12 December 2017
Berkley Futures on how future markets and options can help farmers manage risk
With all businesses, including farming, facing greater uncertainty and tougher market conditions we recently asked Berkeley Futures to provide more information about how farmers can use financial and commodity markets to their advantage.
The next few years have the potential to be crucial for farmers, possibly more so than most other industries. Trade talks could take years to achieve agreed results. Basic Payments may or may not be honoured by the government, uncertainty will prevail. This may all be for the good in the long term but as happened in New Zealand, when they removed subsidies, times may well be tough for uninformed and ill prepared farmers. On top of the political worries, farmers need to contend with the weather, world prices and international exchange rate movements. The modern farmer now needs the financial instruments provided by the market to help reduce risk and manage cash flow.
There are two fundamental ways in which access to the financial and commodity markets may help farmers. The hedging of crop prices and until removed, the forward fixing or hedging of the Basic Farm Payment which is subject to exchange rate movement between sterling and the euro.
In March of this year the November delivery of London Wheat price was as low as £136 /t. By July, with hot weather both here and in the USA, the price had risen to above £154/t. Some producers were happy to sell part of their crop at these higher levels by simply selling November Wheat Futures on the London market. At the time this may have seemed brave as the weather and dryness seemed to be continuing. There was a possibility that prices could go higher and they may have missed out on further gains. However, at a level above £150, they felt they were getting a fair price and were happy to lock in, if not on all, then at least on some, of their expected crop. As it has turned out, with prices now, at the time of writing, in the low £140/t area their “hedge” has paid off and they can sell their actual grain at today’s price and buy back their sold futures position at a lower price than they sold, taking a cash “profit” to offset lower wheat prices. This is called a short futures hedge strategy. The danger here is that the forward sold positon is a margined product, meaning that if the position were to go against you on the short side, despite the corresponding gain on your actual crop, further funds would need to be placed with the market. The futures hedge is the most accurate one available and at the keenest price but the funding requirement and risk profile may not be suitable for all farmers.
A lower risk, yet less exact, protective position would be to place a floor on the price of wheat, by buying a put option. Each option is on 100t of London Wheat for delivery in either May or November.
The current price of Wheat for May 2018 delivery is £149/t. Whilst hopeful for firmer prices, you may want to insure against price decline below £120 as seen in 2016. Here a £140/t put option costs £3/t, which effectively hedges the contract at £137/t. If the price fell to £125 then the option you bought for £3/t would be worth £15/t on closing or selling the option. This offsets the lower price you get for your actual crop. However, the benefit here is that if the price rose to say £160/t you would lose the £3/t you paid for the option but still be able to gain from the increased price of your actual crop.
Another variable factor and cost is the fluctuation in Euro/Sterling exchange rate. The payment is based upon the average exchange rate for September of this year but payment may not be until the middle of next. If Sterling is weak one may want to hedge at such prices, to maximise the value of your Euro payment in Sterling terms. The other way the market may help will be in securing your actual exchange rate at a far lower cost than offered by the banks. That is to say the bid/offer or spread in the exchange rate may be more than 3% in many cases whereas dealing through an authorized and regulated broker, you could be charged a tenth of the bank spread, perhaps saving a few thousand pounds.
Price risk is a fact of life, particularly for farmers; however, open ended risk may not be acceptable. There are mechanisms and markets that exist to assist farm businesses. BFL has a designated team of brokers to help farmers utilise these markets, explain the risks and aid the placing of orders.Back to Media & Insights