Buying feed at the right time can prove tricky, but there are ways of insuring against this risk, as the HGCA’s Mike Mendelsohn explains

Growing global demand for grain has seen consumption outstrip demand, resulting in low world stock levels and strengthening cereal prices.

UK wheat futures rose from around £90/t in January 2007 to a peak of £190/t in March 2008, although they have since fallen back to around £100-110/t. Similarly, CBOT soyabean meal futures rose from $185/t (£104/t) in January 2007 to a peak of $455/t (£255), in July 2008, before falling to current levels of around $320/t (£180/t).

The increases have been reflected in a significant rise in animal feed costs, as compounders have had to pass on the higher costs to poultry producers. Consequently, these higher costs put pressure on poultry businesses to look at ways of limiting this risk.

How can producers reduce risk?

One way to hedge against this risk is by using the futures market. There are no specific feed futures (and hence no feed options), so there is no way to directly manage exposure to feed prices. As a result, it is necessary to use an indirect hedge. This can be done using the LIFFE wheat market, or CBOT soyabean meal market.

Options are tools that can be useful in effectively managing exposure to price risk, allowing the holder to choose whether or not to go through with the specified transaction. There are two main types, a “Call” and a “Put” option.

For simplicity, the two examples focus only on the wheat market and assume a direct relationship between feed demand and wheat.

What is a Call Option?

A Call Option would be used if you have not bought grain forward and, therefore, need protection against a rise in prices.

Supposing you know you will need 1000t of feed in May 2009 and we will assume this equals 1000t of wheat. The current futures price for next May is £115/t (as at mid-September 2008), which implies a delivered price of around £120/t, including haulage.

By choosing not to make a forward purchase, you are leaving yourself exposed to any potential rise in prices between now and May.

In order to protect against this exposure, you can buy May 2009 Call Options, giving the right, but not obligation, to buy wheat futures for £115/t. This right can be exercised at any time between now and the end of April 2009. For this option, a premium of around £10/t is payable.

If the wheat price does rise, you can exercise the option, buying futures for £115/t and immediately selling them at the prevailing market price, giving you the difference as profit. Since this profit will offset the higher price you have to pay for your physical wheat, the resulting maximum you would pay for your physical wheat would be the current price of £115/t, plus the £10/t premium, which equates to £125/t.

If, however, the market falls, you would simply abandon the option, since there is no obligation and as a result, you would pay the current price plus the £10/t premium for the options you bought.

What is a Put Option?

If instead you have bought grain forward, but are waiting to sell finished product, it is worth considering a Put Option as protection against any fall in prices.

Suppose you have bought 1000t of feed, as before assuming this equals 1000t of wheat for May 2009 delivery, at £120/t (£115/t futures plus £5/t haulage). You are, therefore, exposed to any price falls between now and delivery of finished poultry.

To protect against this, you can buy May 2009 Put Options, giving you the right, but not obligation to sell wheat futures for £115/t at any time between now and the end of April 2009. For this option, a premium of around £11/t is payable.

If the wheat price falls, you can exercise the option, buying futures at the prevailing (lower) market price and immediately selling them for £115/t (as you are entitled through your option). You will gain back any fall in the market, minus the premium paid.

This gives the ability to buy forward and secure your feed requirements, without missing out if the market moves lower against your purchase price.

In conclusion, the two strategies above will offer price insurance for wheat as a proportion of your feed requirement, reducing – but not eliminating – your potential exposure.

The meal portion can be similarly secured using the Chicago market. Overall this is an important step in the direction of minimising price risk, so that you can make decisions that are appropriate to your business, rather than be buffeted by much increased market volatility.