Drawing from the unique challenges of drought-reduced crops.
“I’m never going fishing again — costs me too much money.” Mike tosses his fishing cap onto the file cabinet and turns to Jason, his youngest son and newest employee. “Now tell me again, what happened the past two weeks? How did the U.S. corn yield drop from 166 to 146? I go where there’s no Internet and no cell phone service and 12% of the corn crop vanishes before they even do field surveys? And you say it’s getting worse?”
Jason runs his hand through his hair and hands Mike a printout: “Well, corn was already up over a dollar when you left for Canada on July 1. But the 100-degree heat just didn’t break, and the drought kept spreading. Look at this new report out yesterday from NOAA — the Drought of 2012 was already in the Top 10 of the last 117 years as of the end of June, and last night’s crop ratings on corn fell hard for the sixth week – 8 of 18 listed states now show corn rated at least 50% poor or very poor. It’s really bad out there. Now some research folks are talking about a yield of less than 140 bushels per acre!”
Mike just stares at Jason in shock. “But it was great in Canada — cool and wet the whole time. Jason, still a little rough in the subtleties of dealing with managers, replies, “Yeah, but we’re not in Canada….”
“So Mr. College Graduate, let’s map out a game plan for managing this elevator. How are we going to make money? I see the futures carries are completely gone on corn and soybeans. And December corn futures are almost to $8 and we have a lot of corn bought below $6. So those margin calls have chewed through $2 per bushel of our credit line, plus the cash flow for the soybean hedges.”
“Well,” Jason starts, “I had orders in to set the Dec/March, Dec/May, and Dec/July corn spreads but we didn’t get anything filled. All our short corn hedges are still in Dec 12 futures.” He holds his breath and waits for Mike to chew him out, but to Jason’s surprise, Mike replies softly, “I know you’re kicking yourself — same thing happened to me in 1988. The drought took hold that summer, and before I knew it futures had shot up and the Dec 88/July89 corn spread had gone to an inverse. I still remember what I learned from your Granddad that summer — first, don’t panic. Second, lay out a plan; get rid of the risks you can’t afford, and pay attention to market signals.”
Mike pulls a legal pad to the center of his desk and starts three sections: 2012 Factors, 1988 Revisted and Action Plan. He listens to Jason recap what’s been going on in other markets and starts listing some factors:
- Gross ethanol margins have fallen hard, to negative territory; almost $1.50/bushel below the fall of ’11 (excluding basis, the value of DDGs and other co-products).
- Ethanol production is already slowing.
- The hog/corn ratio is nearly as low as it’s been in years.
- Feeder cattle prices are down 15% to 10 month lows as more calves are moving to market. Fat cattle prices are stable for now.
- Egg and chick placements are down.
- Export basis on corn has dropped off 30¢ since mid-June but is still fairly strong for new-crop.
- We already have three messages from buyers looking for new-crop basis offers on corn, for fall out into Spring 2013.
- The forecast for the next ten days points to more deterioration in crops.
- A lot of farm and commercial bin space has been built the past two years. Too much?
Next Mike thinks back to 1988 but wonders whether that’s a smart thing to do. A lot has changed since 1988 but it doesn’t hurt to at least think about it.
- There were only a few ethanol plants in the country; corn moved to terminals or for export, or stayed local for feed.
- Surprisingly, corn basis in the fall of ‘88 was neither especially high nor low.
- The Dec88/Jly corn spread was inverted before harvest but widened back to a 15¢ carry by fall.
- The 1988 drought cut the corn yield by 30%, but there were 4.3 billion bushels of corn on hand on Sept 1, 1988; 2 billion was Farmer Reserve corn and CCC inventory. That left 2.3B bushels of ‘free stocks’ on hand that USDA had sold out of CCC inventory, and farmers had redeemed from the Reserve.
Mike turns to Jason, “Now for the tough part. We need to list specific things we need to do — and when to do them.” After some debate they have their preliminary Action Plan:
- Review all open farm purchases. Then talk with the farmers about crop insurance coverage — that indemnity can help offset the cost of cancelling contracts.
- Meet with the banker; she needs to know our game plan. Run “what if” scenarios and identify dollar needs if corn should go to $10 or soybeans to $20. Remember that futures Initial Margins will also likely rise.
- Put in “good until canceled” orders to set corn and soybean carries at reasonable objectives — just in case. Otherwise hedges stay in Dec corn and Nov soybeans — for now.
- New-crop export soybean basis is near record highs. Look to make some harvest sales to reduce overall basis risk.
- Widen our new-crop bids/margins. Calculate how much corn and soybeans we can ship by December 1. Anything we buy over that has to be priced to allow for the cost of the inverse(s) plus interest past December. Don’t raise bids to ‘chase’ bushels at this point!
- Check on buying Dec12/July13 corn “Calendar Spread Options.” Buying Puts would give us a way to gain if the carry returns; buying calls would make money if the spread inverts further.
- Be careful about forward sales over extended periods to any single buyer. The ethanol and livestock sectors will be going through some lean months and accounts-receivable could become an issue for us.
- Work on how we’ll fill our space. Jason can estimate local production and ‘market share.’ Consider very cheap DP, or even free Delayed Pricing. We’ll get title and the farmer can price the grain later. If farmers are still bullish at harvest this could be attractive to them.
- Review discount schedules. “% of Price” schedules can get very expensive.
- DO NOT buy forward year grain against 2012 crop year futures. That bankrupted a lot of farmers and some elevators in 1996. Research the history for Jason to read.
Mike closes the office door and turns to Jason, “We don’t know yet what we’ll face, or how small the crops may be. But we’ll get through this. We will have to work a little harder and think a little more. Today’s Action Plan is our starting point, not the end game. Remember Granddad’s words: Don’t panic; learn to respect market signals. We can earn storage revenue, or if farmers are heavy sellers at harvest then basis should break back or futures carries should return. Somebody will have to be paid to hold grain the market doesn’t need at harvest. If farmers don’t sell and basis skyrockets at harvest, we can consider selling DP inventory and buying it later. Just fasten your seat belt, Jason; this is a year you’ll never forget.”