Most farmers were cheering on the bull market this spring until elevators quit accepting forward contracts because they could no long afford the multi-million dollar daily margin calls. Sobriety set in. What does a farmer do when the market climbs, he tries to price part of his crop, and the elevator manager says “Do it yourself at the Board of Trade and pay your own margin calls.”

That happened to thousands of farmers across the Cornbelt last spring, who were concerned they did not have their favorite marketing tool, and were unsure about the others. Faced with the loss of the forward contract, more farmers probably just held onto their grain longer than switched to futures and options. What were the alternatives? Nebraska economists Darrell Mark and Rebecca Small and Oklahoma State economists Wade Brorsen and Kim Anderson outline their suggestions in the latest issue of Choices Magazine.

The economists say the diminished farm program payments and the availability of crop insurance to pay non-performance penalties in the wake of crop failures has increased the use of forward contracts. The big benefit is the avoidance of margin calls, typically paid by the elevator, but which became financially burdensome as prices rose earlier this year. Some elevators quit offering them; some reduced the basis to help pay for the margin costs; and some put short time limits on the delivery options.

When the Chicago Board of Trade increased daily price limits from the initial 20¢ on corn to 70¢, margin requirements also increased to amounts about equal to the daily price limits. Elevators quickly emptied their margin accounts, and then sought loans to cover more margin calls in lieu of closing out their accounts.

In addition to the margin risk, elevators also faced increased basis risk, which has been the lack of convergence between cash and futures for the past couple years in several commodities. That has resulted because of the growing number of ethanol plants that are drawing in as much corn as do river terminals, as well as the increased cost of transportation. The inconsistent convergence has resulted in action being taken by exchanges at Kansas City and Chicago to correct the problems. Parallel with that action, some elevators are controlling basis by selling to non-traditional buyers such as feedlots, or passing on their margin costs to producers obtaining forward contracts by widening the basis.

So what does a farmer do if faced with a forward contract that no longer exists, or does not approach the value the farmer has in the grain?
1) Hedging on the grain exchanges can lead to higher net prices than at local elevators since the merchandising margin is eliminated. The basis risk remains, but that may be controllable depending on location of the grain. The farmer still has the problem of margin calls and the economists calculate a producer who hedges half of his corn and soybean production from 2,000 acres may have a $42,000 margin liability.
2) A basis contract is another option, which leaves open the futures portion, but allows a farmer to lock in a basis when it is narrow and to his advantage. Payment on a majority of the production may be available upon delivery, but the producer still has to manage the futures portion and lock it in at an advantageous time, and that can be done with a commodities broker on a paper transaction.
3) Options on futures positions are another alternative, but they too, are a paper transaction and the basis risk remains. Using it to replace the unavailable forward contract would be the purchase of a put option on December futures in the spring. Gains in its value, should the market value diminish, leave the farmer with the right to exercise the option and force the buyer to complete the purchase, which would be similar to an insurance contract.
4) While option premiums are expensive, there are numerous ways to reduce the costs by selling options, and obtaining someone else’s premium. Those require risk that a user should be familiar with before entering into a option strategy.
5) A rarely used alternative is contracting with a user of the grain, such as an ethanol plant, or a feedlot, or a grain processor that pays premiums prices for specific grades and types of grain. Wanting to manage their financial expose, they may be quite willing to forward contract just to get the grain. The downside is the potential complexity.
6) Another alternative is the use of crop revenue insurance that covers both yield risk and price risk. Crop insurance does not protect against basis risk, and price level changes are capped. One aspect is the new ACRE program in the Farm Bill that will become effective in 2009, and indemnify producers with revenue shortfalls.

Summary:
Farmers lost an old friend earlier this year when forward contracts were denied by many elevators unable to meet margin requirements. That forced many farmers to abandon their marketing plans and either hold grain without selling or using a variety of other marketing tools including hedging on their own. If a similar scenario recurs, farmers will have opportunities to use either basis contracts with a futures hedge, option strategies, or look for alternative purchasers of their grain.