Today’s Opportunities: Low-Cost Feed Protection

As both corn futures prices and corn option implied volatility hover near historical lows, livestock producers may want to consider securing low-cost protection now for corn purchases farther out in the future.

New Lows for Corn Option Volatility
After a growing season that was surprisingly better than most analysts expected, the U.S. is projected to harvest 14.28 billion bushels of corn which will allow ending stocks to build for the fifth straight year since the historic drought of 2012. As a result, corn prices are languishing at multi-year lows just above $3.00/bushel, a level that has established itself as a de-facto floor in the post-ethanol era (see Figure 1).

Figure 1: Continuous Corn Futures (Oct 2006 – Present)
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Given this knowledge, there isn’t an expectation for prices to decline much further, especially considering that we are about halfway through harvest which seasonally marks a low point in futures as well as the cash market. At the same time, there isn’t much of an expectation for prices to rise significantly either with the large stocks overhang and lack of any near-term catalyst to cause longer-term supply concerns. As a result, options on corn are priced accordingly, with expectations for future volatility very muted as we move forward through 2018. As an example, the implied volatility on July 2018 corn options is currently trading at 16%, a new 15-year low for not only this time of year, but at any point during the year (see Figure 2).

Figure 2: July 2018 Corn Implied Volatility vs. 15 Year Range
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Risks Remain for Corn Buyers
While there certainly isn’t much on the horizon to jolt the market higher and cause corn to break free from the 15-cent trading range it has been stuck in for the past two months, risks still remain for corn buyers. First, commodity funds now hold 213,806 contracts of short positions in the market, approaching a record level from early 2016 (see Figure 3).

Figure 3: Commodity Fund Net Corn Position, Jan 1, 2006 – Oct 24, 2017
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In addition to the possibility of commodity fund short-covering, there is also the issue of a potential adverse weather development in South America as their growing season gets under way. According to the Rosario Board of Trade, corn planting progress in Argentina is almost 35% delayed compared to last year due to flooding. As of October 13, only 57% of the area had been planted, compared to 92% at this point last year. In addition, almost a million acres are still flooded in the north of Buenos Aires Province and south of Santa Fe. Meanwhile, a lack of rainfall has been a focus in the Midwestern growing region of Brazil. Although it is early in the growing season and there is no immediate concern to crops in either country, these are still risk factors for corn buyers to contend with over the next several months.

Purchase Protection When It’s Cheap
Given these uncertainties and the low historical level of both corn futures prices and corn option implied volatility, it may be prudent for livestock producers and other purchasers to consider longer-term protection for projected purchases through 2018. While some corn buyers may be comfortable simply booking corn in the current market given the historically low price levels, others may be more cautious with deferred purchases. Even though the spot corn price is historically low, the “carry,” or premium, of deferred corn futures prices to spot values is also historically wide. Figure 4 shows that at a current carry of around 30 cents/bushel, the spread between spot December and next year’s July corn futures contracts is near a five-year low and at the 10th percentile of both the past 10 and 15 years. Therefore, a buyer of deferred corn would be paying into this historically wide premium to secure future purchases.

Figure 4: Corn Futures Historical Spread Statistics (Dec 17-July 18)
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Because of the historically wide carry and amidst the uncertainty over the future price outlook, corn options may be an attractive way to protect forward purchases and upside risk in the current environment. As an example, let’s say a hypothetical corn buyer has to purchase the equivalent of 100,000 bushels for the months of May and June against July 2018 futures. The July 2018 corn futures contract is currently trading at a price of $3.76 ½, about 30 cents/bushel over the spot December 2017 price. The buyer wishes to protect this price level but at the same time, preserve the opportunity for the price to decline in a falling market. A July 380 call option is trading for a premium of 17 ½ cents/bushel. If the buyer purchases this call option, their maximum price for corn in this purchase period (exclusive of basis) would therefore be $3.97 ½, which is the equivalent of the strike price of the option plus the cost of the premium. Should the market move lower, the buyer will be open to price and effectively 17 ½ cents above the market for their purchase.

While this scenario assumes the option is held until expiration in late June, the buyer will most likely exit the option ahead of expiration following a change in price. Ideally, if the market moves lower, the buyer will be able to purchase the corn cheaper while still retaining some of the residual call option value. Even if the market does not move, this premium will erode very slowly with the passage of time. Figure 5 illustrates the theoretical value of the option about three months from now on February 8. Assuming no change in the corn futures price or in the implied volatility of the option, the July 380 call would still be worth almost 14 cents, thus only losing about three cents of value in the next 98 days.

Figure 5: July 2018 Corn 380 Call at 135 DTE
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Now let’s consider another scenario in which there is still 135 days to expiration on February 8, but the implied volatility of the option has risen four points to 20%, about the same level as this year’s implied volatility for July corn options in early February, and still well below average from a historical perspective. Figure 6 shows that the increase in implied volatility in this scenario will give the option a theoretical value of about 17 ½ cents, completely offsetting the time decay of holding the option over the next three months.

Figure 6: July 2018 Corn 380 Call at 135 DTE and 20% Implied Volatility
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While the implied volatility of July corn options may also decline between now and February, there is a seasonal tendency for it to gradually increase into the spring (see Figure 7). Thus, a corn call option buyer can leverage a few characteristics of the current market profile to their advantage: the fact that prices are historically low, but the carry is also wide; that corn option implied volatility is trading at a new 15-year low; and that there is a seasonal tendency for this implied volatility to rise over the winter – potentially mitigating the impact of time decay during this holding period. While it may be unlikely for corn prices to rise significantly over the medium term, there remain risk factors in the market and it is not necessarily wise for buyers to be complacent. Call options can help draw a line in the sand against deferred purchases, protect historically low price levels, and preserve opportunities for better pricing opportunities down the road.

Figure 7: July Corn Option Implied Volatility 10-Year Seasonal Tendency
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If you’d like more information about how to protect forward corn prices and livestock margins, and how options can help you maintain the flexibility you need to navigate an increasingly uncertain landscape, please call CIH at 1.866.299.9333.