AgDM newsletter article, October 1998

Marketing loans add a new dimension to grain marketing

Bob Wisner Don Hofstrandby Robert Wisner, Extension Economist, 515.294.6310, rwwisner@iastate.edu; and Don Hofstrand, Extension Farm Management Specialist, 641.423.0844, dhof@iastate.edu

With the severe weakness in the markets for corn and soybeans, cash prices throughout the Midwest are below local Commodity Credit Corporation (CCC) loan rates. This creates opportunities for farmers to enhance returns through marketing loans (MLs) and/or loan deficiency payments (LDPs).

Marketing loans are designed to let cash prices seek whatever level is needed to increase the quantity of grain demanded and avoid building large stocks. 

While gains from MLs and LDPs will only partially correct major income shortfalls for grain farmers, this source of added income can help to modestly reduce the negative cash-flow impact from the severely depressed grain market. 

Marketing loans

Marketing loans (MLs) can be used when ownership of the grain will be retained during and after harvest. When prices drop below the local county loan rate, a farmer can repay the CCC loan at its posted county price (PCP), keep the difference between the loan rate and the PCP, and avoid paying interest on the loan. This creates a minimum or floor price for the farmer’s grain equal to the county loan rate.  If the PCP accurately reflects the local cash price (it is often lower), the sale price for the grain plus the PCP/loan rate differential equals the loan rate amount.

Loan deficiency payments

For farmers selling grain at harvest, loan deficiency payments (LDPs) are an alternative to MLs. Farmers can receive LDPs while selling grain directly out of the field without taking out a loan.  LDPs pay farmers the difference between the county loan rate and the PCP on the day the farmer either transfers title of the grain to a buyer or chooses to receive an LDP.  LDPs can also be used if you plan to store grain.  However, once the LDP is taken you loose the price protection of the loan program.

Marketing strategies

MLs and LDPs increase the complexity of grain marketing decisions. With prices below local loan rates, these tools put grain farmers in an unusual position where their potential income may actually increase as grain prices decline.

LDP and store vs. ML and store
When farmers take the LDP or close out an ML but continue storing, they lose the protection of the price support loan program, although that protection is at very low price levels.  If cash prices rise before taking the LDP or closing out an ML, the value of the LDP and the advantage of the ML will be reduced.

Storage hedge
With this fall’s abnormally wide basis and large carrying charges provided by the market, above average returns are available from storage hedges for those producers who are knowledgeable and comfortable with the futures market. Some basis risk is involved with storage hedges and adequate financing for possible margin calls is a must.  For those who have limited knowledge and experience with hedging, a forward contract for spring delivery is an alternative.

LDP, store, and buy put options
Buying put options is an alternative for farmers who are concerned about the possibility of lower prices if they store grain after they take the LDP. Put options provide a floor price because, if prices decline, the value of the put option increases which offsets the decline in the value of the corn.

This strategy involves buying a July $2.20 strike price corn put option (September put would provide protection for a longer period of time).  A $2.20 strike price put would provide a floor price of about $1.82 next May or June as shown below.

Strike Price

$2.20

Premium

-.11

Est. May basis

-.27

Minimum Price

$1.82

Harvest LDP

+.25

Min. Price + LDP

$2.07

LDP, harvest sale, and buy call options
Another alternative is to take the LDP at harvest, sell grain at harvest, and buy call options.  Call options allow you to participate in rising prices if the market moves upward but do not subject you to losses if prices decline.  The call premium is the cost for upward futures price flexibility.

The disadvantage of this strategy is that it does not participate in the rising cash market (relative to the future market) caused by the abnormally large basis and carrying charges that the market is currently offering.

LDP, harvest sale, and buy July futures
This strategy is similar to the call option strategy except that you buy futures contracts rather than call options.  As with the previous strategy, you do not participate in the rising cash market relative to the future market caused by the abnormally large carrying charges.

Although you don’t have to pay an option premium, your net price may decline due to falling futures prices.  This may occur at a time when cash prices are actually rising.

Timing of strategies

A logical strategy in timing the use of MLs or LDPs is to wait until you think local prices are near a bottom before cashing in returns offered by these tools. The grain can then be sold or it can be stored until later in the season if prices are expected to rise.  Or the grain can be priced for later delivery with a hedge or forward contract if the market is offering storage returns.

There is no precise way of identifying when LDPs will reach their maximum.  The PCPs do not necessarily reflect actual market conditions.  In wheat, the differentials of terminal market prices to the PCPs were adjusted at times, causing abrupt changes in LDPs.  The same situation occurred several times in the mid-1980s, when pic and roll processes were based on PCPs. 

Barring major changes in differentials, one might expect LDPs to reach their maximum during harvest, when pressure from lack of storage space creates maximum pressure on cash prices.  Historical, monthly price patterns for corn and soybeans show a high probability that local prices will increase later in the marketing year, often reaching a peak in May or June. 

Other timing considerations

PCPs are adjusted only once a day, after the market has closed.  So, PCPs from the previous day’s close are useable for redeeming MLs or taking LDPs until the market close on the next business day.  This process virtually guarantees that in a volatile market, PCPs will not move in lock step with the cash market.  However, this creates opportunities for additional income gains through careful observations of market movements. 

For example, on October 5, after a weekend of rain and forecasts for several more days of rain and delayed harvesting in the Midwest, corn futures prices were up by 5 cents per bushel.  For those wanting to LDP and then store and hedge, on Oct. 5 they could have locked-in a 5 cent higher net hedge price while still getting the previous Friday’s LDP.

It is important for farmers to stop at the local FSA office and fill out the required forms for marketing loans and/or loan deficiency payments at their earliest opportunity. This will help ensure eligibility and expedite payments.

Comparing alternatives

Comparing the alternatives of selling corn at harvest and taking the LDP to various storage alternatives is shown in Table 1. The comparisons are for corn and are based on early October prices. 

Example Assumptions

Loan Rate
$1.78
PCP
1.53
Cash Price
1.60
July Futures
2.32

All gains from the storage strategies are figured after eight months of storage (corn sale in May).  This is when net storage returns have often peaked with a large crop. 

In the example, the same 7cent positive differential between the PCP and cash price at harvest ($1.60 cash – $1.53 PCP) is assumed to still exit in May.

Five different scenarios of price levels during May are used.  The differential between July futures and cash price narrows from 72 cents at harvest to 27 cents in May, a change of 45 cents.  This means that over the 8-month period, cash price will rise 45 cents relative to July futures price.

Storage and Interest Cost (Oct. – May)

Interest on corn Inventory

CCC interest rate (6%)

.07

Commercial rate (9%)

.10

Storage

Farm *

.09

Elevator **

.30

Option Premiums

 

$2.30 July Call
.18
$2.20 July Put
.11


* Extra shrink and drying for a reduction from 15% to 13% moisture, handling and aeration, 1% quality deterioration, & interest on value of inventory.
** Extra drying and shrink for a reduction from 15% to 14% moisture, and a storage charge of 13 cents for the first three months and 2.5 cents per month for each additional month.

Table 1. Net return from various corn marketing strategies (per bushel)

Results

The strategies outlined above can be divided into three types:

Fixed price strategies
Two strategies fix the price at harvest.  The first is the harvest LDP and harvest sale.  The other is the harvest LDP with the hedge.  The net return of the hedge strategy may vary slightly due to unanticipated changes in basis.

The hedge strategies have a higher net price than the harvest sale.  This is especially true if the corn is stored on the farm. Essentially, the 45 cent narrowing of the differential between cash price and July futures more than offsets the cost of storage and interest – even the 40 cent cost of elevator storage and commercial interest.

Variable price strategies
Two strategies are variable price strategies.  They are the harvest LDP and open storage until May; and the harvest LDP, harvest corn sale, and harvest purchase of July futures with sale in May. 

Of these strategies, the harvest LDP and open storage provides the higher net returns, even when elevator storage and commercial interest are considered.  Once again the narrowing cash price/July futures differential is the reason.  The storage alternative takes advantage of the seasonal rise in cash prices while the July futures alternative does not.

Minimum price strategies
The strategies involving options (calls or puts) or the marketing loan are strategies that provide a minimum price under which the net price cannot fall, but allows for higher prices if the market rises in May. 

The strategy of harvest LDP, storage, May corn sale, and the purchase of put options returns the highest net minimum price and the highest net price if prices rise.  It exceeds the marketing loan alternative under the low price scenarios because of the exercise value of the put option under falling futures prices.  It exceeds the ML alternative at high prices because the LDP value is not realized under the ML alternative.

The strategy of harvest LDP, harvest corn sale, and the purchase of call options yields the lowest net floor price and the lowest relative price if prices rise.  This occurs because this alternative does not take advantage of the seasonal rise in cash price relative to futures.

More information

The following Decision Files provide additional information:

 

|Ag Decision Maker Home Page|