Last fall, Jay Hardwick, a cotton producer in northeast Louisiana, was faced with a dilemma. While he was busy harvesting his 2003 crop, I (his marketing consultant) recommended that he price at least 50 percent of next season's expected production. December 04 cotton futures were trading at 69.50 at the time.
Hardwick had two problems with that recommendation: (1) Given an average yield, selling cotton into a 70.00 futures price typically does not produce much profit once all of the charges are taken out. “Why would you want to lock in what amounts to little more than a break-even price, seven months before the crop is even planted?” (2) The 2003 cotton market at the time was trading above 80.00 and expected to go higher. There was excitement in the cotton market, and the 2004 crop seemed a long way off. His instincts told him to do what most other producers were doing at the time, wait and see what happens.
Yet I was telling him to pull the trigger.
As it turned out, Hardwick took my advice and priced 2005 crop cotton. He also followed the second recommended step later — he backed up his sale with the purchase of December 75.00 calls, spending 2 cents in premium.
Shortly after he sold the market and bought the calls, Hardwick had reason to doubt his decision as he watched prices trade higher. His doubts did not linger very long as cotton futures then proceeded to fall almost 30 cents over the course of the next 10 months.
So how did it all turn out? With prices trading below loan, Hardwick approached harvest with the expectation that he would receive a substantial LDP payment, the proceeds of which he would add to his booking price. As for his calls, he expected them to expire worthless, but considering where his net price would likely end up, he did not mind.
Those with a long memory may remember the 1999 marketing season which was the last time a cotton producer had the chance to lock in a 70.00 futures price prior to harvest. That opportunity came in the spring of 1998. By the time the 1999 harvest rolled around, December futures were trading in the high 40s and producers were collecting a 10-cent to 13-cent LDP.
Those who priced cotton at 70.00 that season ended up with the equivalent of an 80 to 83 futures price before basis and charges. Producers who did not price early that season had to settle for significantly less.
The 2004 marketing season and the 1999 marketing season provide cotton producers important marketing lessons — protecting a breakeven price point early in the game is often a good idea. Here is why.
The current LDP program encourages a producer to book before harvest. Why? Because of the way LDP is calculated. If prices are trading near loan at harvest, a producer can expect to receive an LDP payment.
It has to do with the relationship of the world price vs. the loan rate. The lower world price trades, the larger the payment. To collect the LDP the producer agrees not to use the loan and, instead, sells the crop in the cash market.
For a producer, the LDP acts as a free put option. The lower the market, the more valuable it becomes. The idea is to help offset the cheap cash price. The real benefit of a large LDP goes to the producer who has previously negotiated a booking price at a higher level. As long as beneficial interest is maintained, a producer is able to collect the LDP and then apply the production to the booking contract.
Locking in a relatively low price is fine as long as prices trade lower and there is an LDP at harvest. But what happens if prices go the other way? That is where the calls come in.
In the 2004 example, Hardwick bought December 75.00 calls to support his cash sale. Had prices gone up, his calls would have appreciated in value, moving his net proceeds higher.
Even though he priced crop at a break-even price point very early in the marketing season, Hardwick knew he had a chance of adding to his booking price with either an LDP should prices trade lower or call premium should prices trade higher. Dealing with a market as volatile as cotton, odds were good he would do one or the other. It is a strategy he and I will keep in mind in seasons to come.
Steven H. Scott is an agricultural marketing consultant with Scott & Associates in Little Rock, Ark., 800-206-2474, e-mail: [email protected].