Bruce Blythe, for the CME Group
AT A GLANCE
- Short-term options were introduced in 2012 amid a severe drought and have since proven to be well-suited to uncertain times
- Demand for US grain and oilseed stocks among ‘tightest in over a decade’
Already in the first months of 2012, the first signs of problems in US agriculture appeared. High temperatures in Chicago on St. Patrick’s Day reached 82 degrees Fahrenheit, the warmest that day in 141 years. Unusual heat and drought persisted throughout spring, and severe heat and drought gripped much of the Midwest in midsummer, sending market volatility and grain prices skyrocketing.
A decade later, the risk factors American farmers must deal with during a crop year have multiplied, with 2022 including drought or excessive rain in several key US growing regions, coupled with rising inflation, rising interest rates, high fertilizer costs, a war in Ukraine and a potential recession.
In May 2012 the CME Group started Short-Dated New Crop (SDNC) options on corn, soybean and wheat futures, aiming to give farmers and others in the agricultural supply chain more flexibility to manage risks such as drought during the growing season. Coincidentally, the product became available at the onset of a major drought.
Since then, they have proven to be well-suited to uncertain times. Volume and open interest were at record levels in early July, demonstrating the industry’s increasing acceptance of flexible hedging tools that can be tailored to anticipated news (e.g. USDA reports) as well as the unexpected.
Open interest for short-dated New Crop options — the number of outstanding contracts — hit 244,942 contracts in June, while the average daily trading volume in June in 2021 and 2022 marked the most active months for the contract since 2015.
Extreme events require “greater choices” for producers.
The 2012-13 drought, one of the worst in US history, covered 81% of the contiguous US at its peak and caused an estimated $30-$40 billion in losses in the Midwest as corn and soybean production slumped has been restricted. In September of that year, soybean futures rose to a record high of just under $18 a bushel.
“Extreme, volatility-generating events such as droughts were among the real-world scenarios that CME considered when developing the short-term options,” said Tim Andriesen, CME Group’s Managing Director, Agricultural Commodities. The options were inspired in part by Andriesen’s previous experience in the over-the-counter options markets, where traders took “strips” and other positions tied to futures but with shorter maturities.
Read more about near-term new crop options.
“In the OTC world, you don’t have to stick to conventions where a December option expires in November,” Andriesen said. “We looked at a product that would help agricultural producers who are very sensitive to premium prices. Buying a corn or soybean option in January, for example, at a premium of 30 cents is difficult for a farmer to sell. So we looked at our products and said let’s try to give producers more choice.”
Corn and soybean options, traditionally used to hedge production for the US growing season, expire in November or December, which in many cases is too long a time frame for farmers pondering planting decisions and balanced grain prices in the winter and early spring. In contrast, short-term options expire earlier than standard counterparts, giving more flexibility to farmers who want to hedge their production before or at the start of the growing season.
USDA acreage, stock reports hold potential for surprise
Short-term options for new corn and soybeans offer a potential solution to supply disruptions such as the South American drought or the war in Ukraine, where there could be a disconnect between old and new crops. They allow producers to secure some protection at cheap prices, but still leave open the possibility of benefiting from an extended rally.
“Critical USDA reports, such as the agency’s much-anticipated Acreage and quarterly Grain Stocks reports, released June 30, also contain potential surprises that can drive grain prices up or down, another scenario in which the flexibility of short-term options can apply,” noted Brian Burke , President of John Stewart and Associates.
“When I counsel clients, I ask them what movement in this report will make you lose sleep?” Burke said. “And then I usually move on to some short-term options, whether it’s the August new crop short-term options or the July weekly options, which have a short time frame, and advise protecting that risk against that short-term surprise that would work against you . This is often a very successful and effective way of managing risk.”
Global grain and oilseed inventories as a percentage of global demand “are among the tightest in over a decade,” Burke added. “When you combine this very tight global balance sheet with the fact that Ukraine … will have severely limited supply for several months or more, you really get an idea of how critical the US grain and oilseed supply will be this fall is.”
Farmers are increasingly appreciating flexibility – “Must have bushels before price”
For farmers like Betsy Leager of Leager Farms, the geopolitical turmoil and extreme weather events of 2022 underscore the importance of nimble hedging and marketing strategies that address rapidly changing risks.
Leager, who operates farms in the Delmarva area of eastern Maryland, says she has begun adding short-term options to bring some certainty to her operations. They used to use futures contracts or setting base levels, but felt their risk management needed to be more precise as it’s difficult to predict the size of the crop months in advance.
Leager, who manages the books for the farm, said that with input costs rising, she was looking for ways to protect the gains she saw this year as grain prices rose. Compared to futures contracts, short-term options allow for greater exposure to higher prices while protecting against downside risks during the growing season.
“You have to have the bushels before you have the price,” Leager said earlier this year. Using short-term options “gives us a sense of where our profit margin will be before the harvest is in the ground.”
A “powerful tool” for measuring volatility
Another twist for producers and others in agriculture: the volatility of one market is not like the others. Here is the CME Group Volatility Index (CVOL) Index can come in handy.
CVOL is “a very simple way to look at and compare historical volatility,” Andriesen said. “Basically, it makes understanding volatility very easy as it provides a constant measure of volatility for producers to track over time. In its simplest form, it’s a nice clean gauge, and it can be a much more powerful tool for producers to measure volatility.”
Looking ahead to the rest of 2022 and beyond, uncertainties for agriculture and the world in general are likely to remain high, meaning producers will continue to look for ways to better manage their risks and protect their profits.
“In the last two years we have seen significant swings in volatility in agricultural markets,” Andriesen said. “People clearly see a need for options when you have an environment like this. Short-term options for new crops have really helped manage risk in the current environment. Producers want to take price opportunities through options, but they don’t want that when we have high prices and high volatility.”
Read more articles like this at OpenMarkets