Price Risk Management Alternatives for Farmers in the Absence of Forward Contracts with Grain Merchants

Abstract

Grain producers have historically made much less use of futures and forward contract markets than grain merchandisers and other middlemen in the grain marketing channel. When grain prices are close to government support levels, producers are well protected from price decreases and they have little need to manage risk through forward pricing. Also, producers must make many long–term investments in land and machinery, which coupled with yield risk, has made forward pricing somewhat less effective in protecting producers against the risks they face. However, as grain prices rise government supports have also become less effective in protecting producers against price decreases. Moreover, increased use of crop insurance allows producers to be able to pay nonperformance penalties associated with cash forward contracts in the event of a crop failure. Thus, producer demand for forward contracts has skyrocketed in recent years. Most producers prefer forward contracts to futures contracts because they then avoid basis risk as well as the cash required for margin calls. Producers who forward contract receive a few cents less per bushel than they would by hedging (Brorsen, Coombs and Anderson, 1995; Shi, Irwin, Good and Hagedorn, 2004). Elevators have been willing to offer this service because it assures them a supply of grain. At the same time when farmers have a greater demand for cash forward contracts, grain merchants and elevator operators now have limited capacity to offer these contracts. The extra costs associated with margin accounts and extra working capital have been reflected in lower forward basis bids for corn, soybeans, and wheat in many Midwest and Corn Belt states. In Oklahoma, for example, elevators lowered their wheat forward basis bids about 30 cents/bushel rather than discontinue offering forward contracts. Many grain buyers began to restrict their offerings of cash forward contracts in March 2008 instead. Some elevators simply quit offering forward contracts. In other instances, buyers quit offering cash forward contracts beyond the current crop year. Some buyers are only offering cash forward contracts for grain to be delivered within 60 days.