Bruce Blythe, for CME Group
IN ONE LOOK
- Short-term options were launched in the midst of a severe drought in 2012 and have since proven to be well suited to uncertain times
- Demand for U.S. grain and oilseed stocks is among ‘tightest in over a decade’
From the first months of 2012, signs of difficulties began to appear for American agriculture. High temperatures in Chicago on St. Patrick’s Day hit 82 degrees Fahrenheit, the hottest for the day in 141 years. Unusual heat and dryness persisted throughout the spring, and by midsummer intense heat and dryness gripped much of the Midwest, causing market volatility and soaring grain prices.
A decade later, the risk factors that American farmers face throughout a crop year have multiplied, with 2022 characterized by drought or excessive rain in several key growing areas of the United States, to which add to this galloping inflation, rising interest rates, high fertilizer costs, the war in Ukraine and a potential recession.
In May 2012, CME Group launched Short Term New Crop Options (SDNC) in the corn, soybean and wheat futures markets, aimed at providing farmers and other actors in the agricultural supply chain with greater flexibility to manage risks, such as drought, during the growing season. Coincidentally, the product became available at the onset of a major drought.
They have since proven to be well suited for uncertain times. Volume and open interest were at record highs in early July, illustrating the industry’s growing adoption of flexible hedging tools that can be adapted to expected news (such as USDA reports), as well as to contingencies.
Short-term New Crop options open interest – the number of open contracts – reached 244,942 contracts in June, while June average daily trading volume in 2021 and 2022 marked the busiest months for the contract since 2015.
Extreme events require a “larger menu of choices” for producers.
The 2012-13 drought, one of the worst in US history, covered 81% of the contiguous United States at its peak and caused losses estimated at $30-40 billion in the Midwest, corn and soybean production has been reduced. In September of that year, soybean futures hit a record low of just under $18 a bushel.
“Extreme volatility-generating events such as droughts were part of the real-world scenarios considered by CME when designing short-term options,” said Tim Andriesen, CME Group Managing Director, Agricultural Commodities. The options were inspired in part by Andriesen’s earlier experience in the over-the-counter options markets, where traders took “strips” and other futures-related positions but with durations shorter.
“In the OTC world, you don’t have to go by convention, where a December option expires in November,” Andriesen said. “We were looking for a product that would help agricultural producers, who are extremely sensitive to high prices. Buying a corn or soybean option in January at a 30 cent premium, for example, is a tough sell for a farmer. So we looked at our products and said to ourselves, let’s try to give producers more choice.
Corn and soybean options traditionally used to hedge production for the growing season in the United States expire in November or December, which in many cases is too long a period for farmers considering planting decisions and balance grain prices during the winter and early spring. Short-term options, on the other hand, expire earlier than their standard counterparts, allowing greater flexibility for farmers looking to hedge their production before or at the start of the growing season.
USDA acreage and stock reports offer potential for surprise
Short-term options for new crop corn and soybeans offer a potential solution to supply disruptions such as drought in South America or war in Ukraine, where there could be a mismatch between futures contracts old and new crop. They allow producers to secure some protection at favorable prices while leaving open the possibility of profiting from a prolonged recovery.
“Critical USDA reports, such as the agency’s highly anticipated Quarterly Grain Stocks and Acreage reports released on June 30, also include potential surprises that can drive grain prices up or down, a another scenario where short-term options flexibility may apply,” noted Brian Burke. , president of John Stewart and Associates.
“When advising clients, I ask them what move on this report is going to make you lose sleep? Burke said. “And then I usually go to some short-term options, whether it’s August short-term new crop options or July weekly options, which are short in time and advise to protect this risk against that short-term surprise that would work against them. This is often a very successful and effective way to manage risk.”
Global grain and oilseed stocks as a percentage of global demand “are among the tightest in more than a decade,” Burke added. “When you combine this very tight global balance sheet with the fact that Ukraine … will have a very limited supply for several months or more, you really get a sense of how large the supply in the United States is for grains and oilseeds this fall.”
Farmers increasingly like flexibility – “Get the bushels before the price”
For farmers like Betsy Leager of Leager Farms, the geopolitical unrest and extreme weather conditions of 2022 underscore the importance of agile hedging and marketing strategies that account for rapidly changing risks.
Leager, who operates a farm in the Delmarva area of eastern Maryland, says she has started adding short-term options to bring some certainty to their operations. Previously, they used futures or locked in base levels, but felt their risk management needed to be more precise as it is difficult to predict the size of the harvest months in advance.
Leager, who manages the farm’s books, said that with rising input costs, they are looking for ways to protect the profits they have seen this year when grain prices have risen. Compared to futures, short-term options allow greater exposure to higher prices while protecting against downside risk 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 an idea of where our profit margin will be before the crops are in the ground.”
A “powerful tool” to measure volatility
Another twist for producers and other actors in agriculture: the volatility of a market is not like the others. This is where the CME Group Volatility Index (CVOL) index can be useful.
CVOL is “a very easy way to look at and compare historical volatility,” Andriesen said. “At its core, it makes understanding volatility very simple, providing a consistent measure of volatility that producers can track over time. In its simplest form, it’s a nice, clear metric, and it can be a much more powerful tool for producers to gauge volatility.
For the remainder of 2022 and beyond, uncertainties are likely to remain high for agriculture and the world at large, which means producers will continue to look for ways to better manage their risks and protect their bottom line.
“Over the past two years, we have seen significant spikes in volatility” in agricultural markets, Andriesen said. “People clearly see a need for options when you have an environment like this. Short-term new crop options have really helped manage risk in the current environment. Growers want price opportunities at the up using options, but they don’t want to do that when we have high prices and high volatility.”