The 2003 cotton counter-cyclical payment is expected to be a little over 3 cents. That estimate comes from the University of Illinois (www.farmdoc.uiuc.edu). If it turns out to be correct, it will be a far cry from the 13.73 cents those with a cotton base received for the 2002 payment. It is also substantially less than they could have received, had they taken some precautions last spring.
Is it possible for a farmer to protect counter-cyclical payments and if so, what is the best way to get it done? Those questions were hotly debated last winter as we moved into the second year of a brand new farm bill. With the benefit of hindsight and with the 2004 counter-cyclical marketing season still in front of us, this would be a good time to take another look at the issues.
Some leaders in the cotton industry were of the opinion last spring that the only thing a land owner/producer needed to do to protect his 2003 counter-cyclical payment was to plant 85 percent of his base and make sure that the price he received for his cotton was at least as high as the APR (average price received) number the government will use to determine the payment.
They reasoned correctly that if the producer was able to match the APR (which by no means is a given) he would then be assured of receiving at least the target price of 72.40. They then went on to say that any additional marketing positions, such as the purchase of call options, would be unnecessary and would, in fact, be labeled a speculation.
A few of us in the marketing advisory business took a different view. We agreed that planting the program acres and marketing cotton at a price that at least matched the national APR number would return no less than the target price.
We did not agree that purchasing call options last season was an unnecessary speculative position. Instead we saw it as a prudent risk management strategy. So who turned out to be right?
Obviously, since cotton prices went up at harvest, the purchase of calls last winter and spring looks like a good idea. Those clients who followed our advice and bought calls are certainly glad they did.
But what if prices had gone down and the calls our clients bought turned out to be worthless? Would we still be of the same opinion? As a marketing consultant concerned with helping my clients manage risk, my answer is yes.
We see it as an insurance question. The counter-cyclical payment represents a valuable asset when commodity prices are low as they were last spring. Yet as we saw, the value of that asset is subject to substantial risk should prices trade higher.
Call options appreciate in value in a rising market, the very price scenario that takes away counter-cyclical money. That makes them the logical tool to provide protection.
What if prices had gone down last harvest instead of up? In our case, had the market fallen below the strike price of our calls during the heart of the counter-cyclical payment marketing season (September to February), the calls our clients bought would likely have expired with no value. Those same low prices however, would have resulted in a low APR number, which in turn would have enabled our clients to receive the major portion of the potential 13.73 in counter-cyclical money less the cost of the protection. They would have, in effect, bought “fire insurance” on a building that did not burn down.
Do call options provide perfect protection? No, because the actual sales numbers and percentages used to calculate the final government APR are not be known until the end of the marketing period. The timing of the purchase and sale of the calls does require some finesse.
Do call options provide enough protection to be of benefit? We think in certain situations they do and our experience last season bears that out.
Here is a brief rundown of the cotton counter-cyclical payment strategy we presented to our clients last winter:
Our basic plan was to establish some cost parameters and then if the opportunity presented itself, protect 40 percent of program production (85 percent of base X program yield) with December calls and then the other 60 percent with March calls. We would then cash in the calls throughout the counter-cyclical payment marketing season (August through July) on a schedule based on historical sales data.
We also suggested that in the event we were able to cash in the calls and recover the equivalent of the entire 13.73, we would do so. This strategy was presented to our clients last winter.
Here is how the recommended call strategy played out:
Dec. 12, 2002: Bought December 60.00 calls at 2.00 covering 40 percent.
June 2, 2003: Bought March 60.00 calls at 2.50 covering 60 percent.
Sept. 5, 2003: Sold one-half of the December calls at 2.00.
Oct. 16, 2003: Sold the balance of the December calls at 14.10.
Oct. 30, 2003: Sold the March calls at 22.40.
Net result: 14.36 cents per pound credit.
Estimated counter-cyclical payment: 3.24 cents per pound
In the interest of full disclosure, I must report that our clients found it very difficult to stay with our plan once cotton prices started going up. The increased value of the calls became too tempting and most of our clients cashed out of their positions earlier than suggested.
Even though they did leave money on the table, our clients were able to net an additional 6 to 8 cents a pound over and above the expected counter-cyclical payment of 3.24. Considering the fact they also had the opportunity to price the crop itself at very profitable price levels, 2003 turned out to be a tremendous marketing season.
Will we have the opportunity to protect the 2004 counter-cyclical payment? That remains to be seen. As with any insurance question, you must be able to justify the cost of the protection when compared to the level of coverage. At this point, the cost appears to be too high, although that could certainly change before the counter-cyclical payment marketing season rolls around.
Should we go with the same call strategy we used in 2003? Not necessarily. We are working with higher market prices this year, which means we likely will have to look at more complicated strategies.
In our opinion, protecting a valuable asset when you get the chance is always a good idea. We think that applies to your counter-cyclical payment whether you plant your base or not.
Steven H. Scott is an agricultural marketing consultant with Scott & Associates in Little Rock, Ark. e-mail: [email protected].