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Essential preparations for more feed price volatility

Scott Stewart Published on 09 October 2012

How high could the corn price possibly go? $9? $12? $24? By when? These are the questions on the minds of many agricultural producers. Whether you produce corn or feed it, you want to know if the high is in or if it is yet to come.

Many advisers will provide price predictions based on an outlook they have created and, almost always (either for regulatory compliance reasons or because they know they are not soothsayers), they add words like “could possibly” or “more than likely” or “potentially” in front of their price predictions. I might have even been guilty of trying to predict prices a time or two over my 30-year career.

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Understandably, those whose livelihood depends on buying or selling commodities may get frustrated when price predictions are couched this way. You want more certainty from an adviser. Well, here is the certainty: Volatility will continue and it can be managed by preparing for the “likely,” “potential” and “possible” events.

$12 corn

In 2006, I wrote the $12 Corn Special Report. I wrote the report with that provocative title in order to get people’s attention – everyone wants an adviser to pinpoint a price.

Nevertheless, the report’s overall message was not “prepare for $12 corn.” It was “prepare for the volatility that could bring us $12 corn.” Sometimes that message gets lost in the desire to pinpoint a price level.

When the report was released, corn prices hovered around $2.50 to $3. In the preceding decades, the word “volatile” only referred to the weather. But the winds of change were blowing. The effects of freedom to farm, stepped-up world demand, ethanol production and a just-in-time delivery mindset lowered year-to-year carryover stocks and began shaking up what had been relatively stable markets.

In June of 2008, corn rallied 37.5 percent past its previous high and went to $7.625, with some deferred contracts eclipsing the $8 mark. It stopped climbing there; however, it also swung all the way back down to $2.90 in a period of six months.

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Corn may not have hit the $12 mark (yet, as of this writing); however, volatility is more prevalent than it has ever been and those who have not prepared will struggle as it continues. The USDA has predicted an average corn price for 2012 between $7.50 and $8.90.

When that prediction was made, the extent of the crop devastation was not well known. There are developing concerns of other weather disturbances in other parts of the globe and, with tight supplies, it won’t take much for wild market behavior to begin.

Essential preparation

The purpose of my writing is not to predict price. I do not believe anyone should stake their business decisions on someone’s prediction of what might happen with prices.

Over my career, my goal has evolved to opening people’s minds to all the possibilities and helping them prepare for volatility. My recommended approach, which I call market scenario planning, includes these essential steps:

  1. Survey the data and expert opinions.
  2. Develop scenarios of what could possibly happen to the price ... include all the possibilities. For this exercise, don’t get caught thinking, “That could never happen!”
  3. Imagine how your operation will fare in each scenario, thus determining your greatest risks and opportunities.
  4. Create strategies that manage risk and maximize opportunity in each scenario (Plan A, B, C, D and so on).
  5. Implement the best strategies and continue to develop new strategies as scenarios unfold and new market conditions evolve. (In other words, continuously repeat steps 1 through 5.)

The key here is avoiding the temptation to follow one single “marketing plan” based on someone’s price predictions or bias. In this new world of price volatility, an adviser’s role should be to paint possible price scenarios, not predict price levels. It’s so important to look at all the possibilities.

Open your mind. Otherwise, you will be scrambling to adjust when a price level you hadn’t envisioned comes along. (See the sidebar below for an example of strategic vs. outlook-based pricing for feed.)

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It’s important that you become familiar with strategies and tools before decisions are needed. So if you haven’t already taken steps to learn, or found expertise somewhere, now is the time.

More extremes ahead

I still believe that more of the extreme price scenarios described in my $12 Corn Special Report are coming our way. When we look at the conditions that have led to the volatility we have today, we see that they haven’t changed. If anything, the risks have become more pronounced:

  • Weather data: Climatologists have observed that serious Corn Belt drought has an apparent 19-year cycle (also called the Benner Cycle). Two hundred years of weather data and 800 years of tree ring analysis indicate an average of 19 years between major droughts. Probability of this drought was high if you put stock in data patterns.
  • Yield patterns: Additional analysis indicates that there is a pattern to consistent vs. variable yields attributable to growing conditions. According to Iowa State Climatologist Dr. Elwynn Taylor, we are coming to the end of an 18-year stable period of production, which typically is followed by 25 years of high variability.
  • Just-in-time mentality: The world has come to rely on supplies of crops and commodities being readily available. No one wants inventory in advance of need. The most recent economic collapse has accelerated this thinking. Almost no one has stockpiles of agricultural commodities.

Even more of a concern for dairy producers is the magnitude of the volatility ahead. The magnitude of a 100 percent increase in the corn price from $4 to $8 is so different from a 100 percent increase 20 years ago. And one likely scenario is that there is a whole new leg up on corn prices coming.

History has shown us that when commodities go to all-time highs, they typically will go to 130 to 140 percent of their previous levels, and, in some instances, beyond. (Look at what happened to Minneapolis wheat a few years ago when it went to $24.) And when they crash, they can crash quickly.

As a result of all this, the cost of protecting prices has jumped. Options that used to cost pennies to buy are now many times that, increasing the importance of good decision-making. When markets move fast, you can lose money so quickly if you do not know what you are doing.

In this kind of high-price, high-risk environment, advanced option strategies or combinations of both futures and options will be necessary to keep marketing costs low while protecting a price range.

Whenever I paint this picture of an extremely volatile new world, reactions usually fall into two camps:

  • There are those who believe the world “is what it is” and occasional random events come along to mess things up. They feel little, if any, control over their destiny.
  • There are those who believe that catastrophic events will happen with some regularity and you can anticipate them and position yourself to weather them vs. accept a devastating equity drain.

If you haven’t guessed, I am in the second camp. I believe that the complacent will be overwhelmed and swallowed up.

I also know from experience that volatile prices will bring out many analysts with opinions and reasons why their opinions are right. The wise marketer will listen to expert opinions and then use them to paint possibilities of what could happen. Imagine how your operation will fare in each scenario. Then you can begin to create the strategies that will have you fully prepared and confident in the age of uncertainty. PD

Read Scott Stewart’s original $12 Corn Special Report by Clicking here . (Under the “Resources” section.)

Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results.

The 2012 crop production year provides a perfect illustration of strategic market scenario planning in the face of uncertainty.

Scott Stewart
  • Scott Stewart

  • CEO/President
  • Stewart-Peterson Inc.
  • Email Scott Stewart

Early in 2012, no one knew how high or how low feed prices would go for the year. All the fundamentals for corn, including the USDA’s Planting Intentions Report and early weather reports, pointed to a big crop and affordable feed for 2012.

Tight ending stocks meant that good weather and good crops were needed to keep prices low. Weather outlook was mixed but tended toward the positive outlook. Many experts were predicting an end to La Niña as she faded to neutral conditions – and that sent everyone’s hopes soaring for a good crop year.

At the same time, the long-range studies by weather gurus like Dr. Elwynn Taylor of Iowa State University suggested that we have been due for a drought. While La Niña was neutralizing, Taylor also had his eye on an area of low pressure in the Gulf of Alaska that, like 1988, could possibly persist and send weather disturbances (rain) north instead of toward the U.S.

We, as marketers, looked objectively at all the possible scenarios and assumed that any one of them could happen. We created strategies for each scenario and we showed our clients the math. Together we looked for the sweet spots of protection – those that offered the best protection for the most reasonable cost, for the most logical scenarios, with exit strategies in case one of the unexpected scenarios happened.

Our strategizing back in February had clients buying call options for July and August feed corn, and in April we recommended calls for September through December corn feed needs. Some questioned why. “All the fundamentals point to a big crop,” they reasoned. “My gut tells me save the money on calls …” That was true if you were basing your decisions on outlook alone. It is our philosophy, however, to look at all potential scenarios and have backup plans in place.

The way we saw it, the potential swings for feed were so great that there was too much risk to not have price protections in place. When we analyzed the average percentage rallies and declines of the last six crop years, we could see that $8-per-bushel corn or more and $3.50-per-bushel corn could not be ruled out (as well as $400-per-ton soybean meal or $260-per-ton soybean meal). For dairy producers buying all their corn and protein needs, the difference in the two feed bill scenarios was huge.

The clients who followed our recommendations for fourth-quarter corn are now in a position to have a weighted-average price for corn of under $6, even if prices soar all the way up to $12. And, if the rain fell and prices fell along with it, there was also a strategy in place to exit those calls. We were in this position because, before the heat was on, we had analyzed the numbers, prepared for various price scenarios and chose the price scenario that best fit the risk tolerance of each client.

My point here is not to say that any particular recommendation was the right one. It is to illustrate the strategic process. Yes, analyzing all these price scenarios and developing strategies for every potential price direction takes work. But in the face of uncertainty, there is no substitute for preparation.

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