Do We Need Help Marketing Our Wheat?

Will spending more time and/or money on wheat marketing make you a better marketer and increase your income?  Will hiring an advisor or subscribing to a marketing newsletter increase your bottom line?  The short answer is “Probably not in the way you’d expect.”

When I look back over the last 25 years, I realize I’ve spent hundreds of hours discussing the wheat market with other farmers at bi-weekly marketing meetings and in the coffee shop.  I’ve also spent several thousand dollars for my subscription to the White Wheat Report.  I’ve regularly sought advice from the coop staff before making sales.  I know I’ve enjoyed the social interactions, but has the additional information I learned about conditions in the world wheat markets improved my ability to identify good sales opportunities?

In 1998, the Oregon Wheat Foundation hired Steve Buccola and Yoko Fuji to test WW marketing strategies.  After lots of statistical analysis, they concluded we are wasting our time if we spend much effort on marketing.  Selling at harvest every year does about as well as more complicated strategies.  They recommended we focus on producing wheat.

This is the result that most economists—who believe in the “efficient market” theory—expected.  Farmers sell wheat based on the bids of Portland exporters.  The exporters’ bids are set by experienced grain traders who have access to much more information than any farmer.  If new information becomes available indicating prices are likely to rise or fall, exporters will act quickly to raise or lower their bids.  Prices will reflect this new information before farmers become aware of it and no simple strategy should work to forecast prices.

The only way to know the value of time spent studying wheat marketing and/or whether your advisors are providing useful recommendations is to do a test.  Compare your actual net returns over the last ten years to the returns you would have received if you had used some simple strategy—say, selling on September 15th each year or selling once a week from harvest through November.  One reason I was a fan of Larry Lev’s marketing approach was his willingness to test his strategies against selling the crop at harvest.  He was able to show that his “harvest marketing strategy” increases returns by a small amount—about 5% over two decades (see here, here, and here).  Unfortunately, the dramatic changes in the wheat market after 2007 have made Larry’s recommendations obsolete.

I doubt the time and money I’ve spent on marketing has improved my ability to forecast wheat prices or to pick the top of the market.  However, I believe I have benefited in two other ways.  First and most important, attending market meetings often motivated me to stop procrastinating and make sales.  Over the years, I’ve sold most of my wheat on Friday mornings right after a marketing meeting at which Chuck, Raleigh or Jeff outlined the reasons why prices could collapse. The most common marketing mistake is holding wheat unsold too long.  Being forced to confront the downsides helped overcome my psychological bias toward excess optimism.  Raleigh Curtis’s most important teachings were not about predicting prices.  His main interest was in psychology and teaching us to act.  He wanted us to be better decision makers.  If a good price is available any time over the next three years, he wanted us to grab it.

Second, marketing meetings helped me understand hedging and the dramatic way the long-only index funds have changed the wheat market since 2005.  During my first thirty years of farming, marketing was simple.  We sold the current crop on the cash market and had no good way to price future crops.  Base-price contracts greatly expanded our marketing options and attending the meetings helped me understand how to use these new contracts.

Finally, I recommend that you consider giving Kevin Duhling and his marketing service, KD Investors, a try.  Kevin grew up on Wapinitia Flats near Maupin and still helps operate his family’s wheat farm.  He always had a keen interest in marketing and wrote a marketing newsletter for several years before starting KD Investors.  Kevin let me read his newsletter during the last couple of years and I can testify that he is very knowledgeable about futures, hedging, options, and the WW market.  He also knows how farmers think and how to spur us into action when the time comes.  His service costs 2¢ to 8¢ per bushel (depending on the level of personal attention you want) and might be money well spent.  I doubt that Kevin can consistently forecast price movement.  If he could, he’d be living very quietly in a mansion in Lake Oswego.  However, I know he can help you in both the ways that marketing meetings helped me—by encouraging me to act and by helping me navigate the confusing world of long-only funds and base-price contract.

 

White Wheat Basis Update

Several months ago, I updated my data on the white wheat basis relative to Chicago  futures.  I believe the basis graph helps illustrate the effect of the long-only index funds on our basis.  The funds became dominant players in the Chicago futures market after 2005, but their early effects were masked by the two back-to-back years of Australian drought.

Rethinking the Role of “Cost of Production” in Marketing White Wheat

Until September of 2007, I sold my wheat based on a few simple rules—and never thought about my cost of production when marketing.  My rules can be summarized as:

Sell wheat early in the marketing year—normally before Thanksgiving—except when the cash price or the basis is unusually low or the carry is usually wide. Use base-price contracts to hedge future crops when the expected return is at least 10% above the long-term average price of $3.90.

Sell wheat early in the marketing year—normally before Thanksgiving—except when the cash price or the basis is unusually low or the carry is usually wide. Use base-price contracts to hedge future crops when the expected return is at least 10% above the long-term average price of $3.90.

I describe my rules in more detail in this article.

In developing my rules, I was influenced by two articles written by OSU Professor Larry Lev more than twenty years ago (they are still worth reading and are posted under “Wheat Marketing” on this website).  Larry’s approach relies on two characteristics of the white wheat market before September 2007 (see the graphs below).   

First, the trends in the cash price and white wheat (WW) basis were amazingly flat—prices and basis fluctuated around $3.90 and $.44 respectively for almost thirty years.  Second, the price and basis were “mean-reverting,” i.e., within a few months, they usually headed back toward these mean values. Anomalies in the cash price or basis were easy to spot.  Larry tested his rules for exploiting anomalies and, on average, they did better than selling every year at harvest.

Everything changed after September 2007 when the wheat market finally awoke from its long slumber.  In both 2008 and 2010, wheat prices rose to levels more than twice our wildest dreams just a few years earlier.  Both prices and basis also became much more volatile.  Partly, this change is due to the growing and now dominant position of the long-only index funds in the Chicago futures market.  Notice that our basis has been negative much more often recently.

Although the changes starting in 2007 greatly improved my bottom line, they also blew apart my marketing plan and raised many new questions.  How do I spot anomalies?  How do I know when prices are high or low?  How do I forecast where prices are headed later in the marketing year?  What is a “normal” level for the WW basis and how can I determine when the basis is unusually low?  Even my strongest belief—that wheat should usually be sold early in the fall—is now suspect.  The biggest cost of holding wheat is foregone interest income and near zero interest rates have almost eliminated that cost.

One way of dealing with this new world is to go back on basic economics.  Wheat prices should move toward the world’s average cost of production—at least over a period of several years.  If prices are below the cost of production, farmers will shift to other crops, the supply of wheat will increase less rapidly, and prices should rise.  If prices are above the cost of production, wheat farming around the world will be profitable, more wheat will be grown, and prices are likely to fall in the future.  I don’t know any published estimates of “world average cost of production for wheat.”  It would be a complicated calculation since exchange rates are an important factor in determining how the production costs of the major wheat producing countries should be weighted in the average.  However, a farmer may be able make a rough prediction about the direction of prices by examining his own bottom line.  The same movements in energy, fertilizer, and some other input prices affect wheat farmers around the world.  If prices are below an Oregon farmer’s cost of production, holding wheat unsold for a few months longer may be a good gamble.  If wheat prices are well above his cost of production, wheat should probably be sold or hedged now.  Our retired grain cooperative manager, Raleigh Curtis, has been teaching a marketing approach based on cost of production for many years now.  In the current circumstance, I believe Raleigh’s approach makes a lot of sense—especially if cost of production is viewed as a rough predictor of the level toward which prices will tend in the future.

My pre-2007 marketing strategy worked because the wheat price and basis trended back toward known benchmarks—$3.90/bushel and $.44/bushel respectively.  Can similar benchmarks be calculated in the current situation?   Finding good benchmarks will be more difficult because the markets are much more volatile and the new benchmarks won’t be constants as they were before 2007.  I’ve calculated a tentative new benchmark for the WW price that might roughly track “world average cost of production.”  Each year, the USDA publishes an estimate of the total cost of production for U.S. wheat farms (unfortunately the series starts only in 1998).  To test my new approach, I started with this USDA estimate, subtracted their estimate of land costs, and added a 60¢ marketing cost to get the wheat from the farm to Portland.  I then adjusted this total for exchange rate changes by using the USDA’s index of our competitors’ inflation adjusted exchange rates.  When the U.S. dollar depreciates, the world cost of production should increase relative to the U.S. cost of production and vice versa.  My results are plotted on the graph above.

Taking Advantage of the “Long-only Index” Funds?

In my last blog post, I explored how the dramatic growth of “long-only index” funds has affected the Chicago futures market.  These funds focus on worldwide inflation forecasts in making their investing decisions and have maintained their long positions irrespective of what is happening in the wheat market.  Accommodating this huge new semi-permanent demand for long positions requires attracting many more short sellers.  “Long-only index” funds must make the short positions of hedgers—farmers and grain handlers—more attractive and profitable, so they will hedge and store wheat that normally would be sold on the cash market. The higher the futures price is above the expected cash price (i.e. the more negative the basis), the more attractive hedging becomes.  This difference is the “fee” paid by the “long-only index” funds to maintain positions unrelated to the basic supply and demand for wheat.

After some worry, I’ve come to the conclusion that farmers can safely take advantage of this market distortion.  When futures prices are above expected cash prices, hedgers will normally make money and the “long-only index” funds will lose money.  Farmers will lose only if they must close out their hedge positions during a period when the funds are building their long positions and causing the basis to widen.

A New Way of Viewing Basis and Chicago Futures

Farmers in my area are increasing their use of base-price contracts to sell their current and (especially) future soft white wheat (SWW) crops.  Until 2007, the SWW basis (the Portland cash price of SWW minus the nearest Chicago futures price) fluctuated around 44 cents and was usually positive sometime during the early fall.  Since 2007, the basis has fluctuated erratically and spent most of the time in negative territory.  Since a strengthening basis (i.e., a basis that becomes more positive or less negative) adds to the net return from a base-price contract, understanding why the basis has been staying so negative has been a topic of considerable interest to my neighbors and me.

Two years ago, I discussed this issue in one of my first blog entries.

I explain why the basis should average 44 cents in this article.

In trying to understand why the basis has been negative for so much of the time since 2007, I’ve focused on the “convergence problem” problem in Chicago futures.  The futures price has often remained above the cash price of SRW wheat when futures contracts expire.  This isn’t supposed to happen and could contribute to the negative WW basis.  After several years of study, the Chicago Mercantile Exchange has failed to correct the “convergence problem” and I was beginning to wonder whether they really were serious about dealing with it.  However, I now think this lack of convergence is largely irrelevant in explaining our persistent negative basis.

My thinking changed in late October when I attended a U.S. Wheat Associates Board meeting in Minneapolis.  I attended a panel discussion including Mike Ricks, a senior manager for Cargill.  Listening to Mr. Ricks caused me to start thinking about basis in a new way.

A New Way of Thinking About Basis

The classic theory of futures markets argues that their main function is to facilitate hedging.  Normally, short hedgers (farmers and grain elevators) outnumber long hedgers (grain buyers and millers) so the market needs to attract long speculators to buy the extra contracts that short hedgers want to sell.

The Chicago wheat futures market began to change the way it functions  around 2006, when “long-only index” funds started building their positions in the wheat market.  These funds hold wheat futures contracts as a hedge against possible “food price inflation.”  They aren’t concerned about the current price of futures or short-run changes in the supply and demand for wheat—they just want to be long futures.  Shortly before each contract expires, they roll their positions to the next available contract month.

“Long-only index” funds now hold a huge and dominant position in the Chicago wheat futures market.  They hold contracts for at least 1.2 billion bushels—more than five times the size of this year’s soft red wheat crop.  Just as hedgers previously had to attract long-speculators to offset their net short positions in the market, the “long-only index” funds now need to attract short sellers to hold the other side of their huge long positions.

How do you attract new sellers willing to take short positions totaling 1.2 billion bushels?  Attracting the necessary supply of short-speculators might be difficult—since naked short speculation is risky when inflation is a worry.  However, new hedgers can also be attracted into the market to take the necessary short positions.  As the futures price rises above the cash price of wheat (i.e., the basis becomes more negative), hedging by owners of physical stocks of wheat looks more and more profitable—giving grain handlers and farmers an incentive to delay selling the crop so they can store and hedge more wheat.  Because hedgers hold a long position in the physical wheat, their short position in the futures market seems less risky than the position of a short speculator.  By being willing to take the other side of the futures contracts that the “long-only index” funds buy, hedgers have indirectly allowed the funds to accomplish their real desire—to hold physical wheat.

Can the Basis Return to Normal? 

One of the reasons hedging has looked attractive is because the basis has been unusually negative.  In calculating their expected profits, many hedgers are assuming that the basis will not stay unusually negative and will eventually return to “normal” levels.  Can basis return to “normal?”  What happens if basis narrows, i.e., cash prices rise (converge) to the level of futures prices?  If basis narrows, maintaining hedges will look less profitable and hedgers will start lifting their hedges by buying futures and selling their stored wheat.  This will cause the basis to widen again.  As long as the “long-only index” funds insist on maintaining their huge long positions, no big players in the market will be willing to sell contracts to exiting hedgers.  Futures prices will keep rising until hedgers stop wanting to buy futures — because hedging looks profitable again.  Hence, the situation may be unstable—the necessary amount of hedging will be done only if basis is expected to return to “normal,” but basis can’t return to normal if “long-only index funds” insist on maintaining their positions.  I now think I understand why the CME is having such difficulty forcing “convergence.”

Why Do Futures Prices Move with Cash Prices?

If “long-only index” funds are focused only on inflation and if hedgers are focused on the basis, what causes movement in the futures price and how are futures prices related to the supply and demand for cash wheat?  As argued above, the “long-only index” funds have caused an increase in U.S. wheat carryover and this has at times reduced exports.  As Mr. Ricks mentioned in Minneapolis, the index funds are causing the U.S. wheat carryover to reach levels that rival the size of the burdensome government stocks in past years.

Since about half of U.S. wheat is exported and must be priced competitively on the world market, the cash price of wheat is still predominantly determined by world supply and demand.  If the cash prices rise, the basis narrows and hedgers start lifting their hedges and buying futures.  This causes futures prices to rise along with cash prices and by enough to keep the necessary number of hedgers in the market.  Similarly, if the cash price falls, basis widens and hedging increases.  The resulting sale of futures contracts by hedgers causes futures to decline along with cash prices.

How Will All This End?

Mr. Ricks indicated in Minneapolis that Cargill had been giving lots of thought to the question, “How will all this end?”  I believe that until “long-only index” funds start liquidating their huge positions, the basis must remain wide and hedgers expecting the return of a “normal” basis may be disappointed.  When the “long-only index” funds start reducing their positions by selling their future contracts, the futures price will decline and the basis should initially narrow, i.e., become less negative.  Hedgers should then be able to liquidate their hedges at profitable basis levels.  As they do, they will sell their stored wheat and cash prices should decline along with futures.  If “long-only index” funds liquidate their positions quickly, the cash price of wheat could crash along with futures—as our large carryover stocks are dumped on the market.

Appreciating Raleigh

Raleigh Curtis officially retired from his senior management position at Mid Columbia Producers (MCP) on May 31, 2009.  He will still be advising MCP for the next couple of years and has kept the title of “Grain Position Manager.”  However, we won’t see him in the office much anymore.

I’ve known several good coop managers during my 35 years of farming, which included serving 11 years on the Sherman Cooperative Board.  Raleigh is the best — both as a manager and as an innovator.  In his decade managing MCP, Raleigh’s achievements include: dramatically increasing MCP grain trading income by using his knowledge of hedging and futures markets, paying off all MCP’s qualified capital credits, and providing farmers with new marketing tools — such as base price contracts that allow farmers for the first time to take advantage of high prices for future crop years.

My main interaction with Raleigh has been during his biweekly early morning “marketing meetings.”  Although parts of these meetings are used to discuss policy changes or new ventures that MCP is considering, the main focus was always on Raleigh in his favorite role — as an educator.  Raleigh is a enthusiastic teacher and delights in challenging the thinking patterns of farmers.  When Raleigh arrived, attendance jumped from 6-8 farmers to 15-20 farmers — with more after harvest, when farmers have grain to sell.

Farmers come to marketing meetings to learn which way wheat prices are headed.  They want to make sales that hit the top of the market.  Raleigh played along with this desire to predict, but in his heart I think he knew that farmers are wasting their time trying to predict short-run price movements.  Instead, Raleigh tried to convince farmers to change their approach — focus on managing risk and grabbing profitable opportunities.  He taught the techniques that made him a successful trader.

I sometimes wasn’t convinced by the way Raleigh justified his recommendations.  However, if I mulled them over long enough, I always concluded that the recommendations themselves were correct — basically, use all the tools that the government and futures market provide and, most important, sell as soon as you see a profitable price even if it is for a crop that won’t be produced for several years.

Raleigh has made a big contribution to our cooperative and to our area.  I’m glad he’s planning to stay in Rufus and look forward to learning much more from him in the future.

MCP’s average price pool

Until May 15, 2009, Mid Columbia Producers is allowing farmers to put wheat into this year’s average price pool. When a farmer enters wheat into the pool, he selects an ending date between August 19, 2009 and February 28, 2010. MCP’s pool manager then divides the amount of wheat by the number of weeks between May 20, 2009 and the ending date selected and sells an equal amount of wheat each Wednesday using the price MCP is then offering for the ending date.

I always use MCP average price pools to market some of my wheat. For the 2008 crop, the average price pool (ending October 15, 2008) returned a Portland WW price of $8.45 per bushel. In 2007, 2006, and 2005, the prices I received for wheat entered in the average price pool were $6.44, $4.25, and $3.72, respectively. Last year, for the first time, MCP also offered a “high-risk” pool that it managed. The return on the managed pool (for an October 15, 2008 ending date) was $8.71 per bushel — 28 cents more than the average price pool.

I believe farmers should seriously consider putting 10-30% of their wheat in the average price pool. The pool is most attractive when prices in the spring are “high” (as they were in 2008). This year, predicting the direction of wheat prices is more difficult, but plausible arguments can be made that WW prices could be lower at harvest and during the early fall. I regret that this year’s average price pool didn’t start earlier. If prices decline at harvest, I’ll wish I had more $5.70 spring sales in the average.

Direct seeding in the dry areas of the PNW

I’ve seen too many floods and and too much erosion during my 35 years of farming. Watching a flood always doubles my desire to take action and we have made progress in reducing erosion by 1) installing many miles of terraces and dams and 2) steadily reducing tillage so more crop residue is left on the soil surface. The next logical step would be to eliminate tillage altogether and go to chemical fallow and direct seeding.

I hope to make this switch in the future. However, switching to chemical fallow and direct seeding now will reduce average wheat yields and cause big yield reductions when dry falls cause emergence of direct seeded wheat to be delayed into late October or November. I examine these difficulties and attempt to estimate the size of the yield reduction in

Why I haven’t switched to direct seeding

Without significant rainfall in August and/or September, chemical fallow does not have enough moisture in the top 6” to germinate fall seeded wheat. The summer sun bakes much of the moisture out of the top foot of untilled ground. Hence, wheat seeded on chemical fallow must wait for fall rains. If rains are delayed until October or November, the yield of fall seeded wheat is reduced.

Tilled summerfallow has one big advantage. Properly done, tillage establishes a “moisture line” about 4-5 inches below the surface. Wheat seeded into this moisture will usually germinate, even after long dry periods.

I examined the most recent 30 years of rainfall records from the Experiment Station at Moro, Oregon. I estimated that in 15 of the 30 years enough rainfall occurred in August and September to germinate wheat seeded on chemical fallow in late September/early October (the optimum seeding date). Hence, in about half of the years, wheat seeded on tilled summerfallow and wheat seeded on chemical fallow would emerge at the same time. In 10 of the years of the 30 years, significant rains did not occur until October and the germination of direct seeded wheat would be delayed a month. In five of the 30 years, significant rains did not start until November and the emergence of direct seeded wheat would be delayed by two months.

Several studies have examined the effect of delayed emergence on wheat yields. I discuss three studies in the above article. The studies indicate a yield reduction of about 18% if emergence is delayed a month and a reduction of 40% if emergence is delayed by two months. Hence, I estimate the average yield reduction from switching to direct seeding to be

( ( 0% x 15) + (18% x 10) + (40% x 5))/30 = 13%

Assuming a 50 bushel yield and a $5 per bushel price, a 13% average yield reduction would reduce gross revenue by $32 per acre.

The fall of 2008 was very dry and significant rains didn’t arrive until November. The 2009 wheat yields should highlight the yield reductions caused by late emergence. I took the picture below on April 2, 2009. The wheat on the left was seeded in mid September 2008 on tilled fallow and the wheat on the right is direct seeded on chemical fallow.

To make direct seeding more profitable in the dry areas of the PNW, new wheat varieties must be developed that produce good yields when the crop emerges late in the fall. Finding these new varieties should be a research priority.

In the article, I don’t discuss the differences in production costs between tilled and chemical summerfallow. Tillage can be reduced to one primary tillage plus a rodweeding or two by using a reduced tillage system such as the “undercutter.” Hence, I don’t expect much cost savings when chemical fallow is compared with reduced tillage systems. However, I would be interested in your comments.

Hedging WW when futures and cash aren’t converging

Several years ago, my grain cooperative, Mid Columbia Producers (MCP), started offering farmers a new marketing tool — a “base-price” contract. This new contract (which is similar to the “hedge-to-arrive” contracts used in the midwest) allows farmers to hedge their cash white wheat (WW) sales using Chicago soft red wheat futures. If a farmer sells wheat using a base-price contract, he first selects a Chicago futures contract for a month after his grain will be available for sale on the cash market. The price he ultimately receives for his wheat is then the Chicago futures price on the day he enters into the contract plus the WW basis on the day he decides the hedge should be lifted minus MCP’s service charge . The WW basis is the cash price of white wheat for the payment month he selects minus the current price of the Chicago futures contract he selected when the hedge was set.

A base-price contract is particularly useful for pricing wheat that will be produced in future years. The Portland grain trade normally has bids available for future months during the current crop year. However, the exporters are usually unwilling to buy wheat for delivery in future crop years and any bids they do offer are heavily discounted (i.e.,the basis offered is much less than the basis expected).

Since the WW basis fluctuates as much as the WW cash price, using a base-price contract does not reduce price risk for WW growers and is not really “hedging” in the traditional sense. It just shifts the risk from cash price fluctuations to fluctuations in the WW basis and provides a way to price wheat in future crop years. The WW basis exploded to almost $6 per bushel the fall of 2007 when the market realized that the extreme Australian drought was going to last for a second year. Two back-to-back years of drought in Australia have never happened before. For at least the 25 years before the fall of 2007, the WW basis showed no trend and fluctuated around an average value of 44 cents per bushel. See my discussion and graph on page 4 of Rules for Marketing White Wheat.

Transportation costs and market competition should normally cause the WW basis to average between 40 and 50 cents. In most years, the competition between WW and soft red wheat for export sales should cause the price of soft red at the Gulf ports to be about the same as the price of WW at the port of Portland. The cost of transporting wheat from Chicago to the Gulf is about 44 cents, so wheat in Chicago should be worth about 44 cents less than wheat at the Gulf (and wheat in Portland). If the Chicago futures prices reflect cash prices in Chicago, the difference between cash WW in Portland and Chicago futures, i.e., the WW basis, should be around 44 cents. Hence, if a grower wanted to sell his 2010 crop now with a base price contract, he could reasonably expect to receive the current price of the September 2010 Chicago futures contract plus 44 cents minus MCP service charge. Of course, the final price will be much less if the basis turns out to be negative when the contract is settled.

The above discussion assumes that the Chicago futures market is operating as it is supposed to and that the futures and cash prices of soft red wheat in Chicago converge — at least when the contract expires. Recently, futures prices have been much higher than cash prices in Chicago. According to the USDA “Chicago grain terminal report,” cash soft red wheat in Chicago on Monday (October 6, 2008) was $2 per bushel less than December Chicago futures. According to the U.S. Wheat Associates website, soft red wheat at the Gulf cost $4.84 per bushel (FOB) on Friday, October 10, 2008. Assuming a 45 cent transportation cost from Chicago to the Gulf, soft red wheat in Chicago should have been selling for around $4.39 per bushel — $1.25 per bushel below the Chicago futures closing price on Friday of $5.635 per bushel.

The “convergence” problem has been going on for several years now and may be related to the big influx of index fund money into the commodity markets. Regulators and the exchanges are discussing changes to the delivery rules for the Chicago futures contract to force greater convergence between futures and cash prices in Chicago. Forcing convergence would not be difficult, but nothing has been done to correct the problem yet.

How does all this affect a farmer who wants to price his 2010 crop now? I believe it reduces the basis he should plan on receiving when a base-price contract is settled. Assume that Chicago futures prices stay $1.25 per bushel above cash wheat prices in Chicago. I would expect the basis at settlement to then average a negative 81 cents ($.44 – $1.25). Using actual prices for yesterday (October 14, 2008) when the December 2010 Chicago futures contract closed at $7.0275 per bushel, his expected return would be

Chicago December 2010 futures                $7.0275
plus
Expected basis                                                 – .81
minus
MCP service fee                                               – .90

Expected return                          5.3175 per bushel

If the effort of force convergence is successful, the expected return would increase to $6.57 per bushel. Since changes in the rules seem likely, $5.3175 is probably a lower boundary on the the expected return. However, the recent lack of convergence adds additional uncertainty for those using base-price contracts.

Evaluating marketing advice

Advice on when to sell the crop is available from many sources: e.g., magazines, marketing clubs, newsletters, and the trading department of the local grain company. Which of these information sources should I use and how should I set up my marketing plan? I’ve discussed these questions previously in

President’s Half Acre – Marketing Plans

and

Rules for Marketing White Wheat

I have a few additional comments to add — especially about using cost of production in deciding when to sell.

Thousands of farmers and traders are trying to profit every day from buying and selling futures and cash wheat. Some of these traders have substantial resources and can quickly spot patterns in the market or important new information. New information is reflected in market prices very quickly, making wheat markets highly “efficient.” For “efficient” markets, future price movements are pretty much random. Consequently, exceptional returns produced by a particular strategy in a particular month or even an entire marketing year are due mainly to luck. Most strategies will produce similar results when the returns are averaged over a ten-year period. For example, if I tell you to sell all your wheat on September 5th every year (you could pick any other day in the year), the average results over a ten-year period will differ by less than 10% from the average returns of any other strategy. The big exception is a strategy that causes farmers to hold wheat too long — so the net return is significantly reduced by storage costs and foregone interest.

The “efficiency” of the wheat market is what makes deciding on a marketing strategy so difficult. Since no one knows how a strategy will work in the future, the only way to evaluate strategies is to check their average returns in the past and, as I argued above, past returns (neglecting storage costs) will usually be similar. The people selling marketing advice or writing magazine articles don’t want to be proven wrong. Hence, they usually don’t provide a strategy that covers all the possibilities. If the strategy isn’t fully specified to cover all situations, its average ten-year returns can’t be calculated. The reason I like the marketing framework developed by Professor Larry Lev is that his rules cover all situations and hence can be tested. He calculates that the average return using his rules is approximately 5% more than selling the crop at harvest. Increasing your returns by 5% over selling at harvest is about as good as you can do over the long-run.

The manager of our grain cooperative, Raleigh Curtis, is a very knowledgeable trader. Raleigh advises farmers to use their cost of production in deciding when to market their crop. First, farmers should decide on the net return they want, expressed as a percentage of their cost of production. Next, they should calculate the wheat price that is needed to give them their desired return. Raleigh has developed spreadsheets that make calculating this target price easy. Finally, farmers should sell their crop when the market price exceeds their target. He also advises checking the market prices being offered for future crop years and pre-selling part of the crop if the available market prices will produce the desired net return for future crops.

I have never understood why cost of production is relevant in marketing wheat that has already been produced. A farmer’s cost of production is very important in deciding what lease terms to accept, what crops to produce, or whether to continue as a wheat farmer. However, once the crop is harvested, production costs are sunk costs and I don’t see how they are relevant in marketing. A farmer wants to use the strategy that will produce the highest average return.

Although I don’t understand its rationale, I believe Raleigh’s approach would produce acceptable long-run results if he will just fix one important deficiency. As I’ve argued above, all strategies will produce similar long-run returns as long as they don’t cause farmers to hold wheat too long and rack up unnecessary storage and foregone interest costs. A farmer following Raleigh’s approach this year probably has already priced most of his crop, so excess holding costs are no problem. However, what should a farmer do during a year when the market never offers him a price that will produce the net return he wants? Raleigh needs to provide additional guidance on this issue.

I happened to have all the data necessary to test Raleigh’s approach for the nine crop years from July 15, 1993 to July 14, 2002. For each year, I calculated the minimum wheat prices necessary to produce 20%, 30%, and 40% returns and then used these target prices to determine when a farmer using Raleigh’s approach would have sold his wheat. For the 1993-4 through the 1996-7 marketing years, the triggers were achieved before the end of November for all three levels of net returns. During the 1997-8 marketing year, farmers seeking a 20% return would have sold early, but wheat prices never were high enough to achieve a 30% or 40% return. For the 1998 through 2001 marketing years, wheat prices were never high enough to achieve any of the three net return levels.

Raleigh has not specified what a farmer should do if prices remain below his trigger price during the entire marketing year. To be able to test his strategies, I assumed that a farmer sold at the end of the marketing year if wheat prices never reached the target. This meant that farmers were holding wheat unsold for long periods during the latter part of the test period, significantly reducing average returns. The average returns for the 20%, 30%, and 40% strategies were 77%, 39%, and 52%, respectively, of the returns achieved by selling every year near September 15th. If farmers using Raleigh’s approach gave up and sold their wheat at the end of November during years when prices stayed below their trigger price, the average returns were much higher — close to or higher than selling on September 15th.

Raleigh needs to provide some additional guidance to farmers using his approach to prevent them from waiting too long and having their net returns significantly reduced by storage and foregone interest costs.