Last month I started a series of columns to address the topic of carrying charges in grain markets. I discussed how carrying charges (or lack of) send market signals to store or not store grain. This month I promise a better sense of large and small carrying charges.
We can start by calculating a full carrying charge, or the maximum spread between different futures contract months, by using the following formula:
Full carry per month = (price × interest rate) ÷ 12 + (commercial storage rate per month)
Assuming $6 December corn futures, 6% interest and a 5¢/month commercial storage charge, we can calculate a full carrying charge of 8¢/month.
In this case, the March contract three months out should not exceed $6.24/bu. A full carry of 24¢/bu. is the maximum spread because of the possibilities of arbitrage. Trade lingo refers to this as 100% of full carry.
If the December-March spread was greater than 24¢, savvy traders would aggressively buy December and sell March futures and reap a risk-free profit (take delivery in December, pay interest and storage until March and deliver). Markets are not that easy, and the possibilities of arbitrage maintain carrying charges at something less than 100% of full carry.
This summer provided a great illustration of a changing tone in the corn market. We clearly saw the change in prices when new-crop Dec. 2008 futures declined more than $2.50 from mid-June to mid-August. A 33% decline in new-crop prices is a good indication that a raging bull has been tamed. But we could also see this change from a different perspective: that of carrying charges. Let me explain.
On June 18, Dec. 2008 futures closed at $7.80, and the July 2009 contract closed at $8.01 — a 21¢ carry from December to July. A full carry to the July contract would have been 62¢/bu. (See if you can do the math using $7.80 December futures, 6% interest, 5¢/mo. commercial storage and seven months.)
In other words, carrying charges in mid-June were trading at 33% of full carry (21¢ ÷ 62¢ full carry). That's a small incentive for storage in a corn market that has been seen to sport a carrying charge of 80% (or higher) of full carry.
By Aug. 11, the December-July carrying charge had increased to 42¢ ($5.17 Dec. 2008, $5.59 July 2009). Lower futures also lowers our estimate of a full carry to 53¢ because it costs less to store $5 corn vs. $8 corn.
Carrying charges widened to nearly 80% of full carry in just six weeks. The incentive to store grain has returned to the corn market.
Let me suggest a simple three-step process for you to assess the incentive for on-farm storage.
STEP 1: Calculate the carrying charge per month
Carrying charge ÷ # of months
This analysis can be applied to any commodity and any time frame for storage (December-March corn, November-July soybeans, etc.)
STEP 2: Calculate a monthly per-bushel interest cost for grain storage
Cash grain price × annual interest rate ÷ 12 months per year
Interest is an important variable of on-farm storage cost. Your storage bins are a fixed cost; I like to compare carrying charges to my variable costs of storage.
STEP 3: Compare the size of the carry (Step 1) to your interest costs (Step 2)
Carrying charge ÷ interest cost
On my mythical farm over the past two decades in corn, the answer has ranged from 50% to 350% (i.e., the carry in the market was as small as half and as high as seven times my interest costs).
Now ask yourself: Would you store grain if the market carry did not cover your interest costs (less than 100%)? How large should the carry be for a strong incentive to store grain (150%…200%…300%…etc.)?
Ed Usset is a grain marketing specialist for the University of Minnesota Center for Farm Financial Management (CFFM). He can be reached at usset001@umn.edu.