November 24, 2008

Sometimes there is a silver lining in the storm clouds, particularly for US grain elevator operators who hedge their business properly.

 

Although this fall's collapse in cash grain prices has been painful for farmers, the downtrend occurred just in time to pull grain elevators back from the brink of financial ruin. The elevators had been threatened by a record-high spike in corn, wheat and soy markets that occurred earlier this year. Despite their good fortune, however, some analysts caution that volatility is still around to wreak havoc in the grain industry.

 

For the present, grain merchants welcome the turn of events.

 

"Crop prices and co-product values are down from their highs, and of course, we typically benefit from lower corn prices in the longer term," said Steve Mills, chief financial officer for the Archer Daniels Midland Co. (ADM), which reported quarterly earnings of just over US$1 billion earlier on November 4.

 

ADM, the world's second-largest grain company, buys its grain directly from growers to trade and to process. The price it has to pay to grain growers has fallen by 50 percent to 53 percent for corn/soy and 63 percent to 71 percent for wheat during the past five to nine months leaving corn now worth less than it has been in over a year.

 

That extreme drop in grain prices has produced a vast improvement in the cash-flow situation of grain elevators at a time when farmers are selling newly harvested fall crops, and elevator cash-flow needs are the greatest.

 

Another grain firm, Andersons Inc. (ANDE), said on Nov. 4 that its third-quarter earnings were up 22 percent. The company is best known for its string of grain elevators, but also sells ethanol and plant nutrients as well as leasing and repairing railcars.

 

Most of those financial gains come from the extremely profitable short positions that elevators adopted as a futures hedge when producers forward-contracted grain for sale at much higher market prices. A contract-hedge consists of the elevator effectively "selling" an equivalent amount of grain at a futures exchange to cover cash inventory or forward-contracted commodities that a buyer may hold or expect to be delivered.

 

"If prices are lower at harvest, gains in the futures market offset the price difference between the higher contract price and the current cash price, protecting the elevator or merchant's price margin," said John Robinson, Texas A&M University extension agricultural economist.

 

Elevators serve as 'middlemen' in the US grain-marketing system, buying crops from farmers and holding them in storage before re-selling them to stockmen, exporters or food processors. When crop prices are favourable, farmers enter into contracts with elevators as much as two or three years in advance so they can sell their crops at those higher values, even if cash prices fall.

 

Many grain elevators holding hedges experienced a severe cash-crunch this spring, as rising prices forced them to make millions of dollars in margin-calls accrued by their short positions, at times tapping out their credit line and forcing some to stop offering long-term forward contracts. Thus, many farmers were only able to sell grain to elevators on a nearby basis and couldn't lock in long-dated contacts.

 

Andrew McKenzie, an associate professor of agricultural economics and agribusiness at the University of Arkansas, said those margin calls came "large and fast," until about Independence Day.

 

Since then, those unprofitable positions have turned into cash cows, milking millions of dollars from futures market speculators who had bet that prices would continue to go up, and returning that money to the pockets of grain elevators. For soy, that decline has amounted to more than US$40,000 for each CBOT contract entered into during the mid-year high.

 

As a result of the financial improvement, the National Grain and Feed Association - the elevator industry's leading trade group - recently announced a 10 percent across-the-board reduction in membership dues, citing membership growth and strong financial conditions. The NGFA consists of 935 grain, feed, grain processing, exporting, biofuels and other grain-related companies that operate about 6,000 facilities and handle more than 70 percent of all US grains and oilseeds.

 

Although most elevators are flush with cash now, some experts warn that the record volatility of 2008 grain markets may still exact a toll on commercial grain firms. That volatility already has claimed the financial life of several ethanol companies and forced others to disown forward contracts written with growers.

 

"Our ag industry is headed to a crisis in contract law," warned Linn Group analyst Roy Huckabay earlier this week. "This is another fallout of the extreme prices we have experienced over the last year. Counter-party risk will haunt our industry for months to come."