Just because new farm programs offer growers at least some semblance of a safety net doesn't mean they can sprint across the treacherous tight wire of cotton marketing with no fear of falling.
Prospects for peril continue, says Texas A&M's venerated agricultural economist and marketing specialist, Carl Anderson.
Anderson, in his annual address to the Beltwide Cotton Conferences in Nashville, said the new farm bill, instead of simplifying cotton growers' marketing decisions, adds several layers of challenges and opportunities.
“Producers have more marketing decisions to make then ever before,” Anderson said. “Because market prices affect most program payment components, producers must be skillful market observers and rely heavily on pricing and hedging strategies to enhance income.”
Even with a target payment and a few “guarantees” the same factors that have always affected cotton prices continue to exert a significant influence on how much money a farmer can get from both the market and government programs. Market direction and price changes influence program benefits substantially, Anderson said.
He said farmers must understand program provisions as well as the factors that alter cotton prices in both the futures and cash markets during the year.
“Producers should develop marketing plans that include hedging strategies, mostly using options to offset price changes that reduce income or to benefit from sustained price rallies. Seek income from the market that will add to government program payments.”
Anderson explained that the market price, LDP (Loan Deficiency Payment), or loan rate link to annual production on qualified production units. The counter-cyclical payment (CCP) and a Direct Payment (DP) tie to farm program base acres, two different payment yields and a fixed 85 percent.
“The farm program does not guarantee farmers an income based on the 72.4 cent per pound target price,” he said. “Producers are guaranteed 85 percent of the 6.7 cent per pound DP times their base acreage and DP yield. The DP yield was established in 1985, using yields for the 1975-1984 period. These may be far short of actual yields.”
Anderson said if a season average price received is less than 65.73 cents per pound (72.4 cents minus 6.67) producers could receive a CCP equal to 65.73 cents minus the higher of the season average market price or the loan rate (52 cents per pound) times the base acres, the CCP yield and 85 percent.”
He said across the Cotton Belt the CCP yield is likely to be around 93.55 percent of the average 1998-2001 cotton yields. “The CCP and DP could be the same if the producer has not elected to update the program yield for CCP purposes.”
Anderson said DP and CC payments are not tied to current production. “So, producers can not add the 6.67 cents DP rate to the maximum CCP rate of 13.73 cents and assume they will receive 85 percent of this value or 17.34 cents on current production.”
The national average DP yield is estimated at 600 pounds per acre and the CCP is estimated at 640 pounds per acre. “Given these estimates, the DP is worth about 5.2 cents per pound on actual production. At the maximum CCP rate in 2003, the CCP program, on average, will add about 11.5 cents per pound of actual production.”
Adding the DP and CCP to loan rate yields puts the net price at about 68.7 cents per pound of actual production, if prices remain at or below the loan rate and producers capture the full potential of LDPs.
If market prices go higher than loan, the CCP rate declines and farmers receive about 83.7 percent of the difference between 65.75 cents per pound and the market price.
Anderson said producers might add to government payments received by hedging LDP/MLG (marketing loan gain) and CCP. “Producers who understand the cost effective use of options strategies, including option spreads, can gain substantial financial rewards from potential futures price movements, either up or down.”
Call options allow producers to take advantage of higher prices and put options allow them to protect against lower prices. “With the U.S. cotton market heavily dependent on exports for more than half the annual crop, futures price changes due to market forces likely will exceed 20 cents per pound for each two-year contract period,” Anderson said.
The new farm program allows producers some “unique opportunities to protect counter-cyclical payments. The program's 72.4 cents per pound target price decreases to less than 69 cents per pound after payment adjustments (the 85 percent of base acreage stipulation). That's close to cost of production for many growers.”
He said the CCP only goes to base acres and farm program yields established in past years, not on production made in the current season.
“Producers have the option of updating base acres and farm program yields for future years. And those who polish their pricing skills may gain several cents from the market in addition to program payments.”
CCP rate restrictions
Anderson said the maximum CCP rate, 13.73 cents, will be available only to qualified producers in seasons when average monthly prices received by U.S. upland growers and weighted monthly marketings for the August through July seasons are less than the CCC base loan rate, 52 cents per pound. “The CCP will decline to zero when price received reaches 65.73 cents per pound.”
Average price received includes all qualities of cotton. “Quality resulting from weather patterns each season affects the price level received relative to the base grade used in futures contracts,” Anderson said. “The average quality may be above or below the base quality for futures contracts.”
“The difference between futures market and monthly prices may be highly variable,” Anderson said. Influences include cotton quality, supply-demand conditions and other market forces.
“The relationship between prices received and futures, however, is more stable, usually in the minus 4 cents to 8 cents range, from August to December, than the period from January to July, when monthly average prices received fluctuate about minus 1 cent to 13 cents under futures each month,” Anderson said. “Estimating the difference between futures price and farm price is a rough estimate, at best.”
Anderson said the challenge in hedging the counter-cyclical payment lies in “estimating the futures price level and movement of the marketing season well in advance of a sustained price rally. It may pay to purchase out-of-the-money call options earlier (during the preceding fall and winter months) than in past years on December and March futures, when prices are usually seasonally weak.”
Protect trigger level
Anderson said about half the crop is marketed from August through December, so a practical approach would be to protect the 52 cents trigger level for reducing the CCP with a first hedge using December and/or March calls. “When hedging for the 2003/2004 season, use the December 2003 futures price.”
Anderson said a strike price of 54 cents to 58 cents is a reasonable level to start purchasing calls, “considering the potential variation in the relationship of farm price and futures (the minus 4 to 8 cents). When the futures price is below the strike price, growers can expect relatively lower premiums for out-of-the-money call strike prices. As futures prices increase, so does the cost of hedging a full CCP,” he said.
Anderson does not anticipate a futures price rally during the 2002/2003 season to push average price to 52 cents per pound. But the outlook for higher prices in 2003/2004 offers enough uncertainty to leave the maximum CCP a question.
“We see little or no opportunity for CCP hedging if the futures price reaches a 65 to 70 cents per pound range or higher. Also, pay attention to the difference in price for the average farm price received for all upland marketing vs. the futures price. The price an individual producer receives does not affect the CCP.”
Anderson said farmers should estimate prices received for the first five months of the season in late fall and then evaluate the need for further hedging using March, May or July calls. “The hedge will be most beneficial during seasons when futures prices rally into the mid-50 cents to mid-60 cents range. When the December 2003 price tops 50 cents, growers should watch for estimates on 2003/2004 acreage and crop production and the resulting likelihood that average price received will exceed 52 cents.”
Anderson said out-of-the-money call options offer price protection “when market conditions worldwide suggest a potential futures price increase of 5 cents to 20 cents per pound.” That fluctuation, he said, could result in a substantial decrease in LDP/MLG because of an increase in world price, the A index, before cotton is ready for market.
“On the other hand, producers who decide to accept LDPs, but hold their cotton hoping for a price increase after foregoing the opportunity to place the crop under CCC loan, should consider put options to protect against an unexpected price decrease.”
Anderson said when the average world price (AWP) is less than the CCC loan rate, 52 cents per pound, the difference may be made up by a payment of LDP or an MLG.
He said since the A index is subject to worldwide market forces and the U.S. market price bends to a slightly different combination of catalysts, U.S. prices may not move in a direct relationship with the AWP.
“However, the two usually move in the same direction over time. When the LDP/MLG is fairly large because of a low A index and market forces indicate a potential price rise of several cents before harvest, producers may decide to hedge the LDP/MLG by purchasing call options at strike prices below the 52-cent CCC loan rate.
“The lower the futures price, relative to the loan rate, the more flexible the range of strike prices that are out-of-the-money. That situation offers a favorable leverage against option cost and possible gain,” Anderson said.
He said farmers should evaluate pricing strategies carefully to make certain the cost vs. the risk protection is favorable.
Cash flow factor
“The decision to hedge the CCP against potential average price received above 52 cents will be a significant factor for growers to maintain cash flow from base acreage and program yields,” Anderson said. “A strong cotton rally could reduce or eliminate expected CCP. If the base acreage is not planted, no cotton is produced and subsequent sales are not available to offset the payment reduction.”
Anderson encourages producers to check the USDA Web site, www.usda.gov/farmbill, for more details on program provisions.