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Drought has a long tail

Dealing with growing a drought-reduced crop is tough enough, especially when dry weather is as widespread and severe as in 2012. Adding to the stress of seeing a crop suffer is the difficulty of knowing how to adjust marketing plans for a crop that might be considerably smaller than average. One of the first things to consider is the history of how markets responded in prior years when bad weather – usually drought – caused a major rally in grain prices.

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To analyze this issue, I chose seven years (1975, 1981, 1984, 1989, 1996, 2003, and 2004) that followed years with a major rally caused by weather (see chart on the right). For comparison, I used the 20-year period of 1991-2010 (see chart on the left). These charts illustrate how the market acted in years following short corn crop years. That information becomes a guide for making marketing plans for next year.

The first thing that jumps out from the charts is that prices in both groups of years are generally in a downtrend from January 1 through expiration of the December futures contract. This trend does not go straight down. In both charts there are rallies in April-June. The tried-and-true strategies of making sales then are good, except in the years when there was an actual weather problem that caused yield reduction.

Demand destruction hits

In the years following the drought, the highest price of the year in April stands out as being preferable to waiting for a weather rally in the summer. Likewise, in those years when the danger of cropping problems is past, prices continue to drop through the end of November. In the 20-year period, prices, in general, tend to go flat starting around the end of August. Price action then stays in a narrow range until after harvest in November.

In years of reduced production, demand destruction comes into play. This is necessary to make supplies from a reduced crop last until a new crop is produced the following year. When the demand destruction is completed, prices no longer need to be high to stretch a short crop. At that point, prices return to a level that can be higher or lower than before the drought began more than a year earlier.

One really difficult factor in making marketing plans for 2013 is that there is no guarantee that a second or even third year of drought will not follow. In 2002 and 2003, yields were reduced by a large area of very dry weather in the western Corn Belt. The weather rally from the drought in 2003 took prices higher than comparable action in 2002.

One of the worst droughts in history came in 1974. It was followed by dry weather in 1975 and 1976. In some places, 1977 was dry. Yet prices did not make new highs in subsequent dry years. It took until 1996 for corn to again challenge the $4 level of 1974.

It's difficult to find a clear-cut strategy for marketing new-crop corn in a year like 2013. Crop insurance helps to deal with the production and price risk. But no one likes to forward-contract a crop they might not be able to deliver.

Futures and options offer a way to set the price without having to deliver the cash product. Futures do involve margin call risk, however. Options involve a premium that may make a viable strategy difficult to implement economically. Having storage on the farm to handle the bushels in excess of those forward contracts gives flexibility in dealing with uncertain levels of production. Indeed, no one likes to be caught with inventory in a market that drops drastically.

The long-term chart of years following drought is a useful guideline in developing a marketing plan for a year with many unknowns. Use all of the marketing tools available to avoid costly results in dealing with market prices that offer potentially good profit but have a lot of risk in both directions.

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