Options to ‘Weather’ markets
Most growers will be aware of the historically strong domestic pricing currently available as a result of a strong international market combined with the domestic dryness and east coast grain shortage. Alarmingly here in AUS, planting conditions for new crop remain dry across the board, with little forecasted rainfall in the near future. This uncertainty in new season production is making it an even riskier proposition than usual to forward contract or hedge in the form of a swap at this time in the season. In this type of situation there are low risk alternatives to establish price protection for a greater portion of your new season production, namely through put options.
Since January, CBOT wheat futures have been highly volatile, as market participants continually adjust positions on daily forecast fluctuations, particularly for the US Southern Plains. These short-term market fluctuations present opportunities to use options as insurance against falling prices and therefore protect gross margins. Global wheat fundamentals have been bearish for a number of years, which can be attributed to the exponential increase of production out of the Black Sea wheat growing regions plus ideal conditions in other major producing regions. Whilst the world is ‘awash’ with wheat, it makes a significant change in pricing dynamics look unlikely, given the large amount of carry-out stocks available to the market. Given these conditions, we can form a base case scenario that global wheat values should continue to battle heavy resistance in the absence of a large-scale supply disruption in a couple of the major producing countries.
So, when we see short term rallies driven by fluctuations in weather forecasts in the northern hemisphere growing season, we should view them as an opportunity to participate by either selling or hedging. But due to the uncertainty of production domestically given it’s so early in the season, it’s hard to justify the risk in outright selling any market whether it’s a fixed tonnage sale domestically or a hedge (i.e. swap). This is where put options come into play, for the following reasons:
- It is similar to insurance, as there is a premium paid to protect a given price without the physical delivery risk that comes with a fixed tonnage contract.
- Washout risk is limited to the cost of the option (the premium paid) as opposed to selling physical or owning a CBOT wheat swap.
- Allows us to participate if prices continue to rally without margin risk, while protecting a larger portion of our crop if prices fall.
The benefit of using put options as opposed to selling swaps or physical forward contracts is that if the international wheat market has a sustained rally due to major production issues, the only downside is the premium paid for the options.
An options strategy is not limited to the use in the US market, it can also be implemented in our domestic ASX futures market. The ASX futures contract is priced on the cheapest east coast port, which is currently Portland, Victoria. The decision to place put options in the ASX market rather than the US is more desirable in the case of a strong basis environment, i.e. the Australian market is already priced relatively strong against the US market, hence we protect prices in the stronger market.
As in any effective risk management policy, never put all your eggs in one basket but maintain a diversified marketing approach to your grain portfolio. Therefore Put Options, in conjunction with forward fixed tonnage contracts may suit best depending on your minimum crop estimates and risk appetite.
Tom Borowski, 27 April 2018