A Look At New Generation Marketing Contracts
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Corn and soybean producers in Illinois may have a variety of objectives when making pricing decisions. Some commonly articulated goals are: receive an average price, exceed the average price, exceed the harvest price, receive a price in the upper one-third of the price range, and avoid a price in the bottom one-third of the price range. Traditionally, producers have tried to achieve these goals with their own active marketing program, by following the recommendations of a professional marketing service, or some combination of the two.
More recently, the industry has introduced what we refer to as "new generation" marketing contracts. The common features of these contracts include:
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Producers commit a fixed number of bushels to the contract.
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Those bushels are priced during a specified period of time.
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The rules for triggering sales during that period are pre-determined.
- Producers receive the average price generated by the pricing rules.
There are three major providers of these types of contracts: Cargill Ag Horizons, E-Markets (http://www.e-markets.com/docs/drc_tour.html), and Diversified Services (http://www.cgb.com/). In addition, a number of local elevators offer some version of a "new generation" contract. There are three basic types of these contracts: automated pricing contracts, managed hedging contracts, and a hybrid of the first two types.
Automated Pricing Contracts
The first, and most common, type are contracts with automated pricing rules that are detailed in the contract. The most basic form of an automated pricing contract is one that offers the average market price over some pre-specified time window. The average may be of the closing futures price (daily, one day per week, etc.), with the producer to establish the basis at a time of his choice, or the average may be of the local cash price. While there are some exceptions, these contracts tend to be for the pre-harvest period.
As an example, consider the simple average of daily cash forward contract prices in central Illinois for harvest delivery between February 1 and June 30, 2000:
| Average Price | $2.19 |
| Service Charge | $0.03
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| Price at Delivery | $2.16 |
In comparison, the average harvest price in 2000 was $1.64 and the marketing year (September 1, 2000 through August 31, 2001) average cash price (corrected for storage costs) was $1.62.
The basic averaging contact can be modified in a number of ways. The most common modifications include: not pricing if the price is below the CCC loan rate; pricing only on days when the price is lower (agree on how large a change is required); establishing a minimum price, a maximum price, or both; varying the proportion of bushels sold by month; and pricing only when pre-specified targets are reached.
Managed Hedging and Hybrid Contracts
The second type of "new generation" contract can be referred to as managed hedging contracts. The quantity of the crop committed to these contracts is priced according to the recommendations of a market advisory service. The advisory service may use a variety of pricing instruments, including futures, options, or forward contracts. These contracts may also include a minimum price (futures) guarantee.
The third type of contract is a hybrid of the first two types. These are typically automated pricing contracts with a provision to share the hedging profits of the professional with the producer. Typically, two-thirds of the hedging profit is shared. These contracts may include minimum futures price guarantee and may include higher service charges to the producer based on performance of the professional hedger. For example, if the average hedge is in the top one-third of the price range, an additional service fee is assessed.
The Growth of "New Generation" Contracts
There are likely a number of factors motivating the development of "new generation" marketing contracts. One likely factor is the finding that it is difficult for farmers and even professionals to outperform, or beat, the market. That is, it is difficult for farmers to receive an above-average price year in and year out. This is consistent with the theory of efficient markets and is reflected by the widespread use of stock index funds, for example, by investors.
A second motivating factor may be the belief that producers generally concentrate marketing in the post-harvest period and do not make sufficient use of the pre-harvest period to price the crop. Closely related to this idea is the belief that although markets are generally efficient, "weather premiums" systematically occur during the pre-harvest period. Thirdly, the pre-harvest contracts offer an opportunity for grain handlers to ensure larger supplies of the crop. This competition issue is becoming more important as the grain-handling industry continues to consolidate.
Pricing Corn and Soybeans
It becomes an empirical question as to whether or not the market offers a preferred window of opportunity for pricing corn and soybeans. For example, the central Illinois average cash price as reported by the Illinois Department of Agriculture can be used to calculate average monthly corn and soybean prices during the period of one year before harvest and one year after harvest.
The price series used before harvest is the cash forward contract price for harvest delivery, and the price series used after harvest is the spot cash price. The average monthly price is the simple average of the daily prices. The time period for calculating these averages starts with the 1988 crop in order to avoid the price distortions created by the certificate program of 1986 and 1987. In addition, government payments associated with the 1998, 1999, and 2000 crops are not included. As a result, a relatively short time period of 13 years is used.
Over that 13-year period, there was little difference between the average pre-harvest and average post-harvest price of corn and soybeans. On average, however, prices were lowest in the summer and fall months and highest in the spring months. This comparison of pre- and post-harvest prices is incomplete, however, since it ignores the cost of storing crops beyond harvest. To correct for this cost, post-harvest prices were adjusted to reflect the interest opportunity cost of holding the crops beyond harvest and the commercial cost of storing the crop beyond harvest. The resulting seasonal price patterns for corn and soybeans are shown in.
For the 13-year period, the average cash contract price of corn for harvest delivery in central Illinois was $2.35, the average post-harvest price (corrected for commercial carrying costs) was $2.14, and the average price for the 24-month period was $2.25. The highest average harvest equivalent prices occurred in March, April, May, and June before harvest, and the lowest average harvest equivalent prices occurred in June, July, and August after harvest.
For soybeans, the average pre-harvest price was $5.99, the average post-harvest price (corrected for carrying costs) was $5.61, and the average for the 24-month marketing window was $5.87. The seasonal pattern was very similar to that of corn.
The results are slightly different if post-harvest prices are adjusted by on-farm variable costs of storage rather than commercial storage costs. Using on-farm variable storage costs increases the postharvest and 24-month average prices. In addition, the average monthly prices of corn in March, April, and May following harvest are above the 24-month average price.
While average monthly prices tell an interesting story, they do not tell the complete story. The other consideration is the variability in seasonal price patterns from year to year. The 95 percent confidence interval for monthly average prices is extremely large, suggesting that there is some risk associated with pricing crops, even in the periods when prices are, on average, at the highest level. The 1980, 1983, 1988, and 1995 crop years illustrate that risk. The pattern of consistently declining prices into harvest since 1996 is unique. For the period 1975 through 1995, for example, prices were much more volatile, and average futures prices on October 1 were only marginally lower than on March 1 and May 1 before harvest. For the period 1952 through 1972, prices were very stable, with little difference in average futures prices on March 1, May 1, and October 1.
Conclusion
It appears that "new generation" marketing contracts that result in producers pricing more of the crop in the pre-harvest period may result in somewhat higher average harvest-equivalent prices over a period of years. However, the advantage may not be as large as has been the case over the last six years.
It is important that producers evaluate the "new generation" contracts carefully to determine where they fit in their marketing plans. In some cases, producers can duplicate these contracts with disciplined pricing decisions on their own. For some of the managed pricing and hybrid contracts, full transparency of the transactions by the professionals is important. Producers should be able to monitor those transactions.