The 2018 Agricultural Commodity Futures Conference was held in Overland Park, Kansas on April 5-6, 2018. This meeting was sponsored by the Commodity Futures Trading Commission and the Center for Risk Management Education and Research in the Kansas State University Department of Agricultural Economics.
The agenda for this conference and a number presentations are available at the following web location:
Following is the second of two articles by KSU Agricultural Economics Art Barnaby and Daniel O’Brien discussing the findings of the conference – with a focus on the relationship between crop insurance and grain futures. This article is also available at the following web address on the KSU AgManager.info website:
Experts Overstate Crop Insurance Competition with CME
G. A. (Art) Barnaby, Jr. (firstname.lastname@example.org) , Professor, Dept. of Agricultural Economics
Daniel O’Brien (email@example.com), Extension Agricultural Economist
K-State Research and Extension, Kansas State University, Manhattan, KS 66506
April 18, 2018.
Kansas State University and the Commodity Futures Trading Commission (CFTC) recently held a joint conference on the lack of convergence in grain futures. In addition to hedges, convergence is required for crop insurance claims to work properly. Many in the grain industry still think revenue-based crop insurance tools compete with their grain futures contracts. Making this argument even more confusing is a new report from Harvard and other Law Schools[i].
[i] Art Barnaby’s Disclaimer. Harvard Law did contact me and asked me to put together a group of people to discuss these Farm Bill and risk management issues. I don’t want to speak for the group, but as for myself, I agree very little in this report. We gave them the other side of the crop insurance, commodity titles, and hedging story, but those comments were not included in their report.
Issue #1: Crop Insurance
As a group, there are still a large number of traders who think government-backed crop insurance competes with them for the farmer’s risk management dollar. Many of these misunderstandings originated from academic researchers, and more recently by a group of Law Schools.
The FBLE group (see list of Farm Bill Law Enterprise (FBLE) member institutions in AgManager article) argue the existing Harvest Price Option (HPO) subsidies encourage over-exposure to the futures markets and farmers should not forward price more than a third of their expected crop.
However, Smith, et al., argue that price coverage is available via private futures market exchanges, therefore revenue insurance is unnecessary. See Smith, Vincent H., Joseph W. Glauber, and Barry K. Goodwin, “Time to Reform the US Federal Agricultural Insurance Program”, American Enterprise Institute, 2017. As a result, one academic expert suggests farmers should use futures, and another academician says no, farmers are over-exposed to the futures.
However, both are wrong. Once farmers plant their crop or hold unpriced inventory they are 100% exposed to the real cash market of potentially falling prices. Following the one-third argument, farmers would still have two-thirds of their crop exposed to downside price risk.
Issue #2: Limited Put Competition
The USDA-backed revenue insurance provides limited competition to Chicago Mercantile Exchange (CME) traded puts, but not calls. About 79% of Revenue Protection (RP) insured corn acres are insured at 80% or less. An 80% RP insured farmer currently has an effective “put” strike at $3.17 (80% X $3.96 for 2018) on new crop corn. Farmers insured with 80% RP coverage and an average crop will need an October average closing December 2018 corn futures price below $3.17 to trigger payments.
However, this insurance “put” is way out of the money with current new-crop corn futures trading over $4, so the competition with CME is “small”. If yields are above average, then the effective RP “put” strike is even lower. Farmers can always produce their way out of a RP indemnity claim.
Note that the $3.96 corn strike price and October settlement price applies to crop insurance in Kansas, Northern Great Plains states, and Corn Belt states for the 2018 crop insurance contract. The crop insurance strike price is set earlier and the settlement price is determined earlier in Southern states.
Issue #3: Call Options
Revenue Protection is mis-named because when prices increase above the base price, RP is no longer a revenue contract. RP turns in to a yield-protection contract only. At that point, the only difference between RP and Yield Protection (YP), is that YP indemnifies guaranteed bushels at a below-market price, while RP indemnifies the same lost bushel at the current market price.
This is only complicated because the critics make it complicated in order create confusion among decision-makers, when it is actually simple. Should farmers be paid for their crop losses at a below-market price, or at the current market price?
Issue #4: Put Option Competition with Commodity Programs
The Farm Service Agency’s (FSA) Price Loss Coverage (PLC) provides a free “put” on old crop held in “inventory”. While the crop has been harvested, the PLC payment rate is applied to 85% of the farmer’s base acres times the historical program yield and subject to sequestration cuts. This payment procedure removes any yield risk, unlike the new-crop out-of-the money “put” in RP. The PLC “put” corn strike of $3.70 is based on the after-harvest 12-month national Marketing Year Average (MYA) price. USDA’s MYA price is normally about 15 to cents lower than futures and PLC payments are made about a year after harvest, if any.
Agricultural Risk Coverage (ARC) also provides some old crop “put” protection, but it is more complicated than PLC because the payment is tied to the county yield and the strike price is a 5-year Olympic average of the USDA-determined price. The current Olympic average USDA price is $3.95 X 86% setting the effective corn “put” strike at $3.40 with an average county yield. Both PLC and ARC have a price stop-loss at the loan rate. There can be a little slippage because the ARC-PLC trigger payments are based on NASS prices and loan payments are triggered by the FSA-determined county price (explained below).
For those who are “concerned” about small farmers, their crop yields are less likely to be highly correlated with the county yield. If a farmer were to farm the entire county, then there is no difference between their enterprise unit yield and the county yield. Nearly all farmers can cite cases where they received no ARC payments, but the county across the road did receive an ARC payment. So as a replacement for put option price protection, ARC is a bit iffy, especially on small farms. Again, any ARC payments are made only on 85% of the base acres, about a year after harvest, and subject to sequestration cuts, if any ARC payment is due.
Issue #4: Marketing Loans
At very low price levels, the FSA loan rate is effectively a free “put” on all farmer-produced bushels with no effective payment limit. The current national loan rate for corn is $1.95 and $5.00 for soybeans, therefore the loan provides a “put” that has been way out-of-the-money for years. Effectively, the loan rate on corn and soybeans provides a “put” with a near zero value. However, the wheat national loan rate of $2.94 did trigger in Kansas and many other counties after the 2016 wheat harvest, and created an in-the-money “put”. Note that the loan rate price is set by county. Rather than requesting an FSA loan at the loan rate, farmers can elect to take Loan Deficiency Payments (LDP). An LDP payment is the difference between the loan rate and the FSA-determined Posted County Price (PCP). The PCP is a daily USDA price and is not the same as the NASS MYA price.
Most farmers just claim the LDP, but farmers can take a loan on all harvested bushels at the county loan rate price. Unlike a put where farmers pay premium for a CME put, farmers can take the loan and receive cash. They will receive the loan in cash and at the end of 9 months they can pay off the loan at the lesser of the PCP or PCP plus interest, keep the difference, and avoid the payment limit. Farmers have the option to pay the loan off early. This is a non-recourse loan, therefore at the end of 9 months, farmers can forfeit the grain to the government and keep the loan proceeds. Most farmers don’t forfeit grain because they gain more by repaying the loan at a PCP price that is normally lower than the loan rate. The loan gain, similar in concept to loan right down, will approximately equal to the LDP.
The loan puts a price floor in the market for farmers, but not the market. Because farmers can pay the loan off at the PCP, the farmer’s minimum price is the loan rate, but the cash market can still go lower and did on 2016 wheat. There were days when the Kansas LDP wheat payment was over 40 cents a bushel. During this period the loan rate was providing a deep in-the-money free “put” and was in direct competition with CME traded puts.
In most years, the LDP payments are not a factor. The corn and soybean loan rates are so far out-of-the-money and provide almost no competition with CME traded puts. The only recent exception was 2016 wheat when the LDP did trigger on wheat in many counties. When prices are near the loan rate, there is no reason farmers would purchase puts when they are effectively receiving “free” puts from FSA.
Issue #5: Whole Farm Crop Insurance (WRCI)
WFCI contracts are whole-farm insurance with RMA premium discounts and guarantees based the farm’s prior 5 years of tax return incomes. The WFCI should not be used by farmers that use CME traded futures and options, because the gains are not counted in the historical 5 years of income that set the guarantee. However, hedging losses in one’s brokerage account are not included in a claim settlement, resulting in a lower indemnity payment. WFCI insured farmers who want to manager some of their price risk will need to use derivatives offered by elevators such as forward contracts.
One should not rule out the possibility that a WFCI insured farmer could set up a separate LLC organization to hold one’s futures trades and remove those trades from the farm tax return. This would require professional help from an attorney and tax accountant to keep futures gains-losses separate from farm income. This is another example of government policy generating unintended consequences.
The CME could argue the WFCI provides direct competition for their farmer customer who uses private tools to manage price risk. However, at this point, WFCI has been sold mostly to farmers growing crops that are not traded on the CME or in locations where the price basis is unpredictable, providing another example of why it is important that convergence occurs and gives some predictability to the cash basis.
FSA’s PLC and Marketing Loans provide direct competition with CME-traded puts WHEN markets are extremely low. However, currently the “strike” for these program are low enough that the “put” protection is way out-of-the-money for corn and soybeans, but these USDA programs have provided recent “put” protection on wheat.
Revenue insurance and ARC provide limited competition with CME traded puts, but currently these “put” derivatives are out-of-the-money on corn and soybeans. If policy makers want to eliminate any “small overlap” with traded puts or the commodity programs, they would remove the “put” (revenue) from RP and retain the HPO.
The HPO is NOT competition with calls. HPO turns the revenue insurance product into a yield guarantee only. When HPO triggers, the RP is the same guarantee as YP, but YP indemnifies the lost bushel at a below-market price while RP indemnifies the lost bushel at the current market price. As a result, RP is a complement to futures because it maintains the hedge on forward-priced bushels. Both YP and RP contracts require a yield loss greater than the yield guarantee to trigger any payments.