Grain hedging: lessons from the farmers who get it right

Since South African agriculture converted from control boards to the free market system in the 1990s, farmers have had to learn how to contend with extreme volatility on commodity markets. According to Silotrat’s Werner Rossouw, hedging is a valuable tool that maize farmers can use to reduce the risk of fluctuating prices. However, in order to benefit from the system, they must learn the rules of the game.

Grain hedging: lessons from the farmers who get it right
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Price trends for maize since the adoption of the free market system in South Africa clearly show that in those years when the country’s maize production exceeded domestic demand, prices decreased, and in years when production fell short of demand, prices tended to increase.

This volatility from one season to the next, and even within a season, poses a risk to the long-term profitability of a maize farmer.

Fortunately, this risk can be reduced through grain hedging. The following are key lessons learnt from our observations of farmers who have been particularly effective at hedging their grain over a sustained period.

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Hedging vs speculating
Hedging and speculating are two completely different things. Farmers who wish to put a derivative strategy in place must evaluate carefully whether this strategy will reduce risk or increase it.

There are too many cases where a farmer has unsold surplus maize left over from the previous season, as well as a harvest waiting on the land, yet still decides to buy futures.

The primary function of a futures contract on the stock exchange is that it should decrease your risk as a farmer.

Scott Irwin, Darrel Good and Joao Martines-Filho, three researchers at the University of Illinois in the US, looked at how effective farmers in that country were at minimising risk in terms of price movements.

They found that two-thirds of farmers sold their maize in the bottom third of the price band, and two-thirds of buyers bought their maize in the top third of the price band.

Unfortunately, no research has yet been done in South Africa for comparison, but I suspect we would see similar results. The lesson we can learn from this is that although it is unrealistic to expect to always earn the highest price on the market, a farmer should aim to earn a good average price.

The researchers also found that a major obstacle to effective hedging for farmers and buyers was that their emotions got in the way of making sound decisions. Speculation about the weather, for example, can result in an emotional reaction that can affect decision-making and, ultimately, prices earned and paid.

As a farmer, you should also be careful about how you use and interpret information on social media.

Social media can be a wonderful tool if used and interpreted appropriately, but you should avoid joining a group or a discussion forum where emotions become inflamed by wild speculation.

Cost of production
Many farmers still do not know what it costs them to plant their crop. How can you effectively hedge your grain if you do not know the value of what you need to protect?

Before the season begins, conduct a cost estimate of what it will cost to get that crop in the ground and through to harvest. Once this information is available, you can decide on a trigger level to protect your profits.

To determine this, calculate a price level at which you are comfortable selling your crop, after incorporating total costs and expected harvest on the land.

The trigger level is essentially the price at which it will be possible to earn a profit. As soon as prices reach that level, start hedging. This will enable you to eliminate emotions, remove risk from the table, and protect profits.

Don’t carry profitable stock over to the next season. It is unnecessary to carry stock over to the next year every time. If you hit your trigger and can make good money, get rid of your risk.

Use the market instruments for the reason they are there. As already mentioned, your aim is not to increase your risk with futures and option contracts, but to reduce or get rid of it.

Markets will always provide opportunities to sellers and purchasers if they are prepared to wait for the right moment. From 2010 to 2018, the average price movement for the July white maize contract was R1 237/t.

This represents the maize price movement over the space of a year, with the smallest movement experienced in 2011, when the market moved only R533/t, and the greatest in 2016, when the market moved R2 847/t.

The 2005 season was interesting. The price dropped to a low of R500/t, but during the course of that season it also increased to R1 200/t at one point. In 2016, by comparison, the price hit a high of around R5 000/t, but within the same season dropped to a low of R2 300/t.

Price vs value
We often speak about a poor price but fail to realise there is a major difference between price and value. Consider a scenario where the maize price is either R2 171/t or R4 313/t.

Which of those would you as a farmer prefer? Obviously, the higher price. But to look at it from a value perspective, let’s go back to 2016 when the average white maize price for July was R4 313/t.

At the time, farmers in the Free State harvested white maize at an average of 3,05t/ha for that season. So, if a farmer managed an average yield and realised the average price, he/she would have had a turnover of about R13 200/ha.

In 2017, the average July white maize price was R2 171/t and the average yield in the Free State for white maize was 6,35t/ ha. In this scenario, yield multiplied by price gives a turnover of R13 800/ ha.

From a value perspective, there is not that much difference between the two. The moral of the story is: don’t be blinded by prices; make your calculation from a value perspective.

Know your price brands, and hedge your grain accordingly
As a farmer, you should know where your boundaries lie. Picture a rugby field. If you kick the ball out, play cannot continue and there has to be a line-out. The game always has to take place within the lines.

Now imagine a graph with three lines: a green line and a red line for import and export parity price levels respectively, and a grey line representing South Africa’s domestic maize price as per trading on Safex.

Every time the grey line reaches levels near the green line, at import parity, it is a good opportunity to hedge your grain. And if you are a buyer instead of a seller, every time the prices move closer to the red line, it is a good time to buy grain.

The views expressed in our weekly opinion piece do not necessarily reflect those of Farmer’s Weekly.

This article is based on a presentation given by Silostrat grain trader Werner Rossouw at the 2019 Grain SA Annual Congress.

Phone Werner Rossouw on 057 391 1935, or email him at [email protected].

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