margin calls associated with marketing plans.”
With the grain exchanges raising margins to dampen volatility, FCS and other lenders have had to raise their credit lines to farmers. And it's not just the initial margin deposit that has increased. Maintenance margins are higher, too.
Meanwhile, another margin-funding issue that concerns FCS is not only that farmers are hedging their latest crop, but also the exchanges have listed futures out to 2013 and 2014. Some farmers have multiple years hedged at the same time, raising their total futures margin exposure.
The soon-to-retire Anderson and his successor, Jeff Swanhorst, are also watching rising cash rents, pushed higher by $7.50 corn and $14 soybeans. Some Midwest farmers are reportedly paying more than $400 to rent an acre of land, and this becomes a fixed obligation that doesn't decline if crop prices fall.
Farmers see their cash rent as an operating expense, but Anderson sees it as a leveraged preplanting financial obligation against potential deferred crop sales, which is not all that different from selling futures before a crop is made.
Warns Anderson, “When a farmer pays these high cash rents, he needs to realize the risk he's taking on. He's created operating leverage, which may be similar in cash-flow requirements as those buying land and incurring financial leverage.”
Like the example on the previous page with corn futures margin calls, this chart shows the same volatility in soybean maintenance margins.
In many cases, it's hard for a farmer to avoid taking on this leverage, as he needs to rent land to achieve economies of scale. In those cases, his overall leverage can be reduced by avoiding futures altogether.
Indeed, brokers at the Advance Trading Inc. in Illinois rarely use a straight short futures hedge anymore, says company research analyst Brian Basting. Instead, he thinks options are well-suited to times of high volatility because, for a small cost, farmers can protect against a price collapse, yet they can still participate in possible appreciation.
A put option gives the buyer the right to sell at a given price, and it's a very straight-forward hedge that's similar to a short futures hedge, says Basting. Significantly, the buyer of a put option has no more margin calls after his order fills, while the seller of a short hedge has theoretically unlimited risk of margin calls.
A sale of a call option (the right to buy) is similar to a short futures hedge, but risk is not limited. An option seller can still face additional demands for margin money.
After 40 years of farming, Zinke utilizes some option strategies during the year, but his main marketing tool is short futures hedges that he places himself. Instead of running from margin risk, he embraces futures for the control it gives him over his marketing strategies.
He used to rely on hedge-to-arrive (HTA) contracts, letting grain buyers take the margin risk. But that all changed during a market freeze-up in 2008 when local elevators and big river terminals refused to write any more HTA contracts. The sharp rise in corn prices in 2008 caused substantial margin calls for dealers who had written HTAs for deferred delivery. To maintain existing HTAs, they simply stopped accepting new HTAs.
That locked Zinke out of his marketing plan and blocked him from taking advantage of rising prices. So he spent the next three weeks setting up a line of credit with his bank and a trading account with a broker, and he hedged his crop with straight short futures. “I've definitely changed how I trade since then,” he says.
He now has closer control over his marketing and often takes advantages of each rally to sell just 2% to 3% of his production at a time. “I adhere to the philosophy of sell often and sell early. You aren't going to hit the high in the market every time, but when you know you've got a profit, sell something to lock in that profit,” says Zinke.
HTAs are a good hedging tool, but diversifying his marketing toolbox with a futures account has helped, he says. For example, an elevator might charge 5¢ a bushel to write an HTA for the current crop year but possibly charge 12¢ for the risk of taking on next year's crop. So Zinke will often lift his short hedge on current crop, transfer that risk to an HTA at 5¢ a bushel, then use the futures to hedge next year's crop.
Even as his 2011 corn was still drying in the field, Zinke had already sold a portion of his 2012 and 2013 crops in the futures market. With so much volatility in the market and the potential impact of unknown events in coming years, he wanted to lock in current profitable futures.
Futures Vs. Options
Like HTAs, options, too, are criticized for their high cost in the deferred years. Options values are based on time till expiration, so every week costs you extra. That's why southern Minnesota grain grower Doug Felton favors futures over options. He says options don't go out far enough for his hedging. Futures do. Also, even when options go out a long way, they are expensive, because you are paying for the time premium.
So Felton uses futures to hedge his corn production as far as three years out. He will hedge as much as 100% of a year's production at one time, but those bushels are spread over three years.
To manage margin calls, he has set up a hedging account with a predetermined limit. If margin calls take him over the limit, he will look at his choices, such as drawing from his operating loan.
“It takes a fair amount of liquidity to manage my hedges,” says Felton. He doesn't want to be forced to liquidate his hedge should futures prices rise, as then it's no longer a hedge, he says. “I want to make sure I maintain my position.”
Felton plans to stay in the game.
By Andre Stephenson