Hedging vs. Forward Cash Contracting

• January 5, 2010
• Paul Neiffer

 Most ag grain producers are able to lock in prices by using either a hedge or a forward contract.  Forward cash contracting involves a commitment to deliver grain to a grain buyer at a future time.  Both alternatives can be used to: price before and after harvest; establish a return for storage of grain; and reduce price risk.  Thus, deciding which alternative to use depends upon weighing hedging advantages and disadvantages in comparison to forward cash contracting.

Hedging Advantages vs. Forward Cash Contracting

• Hedging allows flexibility to later select the appropriate delivery point to take advantage of competing buyers for your grain.
• Hedging allows you to reverse a decision based upon changes in growing conditions, changes in price outlook and changes in the condition of stored grain.  Once a forward cash contract commitment is made, it is very difficult to change or cancel.  A position in a futures contract can be terminated almost immediately.
• Hedging allows the farmer to speculate on basis improving.
• Hedging generally lengthens the potential pricing period to 20 to 24 months, including about one year before and after harvest.  This can be longer than a forward cash contract.

Hedging Disadvantages vs. Forward Cash Contracting

• In hedging, you may not know the final price due to changes in the final basis as compared to the initial basis.
• Hedging is more complex than forward cash contracting.  To hedge successfully, a farmer must understand futures markets, cash markets and the basis relationships between the two markets.  They must trade in a futures market and involve a commodity broker and have a banker who understands and is committed to hedging.
• Margin money is required to maintain a futures position.  A forward cash contract typically does not involve margin deposits.
• Hedging involves commissions and interest on margin money.  These extra costs may average 1 to 2 cents per bushel.
• Since hedging generally involves using future contracts in either 1,000 or 5,000 bushel lots, the farmer is locked into these quantities to hedge.
• Basis levels may not gain as expected and can even widen more than expected.

Remember that hedging never guarantees a profit.  The hedging decision needs to take into account production costs and market outlook.  However, the good use of a hedging program can help the farmer prevent pricing indecision where the farmer “does-nothing-until-forced-to-sell-strategy” which normally leads to much lower prices.

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