Agribusiness Marketing

Agricultural Commodity MarketingMarketing Issues Related To Time

Daisy Odunze

Introduction

The term ‘commodity’ is commonly used in reference to basic agricultural products that are either in their original form or have undergone only primary processing.

A related characteristic is that the production methods, postharvest treatments and/or primary processing to which they have been subjected, have not imparted any distinguishing characteristics or attributes.

Introduction

Commodities coming from different suppliers, and even different countries or continents, are ready substitutes for one another.

Agricultural commodities are generic, undifferentiated products that, since they have no other distinguishing and marketable characteristics, compete with one another on the basis of price.

Introduction

Stages Activity Example

Stage 1 Assembly Commodity buyers specialising in specific agricultural

products, such commodities as grain, cattle, beef, oil palm,

poultry and eggs, milk.

Stage 2 Transportation Independent truckers, trucking companies, railroads, airlines

etc.

Stage 3 Storage Grain elevators, public refrigerated warehouse, controlled-

atmosphere warehouses, heated warehouses, freezer

warehouses

Stage 4 Grading and classification Commodity merchants or government grading officials

Stage 5 Processing Food and fibre processing plants such as flour mills, oil

mills, rice mills, cotton mills, wool mills, and fruit and

vegetable canning or freezing plants

Stage 6 Packaging Makers of tin cans, cardboard boxes, film bags, and bottles

for food packaging or fibre products for

Stage 7 Distribution and retailing Independent wholesalers marketing products for various

processing plants to retailers (chain retail stores sometimes

have their own separate warehouse distribution centres)

Demand as a composite

Purchases essentially reflect: demand for immediate consumption and inclination of consumers to restock their shelves or fill

their freezers when prices are particularly attractive or reduce inventories when prices are high.

Consumers, consider prices as “attractive” or “high” based upon anticipated prices.

Purchases, then, reflect a demand for immediate consumption and a demand for storage and speculation.

Demand as a composite

On highly perishable items, demand by consumers may predominate, but on storable products and items such as inputs into livestock feeding, other forces may be very influential.

Demand to fill storages and provide dependable flows of feed to livestock facilities may prominently influence price.

Food processors have similar demand for dependable supplies.

Demand as a composite On such commodities demand for both storage and

speculation may even override the ultimate demand for consumption in explaining wide swings in farm, wholesale, and retail prices.

Demands for storage and speculation strongly reflect expectations

Expectations are determined by anticipated utilization and product availability, and future changes in other market factors such as agricultural policies. Changing estimates of next year’s crop may strongly influence current prices, even though current crop year availabilities and utilization levels remain constant.

Demand as a composite Demands for immediate consumption, and storage

and speculation could apply to a domestic market isolated from the rest of the world.

Nations participate in an international market and face an export demand.

At high prices, the amount demanded of the domestic product drops sharply at the level of price that attracts imports (negative exports). At low levels of price, the domestic product may become competitive in foreign markets.

Demand as a composite Therefore, the demand for such a product may be

decomposed into demand for: Domestic consumption (by the ultimate consumer). Storage (at various levels in the marketing chain). Speculation (at various levels in the marketing chain) Exports.

Demand for storage and speculation is more difficult to identify than demand for consumption and it is a function of expected gross margins. The higher the expected gross margin, the more product will be demanded by storers.

Demand as a composite

If the total amount available is fixed or perfectly inelastic, the storers bid the product away from consumers or exporters, which, in turn, tends to drive up the current price and reduce the expected gross margin.

In a competitive market, the new equilibrium price will depend on how increased amounts in storage affect the cost of storage per unit of product.

Demand as a composite If the carryover of the end of the crop year is

anticipated to be unusually low, demands for storage and speculation may accelerate as the situation develops. Market prices increase sharply to ration out limited supplies and protect a “pipeline carryover”.

A pipeline carryover can be defined as the amount needed to assure processors, exporters, livestock producers, consumers, etc, that their day to day requirements between crop year will not be interrupted.

Demand as a composite

In the short run, storage availability may affect the demand for storage. If excess storage is available even at the peak of supplies, current prices will be bid up relative to future prices. Tight storage situations depress current vis –a – vis future prices.

Demand as a composite

Forecasting export demand is also challenging in part due to trade policies in both importing and exporting nations and foreign food aid programs of developed nations.

The prices in importing nations, plus their population and purchasing power, would establish the size of the pie.

Futures

Since the early development of agricultural markets, producers have attempted to protect themselves against falling commodity prices at harvest time. Many producers ignored marketing techniques and sold their commodities at harvest regardless of the price.

Today, producers have realised that a marketing strategy is equal in importance to production, capital, and labour strategies. The futures contract as we know it today, evolved as farmers (sellers) and dealers (buyers) began to commit to future exchanges of grain for cash.

Futures What is traded?

A cash commodity must meet three basic conditions to be successfully traded in the futures market:

It has to be standardized and must be in a basic, raw, unprocessed state. Perishable commodities must have an adequate shelf life, because delivery on a futures contract is deferred.

The cash commodity’s price must fluctuate enough to create uncertainty, which means both risk and potential profit.

Futures Futures contract is a contractual agreement,

generally made on the trading floor of a futures exchange, to buy or sell a particular commodity at a pre-determined price in the future.

Future contracts are standardized as to quality, quantity, and time and location of delivery of delivery for the commodity being traded. The only variable is price, which is set through an auction – like process on the trading floor of an organized exchange.

Futures A futures contract is an agreement between two

parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity.

In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy).

Futures Buyers and sellers in the futures markets look at

current economic information (supply and demand) and anticipate how it may affect the price of a commodity.

The standard features are called contract specifications. The futures exchange where the commodity is traded usually provides contract specifications for commodity. Business journals are one of the best sources for commodity market information.

Futures

Friday April 16          

Corn (CBOT) 5,000 bushels, cents per bushels          

  Open High Low Settle Change

May 231¼ 231¾ 227 227¾ -4

July 236½ 237¼ 232¼ 233 -4¼

Sept 241¼ 241¾ 237½ 237¾ -3¾

Dec 246 246¾ 242¾ 243½ -3½

           

A common example of how commodity prices may appear is given below:

Futures Open is the first price anyone paid for corn on

January 5, 1998. High is the highest price anyone paid for corn on

January 5, 1998. Settle or settlement is the last price anyone paid

for corn on January 5, 1998. Change or net change is the difference between

the settlement price on January 5, 1998, and the previous trading day.

Determining the value of a futures contract

Suppose the settlement price for December corn futures is 200 cents a Kg: that is , $2.00 a kg. To calculate the dollar value of one corn contract, multiply the $2.00 settlement price by the contract size.

In the case of CBOT corn futures, each contract equals 5,000 kg of corn, so if 1 bushel of corn is worth $2.00, then a 5,000 kg contract is worth $10,000; $ 2.00 per kg times 5,000 kg equals $ 10,000.

Futures Futures contracts do not always trade in even

numbers: sometimes they move in fractions. These fractions are the smallest price unit at

which a futures contract trades and are called minimum price fluctuations.

In futures lingo it is referred to as ticks. The tick size of a futures contract varies according

to the commodity.

Futures The minimum price fluctuation for a CBOT corn

futures contract, for instance, is ¼ cent per bushel, or $12.50 per contract (5,000 X $.0025).

Keeping in mind that the minimum price fluctuation for CBOT corn futures is 1/4 cents per bushel, the next few higher prices above corn trading at 200 cents per bushel ($2.00/bu) would be 200¼ cents, 200 ½ cents, 200 ¾, and 201 cents.

Futures When fractions are involved, just use the same

equation of settlement price times contract size. For example, if December corn futures are trading at 200 ¼ cents /bu. Then the contract value is

$2.0025/bushel X 5,000 bushels = $ 10,012.50.

Futures

Determining profit or loss on a futures contract Suppose you read in the paper that soil moisture

in the midlands was below normal for the month of June and the forecast does not look promising for rain. Limited rainfall during the growing season could cause the production of corn to decrease, thus increasing the price. Anticipating higher corn prices, you buy one December corn futures contract at 250 cents/bushels. On July 1, if you were right and corn prices rise, you will make a profit.

Futures Determining profit or loss on a futures contract Throughout the month of July, there is no rain in

the Corn Belt. The end result is higher prices, so you decide to offset your position on July 30 by selling one December futures contract at $2.55/bushel.

Did you make a profit or loss? :

Futures Calculation: Jul 1 BUY 1 Dec. Corn futures

at $2.50/bushel Jul 30 SELL 1 Dec. Corn futures

at $ 2.55/bushel Profit

$ .05/ bushel The total profit is $250 ($.05 X 5000 bushel). ** remember that brokerage fees are always

subtracted from your profit.

Futures Who participates? There are two main categories of futures traders

that utilize futures contracts. These are the hedgers and speculators. Hedgers either now own, or will at some time own, the commodity they are trading. Hedger may be producers, elevator owners, or any others in the agribusiness input and outputs sectors.

Futures Speculators are the second major group of futures

players. These participants include independent floor traders and investors. Independent floor traders, also called “locals”, trade for their own accounts. Floor traders handle trades for their personal clients or brokerage firms.

Futures Hedging involves taking a position in the futures

market equal but opposite to what one has in the cash market. If prices fall, a producer who placed a hedge will be protected. This is why hedgers willingly give up the opportunity to benefit from favourable price changes to achieve protection from unfavourable changes.

Futures Long (buying) and short (selling) hedgers Two terms used to describe buying and selling are

long and short. If you first buy a futures contract, this is called going long, or going long hedge. If you first sell a futures contract, this is called going short, or going short hedge. Hedging in the futures market is a two step process. Depending on your cash market situation, you will either buy or sell futures as your first position.

Futures if you are going to buy a commodity in the cash

market at a later time, your fist step is to buy a futures contract. In contrast, if you are going to sell a cash commodity at a later time, your first step in the hedging process is to sell futures contracts.

The second stage in the process occurs when the cash market transaction takes place. At this time, the futures position is no longer needed for price protection, so it should therefore be offset (closed out).

Futures If your hedge was initially long, you would offset

your position by selling the contract back. If your hedge was initially short, you would buy back the futures contract. Both the opening and closing positions must be for the same commodity, number of contracts, and delivery month.

Cash market Futures market

June

Plans to buy 240,000 ibs. Soybean

oil in the cash market at $.26 / ib.

June

Buys 4 CBOT Sept. soybean oil

futures contracts at $.26/ib.

August

Purchases 240,000 ibs. Soybean oil

in the cash market at $.31/ib.

August

Sells 4 CBOT Sept. soybean oil

futures contracts at $ .31/ib.

Purchase price of cash soybean oil $.31/ibLess futures gain ($.31 - $.26) $.05/ibNet purchase price $.26/ibBy using CBOT soybean oil futures, the food processor lowered its purchase price from 31 cents to 26 cents a pound. That was exactly what the company expected to pay.

Cash market Futures market

May

Plans to sell 5,000 bu. Corn in the

cash market at $2.60/bu.

May

Sells one CBOT Dec. Corn futures

contract at $ 2.60/bu.

October

Sells 5,000bu. Corn in the market at $

1.90/bu.

October

Buys one CBOT Dec. Corn futures

contract at $ 1.90/bu.

Sales price of cash corn $ 1.90/bu.Plus futures gain ($2.60-$1.90) $ 0.70/bu.Net sales price $ 2.60/bu.By using CBOT corn futures, the producer increased her final sale price from $1.90 to $ 2.60 a bushel. That was exactly what she wanted to receive.

Futures Speculators, in contrast, will likely never own or

even see the physical commodity. They are in the game to profit from a move up or down in the market. They have no natural long or short position as in the case of the hedger.

Agricultural producers, commodity processors, exporters, food manufacturers, and others use the futures market to shift market risk (the risk of adverse price movements) to someone else.

Futures The party who assumes the risk is the speculator. They just buy and sell futures contracts and hope

to make a profit on their expectations and predictions of future price movements.

The profit potential of a speculator is proportional to the amount of risk that is assumed and the speculator’s skill in forecasting price movement.

Futures The profit potential of a speculator is proportional

to the amount of risk that is assumed and the speculator’s skill in forecasting price movement.

Speculators always offset their positions by buying (selling) futures contacts they originally sold (bought).

Speculators take a price risk on a given product with the hope of making a profit.

Futures The risk a speculator takes is not the same as that

a gambler takes in buying a lottery ticket. In contrast to gambling, a commodity speculator assumes a naturally occurring risk rather than one that is deliberately created

Economic functions of futures markets

Futures exchanges, no matter how they are organized and run, exist because they provide two vital economic functions for the marketplace Enabling hedgers to transfer price risk to speculators: Facilitate price discovery Enhancing information collection and dissemination Assisting in the coordination of economic activity Stabilizing markets and providing liquidity Providing flexibility in forward pricing

Options on futures

In contrast to futures, options on futures allow investors and risk managers to define risk and limit it to the cost of a premium paid for the right to buy and sell a futures contract. Options provide the “opportunity” but not the “obligation” to sell or buy a commodity at a certain price.

Options on futures

When talking about options, the underlying commodity is a futures contract and not the physical commodity. With an option, producers have the right, but not the obligation to buy or sell a specific commodity within a specific period of time at a specific price.

Futures options are much more attractive to many hedgers and speculators than straight futures contracts.

Options on futures

Example of a simplified options contract: consider a call option that conveys the right to buy a used combine from your neighbour. You are debating whether to buy a used combine or to put up capital for a new combine. You convince your neighbour to sell you an option to purchase the combine at any time before April 1. In turn, the neighbour gives you the right to buy the used combine for $ 10,000. For this right, you pay $2,000.

Options on futures

$10,000 is the strike price April 1 is the expiration date, and the $2,000 you paid for the option is the premium. You may choose to not exercise your option-you

can simply let your option expire. You may offset your current position by selling your option to someone else. Whatever measure you take, the writer (seller) of the option keeps the $2,000 premium. With options, once you make a transaction, you can predict your maximum losses.

Options on futures

A call is an option that gives the option buyer the right (without obligation) to purchase a futures contract at a certain price on or before the expiration date of the option, for a price called the premium which is determined in open-outcry trading in pits on the trading floor.

Options on futures

A put is an option that gives the option buyer the right (without obligation) to sell a futures contract at a certain price on or before the expiration date of the option.

The premium is the cost of futures options. It is the only variable in the options contract traded on the trading floor.

Options on futures

Factors affecting premiums Intrinsic value: the intrinsic value of an option is

the positive difference between the strike price and the underlying futures price.

For a put, the intrinsic value is the amount that the strike price exceeds the futures price.

For a call, the intrinsic value is the amount that the strike price is below the futures price.

Options on futures

For example, when the July corn futures price is $2.50, a July corn put with a strike price of $2.70 has an intrinsic value of 20 cents a bushel.

If the futures price increases to $2.60, the option’s intrinsic value declines to 10 cents a bushel.

If the strike for a put is below the futures, the intrinsic value is zero, not negative.

Options on futures

For example, when the December corn futures price is $2.50, a December corn call with a strike price of $2.20 has an intrinsic value of 30 cents a bushel.

If the futures price increases to $2.60, the options intrinsic value increases to 40 cents a bushel.

If the futures price declines to $2.40, the intrinsic value declines to 20 cents a bushel 

Options on futures

Time value: time value originates from the fact that the longer the time until expiration, the more the opportunity for buyers and sellers to profit.

Time value-sometimes called extrinsic value- reflects the amount of money that buyers are willing to pay hoping that an option will be worth exercising at or before expiration.

Options on futures

For example, if July corn futures are at $2.16 and a July corn call with a strike price of $2 is selling for 18 cents, then the intrinsic value equals 16 cents (the difference between the strike price and futures price) and the time value equals 2 cents (difference between the total premium and the intrinsic value).

Options on futures

The time value of an option declines as the expiration date of the option approach. The option will have no time value at expiration, and any remaining premium will consist entirely of intrinsic value. Major factors affecting time value include the following: Time remaining until expiration Market volatility Interest rate

Options on futures

Ways to exit a futures option position Once an option has been traded, there are three

ways you can get out of a position: exercise the option, offset the option, or let the option expire. Exercise Offsetting Expiration

Reference John. N. Ferris (2005) Agricultural Prices

and Commodity Market Analysis 2nd edition: Michigan state university press.

James Vercammen (2011) Agricultural Marketing; Structural Models for Price Analysis 1st edition, Routledge publishers.