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Bryan Doherty: Price floor

03/04/2011 @ 3:14pm

Most commodities have been in an uptrend since late June with agriculture leading way. Our general thoughts are that, as world economies improve and more people move from third-world status to middle-class, the need for food worldwide will continue to grow. However, at the same time, while you can argue for continued demand, history would tell us otherwise. Demand has a way of ebbing and flowing as do crops sizes and conditions. In essence, the market should see increased volatility in the years ahead rather than decreased volatility. Therefore, to take the approach that prices are now likely to hold at high levels (since rallying), could be a big mistake. From a marketing standpoint, we want to encourage you to think long and hard about how to best manage your marketing for your operation. One method is to make sure that you establish a price floor on all of your expected production. 

With improved tillage practices and genetics, as well as development of revenue insurance products, you as a producer should be more confident than ever to become a forward seller, especially after a price rally. From a historical perspective, that time is now. For corn, soybeans and wheat, uncertainty exists for the upcoming year. Currently we know little information about how the crop will turn out. We don't know what the weather will be like, we don't know what China's conditions will be like, and we don't know what the demand will be like. You set the picture. However, making a generalized assumption, we can expect that most producers will produce average to above-average yield and, in turn, this will likely pressure prices. As uncertainties become known, prices have a tendency to remove this variable from price. Often that is why prices trend downward as crop certainty increases in late summer and early fall. 

Therefore, in order to take advantage of high prices, you need to take action. Consider forward contracting anywhere from 25 to over 50 percent of your crop. On what you don't forward contract, buy put options. We recommend at-the-money puts. After a strong rally this year, many farmers may want to spend less money on an at-the-money put and instead buy out-of-the-money options that will act as a flooring mechanism. We would call these put options safety valves. Those are fine as well. Keep in mind they are farther from the current prices and won’t offer as much protection. Whatever the case, you're leaving yourself wide open for price appreciation on crop that is unpriced. If you choose to become more aggressive on total coverage, consider buying call options against your forward contracted production. This will now put you in a position where, whichever direction the market goes (either down or up), you are in a position to participate. If, for example, a drought were to ensue and prices were to rally significantly, you're 100 percent long through the purchase of calls against forward contracts and with unpriced inventory that you purchased puts against. This places you in a position of being prepared before the market makes a move.

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