Drought concerns send markets sharply higher

By Michael Swanson –
Since May 13, the corn and soybean markets have surged relentlessly higher on increasing concerns of a drought developing. November soybean futures have jumped $1.49 per bushel (a 24 percent rally), and corn has climbed $0.34 per bushel (a 15 percent rally). This rally is based on the facts that some areas of the eastern corn/soybean belt are too dry and other areas were hurt by poor weather earlier in the planting cycle.
Still, the assessment that the national crop is in jeopardy remains premature. Every crop year has weather rallies, and most of them disappear as enough areas get the needed moisture to make a normal crop. The question is whether the current rally justifies making additional sales or taking price protection for feed users.

For example, the November soybean future has climbed to 84 percent of observed prices for the last decade. Historically and statistically, this means the percentage of times prices have been higher is down to 16 percent, making it less likely that prices will end up higher in November rather than lower after all the pros and cons have been run through the system.
It is important to remember that besides the odds, the payoff also needs to be considered in the marketing decision. Over the last 10 years, soybean futures have peaked at $10.64 for a Friday close. This makes the last 16 percent of the price spectrum worth as much as $3.06 per bushel in terms of payoff. This considerable upside in price warrants some attention as well.
There are really only two viable options for capturing this upside on any open portion of expected production. The first and simplest is to simply wait for harvest time to see what the market brings. The advantage is the low cost of carrying out this strategy, but the downside is that there is no protection against a large downward correction in price. The other strategy would be to buy a put to lock in the current price less the premium. This would allow the producer to capture any rally, but avoid losing out on today’s excellent price.
The problem with this approach is the high price of the put reflecting the expensive volatility premium. An “at the money” put of $7.60/bushel currently costs 65 cents, which effectively reduces the protected price to $6.95/bushel (74 percent). Almost the entire price represents volatility premium guaranteed to evaporate, and the price delta is a weak -0.46. This delta implies that for each 10 cent drop in the value of the underlying future, the value of the put will only rise 4.6 cents.
With downside protection being too richly priced, the best strategy becomes making additional cash sales. Will some of these sales miss the top of the market? Absolutely. But, that knowledge shouldn’t stop you from making sales at historically good prices.
No one knows the future, but you should always know the odds and payoffs.
Michael Swanson, Ph.D., is an economic analysts with Wells Fargo Economics. Wells Fargo presents this analysis as a service to its employees and customers. It can not guarantee the accuracy of all the sources of data. And, commodity prices are extremely volatile based on unforeseeable changes. These estimates represent a most likely scenario at this time.
Source: AgWeekly