Todd's Take

In last week's column, we talked about buying inexpensive put options as one way for grain producers to protect themselves from the risk of falling prices. We also mentioned how many are under the false impression that 90% of options expire worthless and how a recent Farm Credit Services of America survey found that only 25% of farmers use either the futures or options markets to market their grain (http://bit.ly/…).

In my opinion, inexpensive put options offer farmers one of the easiest ways to reduce price risk, and I am glad to say that readers took note. While most of the comments I received through email and Twitter were appreciative, there was one paragraph from last week's column that some took issue with:

"With DTN's national index of cash corn prices currently at $3.08 and December 2018 corn priced at $3.80, the December $3.20 put is offering to take 84% of the price risk in December corn off the table from now until Nov. 23. The peace of mind from that protection alone should be worth the price of admission, but as we have seen, the put also has other benefits."

Some interpreted this as me believing that corn prices had a reasonable chance to go to zero. No, I don't believe corn prices are headed to zero. But this raises an important point about risk management that deserves elaboration.

If I could put one statement in large bold type, it would be this: Do not confuse risk with probabilities. Risk refers to the amount exposed to loss. Probabilities are judgments of likelihood, often based on past behavior.

Some risks are probable and some risks are improbable, but until humans figure out a way to predict the future, both are still risks. Another way to say the statement above is: Worst-case scenario, if you buy a December corn futures contract at $3.80 a bushel, the most you can lose is $19,000 ($3.80 x 5,000 bushels per contract). Is it likely that you will lose $19,000? No, but that is the risk.

OK, you may say, but let's get practical. What's the lowest price December corn could reasonably go? One responder on Twitter evidently doesn't think corn prices can go very low, because they contended that buying a December 2018 $3.20 corn put was "a gamble, not risk management."

There are two major points I'd like to make. Let's start with this question: What's the lowest price December corn could reasonably reach?

As readers of this column know, I make early price estimates of corn, soybeans and wheat each year, based on historical ranges of where prices have traded in relation to USDA's national estimates of production costs. It has been a helpful way to anticipate price ranges before we know any of the year's specific fundamental details.

Because land costs vary widely by region, I exclude those from the calculations and find that December corn prices normally trade within a range from a landless production cost on the lower end to a 50% premium on the higher end. For December 2018 corn, the low end of the range is currently estimated at $2.71 a bushel.

Looking back at this price-to-cost relationship to 1985, there have been nine years when December corn has traded lower than its national production cost, excluding land expenses. On this model, the 2018 equivalent to how low prices fell in 1986 is $2.30 a bushel.

Now let's go a different route. In terms of risk to corn prices, the most dangerous time, seasonally speaking, has been the six months from the end of May to the end of November. In the past 38 years since 1980, December corn futures finished lower in 26 of those years, or 67% of the time.

To say the average loss was 4.5% does not do this period justice as there have been several large swings, both up and down. Seven of the years had price gains of 10% or more, and 20 years had losses of 10% or more. Thirteen years (34%) had losses exceeding 15%. The largest loss was 44% in 2008, followed by a 35% loss in 2004.

Knowing a little more now about corn's history brings me to the second major point. As we look at what corn prices have done historically, we may conclude that $2.71 is a reasonable low for December corn or even prepare for a 15% drop after May, but who is to say that 2018 will be a reasonable year?

This takes us back to one of the original reasons for last week's column. U.S. grain prices have never been this globally dependent or vulnerable to all sorts of international possibilities. Historical corn prices have seen big surpluses before and survived all sorts of conflicts over the past century, but not all corn growers have. I have no doubt that if we went back and interviewed the producers who didn't survive previous bear markets, many would say that they just didn't think corn prices could go that low.

I appreciate all the feedback and welcome more in the weeks ahead. Just as some assumed last week I was suggesting corn prices could go to zero, some may assume this week that I am ultra-bearish on corn in 2018. Again, purchasing an inexpensive put option should not be based on our perception of probabilities or where any of us think the market is headed, but on the protection the put provides from unexpected events. I don't want to hear our readers say one day that they just didn't think corn prices could go that low.

Best wishes for a New Year.

Todd Hultman can be reached at Todd.Hultman@dtn.com

Follow him on Twitter @ToddHultman1

(AG/BAS)

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