I started this series on carrying charges in August, when I discussed how carrying charges send important market signals about grain storage. I showed that a bear market environment — large crops and/or weak demand — often leads to large carrying charges in the futures market and an incentive to store grain.
Small crops and/or strong demand (traits of a bull market) create small carrying charges or inverted markets — disincentives for storage.
LAST MONTH I continued the discussion by developing a better definition of the terms “large” and “small” carrying charge. Grain merchandisers typically focus on futures prices and the percent of full carry in the market. While the “percent of full carry” approach is useful, I outlined a more relevant process for you to assess the incentive for on-farm storage, which compares current carrying charges in the market to the cost of financing grain held in storage (your interest costs).
Harvest is here and you are about to make some important decisions concerning grain storage. Carrying charges are linked to the incentive to store grain. Can our understanding of carrying charges help us make better pricing and storage decisions? To help me answer this question, I want to introduce you to a couple of mythical corn and soybean producers, Earl Eitheror and Barney Binless.
EARL HAS ON-FARM storage. At harvest he makes a simple choice. When carrying charges are large, Earl plays it safe by storing grain and selling the carry in the market. He does this by calling his broker and selling July futures against his grain in storage. He unwinds the transaction the following May by selling his grain in storage and buying back his futures position. Selling the carry prevents Earl from enjoying a futures market rally, if it occurs. It does however, allow him to lock in the positive carry from new crop to July futures, and benefit from a stronger spring basis.
What will Earl do when carrying charges are small? Small carrying charges or inverses point to a more bullish price environment. In this case, Earl takes a chance with unpriced grain held in storage. He sells it the following May.
Let's compare Earl's performance over time to Barney Binless. Barney has no on-farm storage and prices all of his corn and soybeans at harvest — Barney's price represents the price of grain at harvest. Results appear in the table.
Our comparison of Earl's choice to Barney's harvest price yields some interesting results. First, Earl's choice paid off over time, net of on-farm storage costs. Earl's results are consistent for corn and soybeans despite the fact that his opportunity to sell a large carry is much more likely in the corn market than in soybeans. The “not easy” part of Earl's choice: It does not work every time.
I WILL CHANGE one aspect Earl's approach. His past definition of a large and small carry has become dated in a world of $5 corn and $12 soybeans. For a rule of thumb moving forward, Earl will define a small carrying charge as covering less than 120% of his interest costs. (Large carrying charges will be greater than 120% of interest costs).
Earl lives in a black and white world — you may be better served by diversifying your approach if carrying charges are not clearly large or small.
Earl makes a choice to sell the carry or hold unpriced grain based on carrying charges. This simple choice led to surprisingly good results over time. Harvest is here; how will you make your choice?
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.