Farm Risk Management using Futures Contracts

The agricultural markets are dependent upon the supply and demand balance of the underlying commodity. As a result, farmers are exposed to price volatility stemming from dynamic factors such as weather conditions, disease, geopolitical risk, storage and shipping complications. In an industry where small price fluctuations can have a big impact on profitability — risk management is extremely important! 

Olds College of Agriculture & Technology is currently working with industry partner Algo-Rythmn Corp. to apply machine learning and data-driven solutions to enhance market and financial risk management innovations. This article aims to provide a basic understanding of futures contracts, an effective tool to incorporate when developing a farm risk management plan. 

Futures Contracts Explained

A futures contract is a standardized, legally binding agreement where one party (the seller) agrees to deliver a commodity to another party (the buyer) for an agreed upon price at a future date. Futures contracts specify the commodity, quantity, grade, delivery point, delivery period and delivery terms. 

Consider the following example: 

Assume Andrew is a local wheat farmer growing 5,000 bushels of wheat that he intends to sell four months from now (in December). Andrew is concerned that the price of wheat is going to decline and will result in a loss of money. Also, assume that Sarah owns a local bread factory and needs to purchase wheat four months from now when her current stock is depleted. Sarah is concerned that the price of wheat may increase, and does not want to charge her customers more for her bread. If Andrew agrees to sell his wheat to Sarah in four months for an agreed upon price, this is considered a forward contract. 

For simplicity, a futures contract is a standardized form of a forward contract where a commodity exchange is on the opposite side of the position.

Commodity Exchange Explained

A commodity exchange is a place where commodities are bought and sold. Most commodity exchanges are accessible electronically almost anywhere in the world and are used by a wide variety of market participants. Commonly traded commodity future contracts include corn, wheat, soybeans, lean hogs and live cattle. The primary North American exchanges that offer agricultural contracts include: The Chicago Mercantile Exchange (CME), The Minneapolis Grain Exchange (MGEX), The New York Board of Trade (NYBOT), and The Intercontinental Exchange (ICE). 

Reading a Futures Contract

Each commodity exchange displays the price and market information for each commodity contract that it offers. To better understand future contracts, let's revisit the previous example with Andrew and Sarah. 

Let’s assume that Andrew and Sarah never reached an agreement. Instead, Andrew decides to sell his wheat on a commodity exchange and visits the Chicago Board of Trade (CBOT) website. He sees the following quote for wheat futures:

Wheat Dec ‘22 (ZWZ22)
815-2 , +4-2 (+0.52%) 

Let’s take a look at what this means: 

1. ZWZ22: This is known as the contract code. A contract code is expressed in the following format XXY00. 

   • XX specifies the type of commodity being traded. In this example, ZW is the ticker for Chicago Soft Red Winter Wheat.

   • Y specifies the delivery month for the contract. ZW contracts have five different delivery months: March (H), May (K), July (N), September (U) and December (Z). 

   • 00 specifies the delivery year. 

   • In this example, ZWZ22 means a Chicago Soft Red Winter Wheat contract with delivery December 2022.

2. 815-2: This is the latest price quote. 

   1. Wheat contracts are quoted in USD cents/bushel and have a contract size of 5,000 bushels. Typically, exchanges in the United States will quote their contract size using imperial units. 

   2. Exchanges in Canada, such as the Intercontinental Exchange (ICE), will quote their contracts in metric units. The standard size of Canadian contracts is 20 tonnes and is quoted in CAD cents/tonne. 

   3. To find the total contract price, we have to multiply the latest price quote by the contract size. 

   4. In this example, the December wheat contract is trading at $8.152/bushel. Or $40,760/contract ($8.152 x 5,000).

3. +4-2 (+0.52%): This specifies the change in contract price since the end of the previous trading day. 

   1. The units of change are the same as the units of the price quote. 

   2. In this example, the contract price has increased by 4.2 cents/bushel.

Entering a Futures Contract

It is important to note that futures contracts do not necessarily involve the transfer of ownership of the commodity. One can buy or sell futures contracts whether or not they grow or possess the physical commodity. Market participants who are interested in the physical settlement of the commodity are called “hedgers”. Participants who are more interested in cash settlement and exploit small price fluctuations in the hope of making a profit are called “speculators”.

Continuing with our example, let's assume that Andrew is happy with the futures price and decides to sell his wheat in a four month forward contract. Because Andrew is selling his wheat, he is known as the “short” side of the contract. Similarly, any market participant who buys a contract is known as the “long” side of the contract. Once Andrew places the sell order, he will own a ZWZ22 contract with the obligation to deliver 5,000 bushels of wheat on the delivery date. In exchange, he will receive a guaranteed $8.152 cents/bushel. 

Closing Out a Futures Contract

In order to close out Andrew’s position, he has two possibilities: 

1. Deliver the Commodity: Andrew’s first option is to deliver 5,000 bushels of wheat on the delivery date to the futures exchange. In this case, Andrew will have satisfied his contract commitment and will receive $8.152 cents/bushel. 

2. Offset the Futures Position: Andrew’s second option is to offset the contract by taking an opposite position in the same futures contract. In this scenario, Andrew will buy the ZWZ22 contract and effectively cancel out his obligation to deliver the wheat. If the price of Andrew’s long position is less than the price of his short position, he will make a profit on the difference between the two contracts. In order to deliver his wheat, Andrew will then either purchase another futures contract or sell his wheat at the 'spot price' (the price at which physical commodities are bought and sold today). 

Conclusion

Future contracts are an effective risk management strategy which should be included in a farmer’s repertoire. Price trends show that commodity prices are often lowest at harvest when supply increases resulting in a lower profit for farmers. By buying futures contracts, farmers eliminate the risk of taking a lower profit at harvest and guarantee a purchaser. While there are additional risks and complexities associated with futures contracts, this article aims to provide a basic understanding of their use in risk management.