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.