For the first article in our series of comparing contracting alternatives, we are going to review the features of a forward agreement in the cash market. A forward contract establishes a price between a buyer and seller for a particular commodity to be delivered from the seller to the buyer at some point in the future. The terms of the contract, including the amount or quantity of the commodity, the quality specifications, the specific delivery period, and any particular pricing determinants such as how premiums or discounts may be handled are directly negotiated between the buyer and seller in a private transaction. As an example, a crop producer may reach an agreement with a local elevator to sell a portion of their corn crop forward ahead of the spring planting season for fall delivery at harvest time. Let’s assume this particular grower anticipates harvesting 100,000 bushels given normal yields, and wishes to establish a price on half of their production since current price levels would provide them with an expected return they are satisfied with. They may reach an agreement with the elevator to sell 50,000 bushels at a price of $4.00/bushel for delivery during the last half of October.
The $4.00 price is determined by referencing CBOT corn futures at the CME Group, and taking into consideration a local basis which represents the differential between that futures price and the anticipated discount to futures at harvest time. In this example, let us assume that December CBOT corn futures are trading at $4.25/bushel. The December futures price is referenced because of the agreed upon delivery period in the last half of October. Any spot transactions that would occur in the cash market during this timeframe would reference the December futures contract price as a benchmark, so it therefore would likewise be referenced for this hypothetical forward agreement. The differential or basis in this particular example would therefore be -$0.25/bushel, derived from the agreed upon forward price of $4.00/bushel minus the futures price of $4.25/bushel. We will assume that a “normal” basis in this local cash market at harvest time is typically around 30 cents under futures, and the elevator is giving the producer a volume premium for agreeing to contract 50,000 bushels.
As part of determining the $4.00/bushel price, the contract stipulates quality specifications that may among other things limit the amount of foreign material or mycotoxins allowed to be present in a sample. Likewise, it may be agreed upon that a #2 yellow grade corn is to be received, with some sort of discount and premium schedule applied to quality below or above this threshold. Perhaps the most important aspect of the contract though is that it requires physical delivery of the actual corn. This presents risk to the seller in that they may not have the supply available at the agreed upon delivery period. This might arise from a delay in harvest for example, or a production issue such as a drought or flood which wiped out their crop during the growing season. While this particular producer may feel comfortable in that only half of their expected production has been contracted, this is something that needs to be considered as the elevator may require that bushels be replaced in the open market if the producer is not able to satisfy the delivery agreement with their own production.
The advantage to this type of contracting alternative is that the buyer and seller get to customize the terms of the agreement to their particular needs. In this example, it also provides a “home” for the commodity which may be an important consideration for the seller. Let’s assume for instance that the producer does not have adequate storage on their farm for all of their expected production. It may be a priority to establish a guaranteed channel where these excess bushels can be delivered at harvest time, above and beyond what the producer is able to store. A dairy operation might likewise utilize a forward contract to make sure their fluid milk can be shipped in a timely fashion off their farm to a processor in the local market. In a similar way, a hog producer might want to ensure they have adequate shackle space for their marketing herd and also be drawn to using a forward contact in the cash market. The downside of this of course is that while they are guaranteeing an outlet for their production, they are doing so by committing physical supply to a counterparty at a set period of time in the future. As a result, they would want to feel confident that they can actually deliver this supply, and may therefore not want to contract more than they are absolutely comfortable committing to ship.
Another advantage of this type of marketing arrangement involves cash flow considerations. While a price is agreed upon between the buyer and seller in advance, they do not settle up on that price commitment until the physical delivery takes place in the future. This can be either an advantage or disadvantage, but for many sellers, this is a source of comfort as they simply receive payment for their supply upon delivery and do not have to worry about cash flow on that production in the interim. In our next installment, we will discuss the features of a futures contract and how that differs from a forward contract in the cash market. As we will see in that article, this is a key point of difference in that futures have a daily settlement procedure where cash flow considerations come into play. A final benefit of using a forward contract is that oftentimes a delivered price can be established in advance. By having greater price certainty over a certain amount of production, it assists with planning and budgeting and allows a producer to have better visibility on their forward margins.