There have been more articles written on why farmers should be using options and futures to hedge the prices they receive for their commodities than there are cotton bales traded on the New York Board of Trade cotton futures.
Well, maybe not that many. It just seems like it.
With that much ink on the subject, you would think hedging and options would be an integral part of the business plan for one of the most well-known and progressive cotton operations in California, Borba Farms, a 14,000-acre farming partnership in Riverdale, Calif., in the heart of the San Joaquin Valley.
Surprisingly, it has not. Borba has used futures and options in the past to help price its cotton, but abandoned the practice when the federal farm program seemed to reduce the need for these special tools. However, Borba Farms is once again using options to enhance the returns for a portion of its 4,400-acres of cotton in Western Fresno County.
What has brought back the need for Borba to use options or hedging? Unnerving market swings of more than 30 cents per pound for the life of a New York futures contract for one thing. Rising production costs is another and finally the fear that some day soon the federal farm program safety net may disappear has caused Borba Farms to re-evaluate the role of futures and options in their cotton marketing program.
Borba Farms partners brothers Mark and Ross Borba and Terry Amaro have studied options and futures for a decade and have attended many meetings on the subject.
However, it was not until earlier this year when highly respected Texas A&M economist Carl Anderson spoke at a pair of marketing seminars in the San Joaquin Valley set up by University of California and California State University Fresno's Center for Agricultural Business that they decided to toss a line into waters where few growers venture as an element of their farm business plan.
Understanding how options and futures work is not the secret to using them, according to Amaro.
Act on judgments
“Futures and options are simply instruments that allow you to act on judgments based on your analysis of the market,” said Amaro.
While there is more volatility than ever in cotton and other commodity markets, there still remains some degree of predictability based on discernable facts — size of world crop, supply and demand, weather conditions, world economic conditions based on past history — all the factors that can play into a cotton market.
That is what Anderson pointed out — with conviction. It was that conviction that convinced the principals at Borba Farms to take out options positions for its 2004 upland crop.
“If we want to be champion cotton marketers, we should become better fundamental and technical market analysts,” said Borba. “We believe we understand how options and futures work as well as anybody does. That is not the secret. The secret is becoming more effective at forming judgments on what is affecting the market today.”
Sounds simple enough, but Borba said he believes his fellow San Joaquin Valley cotton farmers have long had difficulty doing that.
“Growers cannot divorce themselves from emotions. When you base decisions on unbiased assessment of fundamental and technical factors you have to divorce yourself from emotions,” said Borba.
“Carl Anderson was not predicting December '04 cotton futures cotton would go to 50 cents per pound, he was asking us last spring to consider what happens to us as farmers if it did,” said Borba.
That is a different mindset for farmers. Farmers are always looking at the upside and seldom evaluating the down side. Anderson tells the story of the two Texas cotton farmers outside the local cafe discussing cotton prices a few years back. They had soared to near $1 per pound, but the farmers decided to dig in their heels and hold out for that dollar. They never saw it and left a lot of money on the table of that West Texas cafe.
Borba learned that lesson last Decembers when spot prices reached 85 cents per pound. “We decided to wait until it hit 90 to sell the cotton we had left. We sat there and watched it go down and down and down and finally sold the balance of the crop at 76.5 cents per pound,” he said.
“I have been told that you should never fly higher than you want to fall,” said Borba. “I am now convinced that is very true.”
“Establishing an acceptable margin and developing a business plan to capture that margin is the hardest thing for farmers to do,” said Mechel Paggi, director for the CSUF Center for Agriculture Business.
“In eight years with Extension in Texas conducting marketing seminars, I realized folks had a difficult time establishing an acceptable margin for themselves — something they were not willing to do — lock in an acceptable price,” said Paggi.
However, it has been Texas growers and producers from other areas of the Belt who have embraced Anderson's admonition to act to protect themselves against wild market swings.
SJV growers have really not had to consider that because of the high yields and strong basis for high quality SJV Acala cotton, which can bring 3 to as much as 10 cents per pound more than other U.S. upland cottons. Growers in other parts of the U.S. Cotton Belt can experience a basis off that much. That is why they have stepped up to become aggressive marketers using options.
SJV cotton is in demand worldwide. There has not been a lot of competition for SJV Acala and as a result we have allowed ourselves to swagger around; plant the crop; harvest it and watch buyers pay 600 to 700 points on and say what's the problem.”
No longer enticing
Borba said West Side SJV cotton growers have long expected with certainty to make 68 to 72 cents per pound (with the farm program) on three-bale cotton year in and year out. However, with increasing costs, the problem has become that is no longer very enticing.
“It is principally the high cost of water that is making growers see red ink at those prices,” said Borba.
In a normal water supply year, growers in the nation's largest irrigation district, the 600,000-acre Westlands Water District that serves 600 farmers in western Fresno and Kings counties pay $60 to $75 per acre foot for two acre feet. If the snow pack is below normal, they could receive less. It takes 2.75 to 3 acre feet to grow a cotton crop. That second acre foot on the open market costs about $150 per acre foot.
“That averages out to about $90 per acre foot for water in a normal year. Add that to other rising cost like diesel and NH3, depending on debt structure three-bale Acala cotton is not that enticing,” said Borba.
That is not the total SJV cotton picture, Borba points out. Pima cotton can be an attractive alternative because of its higher grower return potential. However, breakeven is closer to 90 cents per pound because of added harvest and ginning costs and the seed value is lower, according to Borba. A longer growing season is an added risk with Pima. Pima cannot be hedged and there is no government price support program. However, there are federal loan market enhancement programs.
Borba Farm's 4,400-acres of cotton this season is split 50-50 between Acala and Pima.
Another factor improving the economic picture for SJV cotton is that Acala yields are increasing with newer varieties.
“Four-bale cotton used to be only in the coffee shop. However, it is now happening in the field. Phytogen 72 is legitimate 4-bale cotton potential, which pushes the yield advantage with Acala vs. Pima up 10 to 15 percent,” said Borba.
Nevertheless, Borba said those upsides with Pimas and higher yielding Acalas may not be good enough to stay in the cotton business unless growers can figure out how to flatten out the 30-cents per pound futures upland price annual roller coaster.
“We now realize there needs to be some way to tie a rope around our waist — we need to make some decisions to protect ourselves and our lenders,” said Borba.
That, Borba and Amaro say, can be the futures market and its options.
However, when bankers hear futures from a grower, they perceive speculation and don't like that, Borba admits.
“Unfortunately, growers deserve that reputation. Even if a grower started out with good intentions to hedge his crop and lock in a profit, the futures market can be intoxicating.
“At the coffee shop you hear how someone bought a contract and overnight made thousands. You think you should be able to predict the cotton market because you are in the cotton business and when it goes in the direction you think, you starting believing you are physic. I know because I am guilty,” said Borba.
Speculating is not using options as a safety net as Anderson convinced the Borba partners.
“What caught my attention at the seminars last spring was Carl Anderson's approach to analyzing the fundamental and technical factors affecting the futures market,” said Amaro.
What Borba Farms did was contract two-thirds of its 2004 upland crop with Dunavant of California with a 73-cents per pound floor price and bought put and call contracts to hopefully enhance that price.
Fortunately for Borba, the day their position on put and call options were established, the cost and return to establish their position was the same — 2.7 cents.
“Basically, it was a costless position,” said Amaro. “That does not happen very often. Usually it costs something to take a position, maybe only a few cents per pound. Nevertheless, it is a cost.”
Taking a position with options is not without risks.
“We could lose money. However, when we established our position we decided how far up and how far down we were willing to go,” said Borba.
Their position evolved into an eight-cent per pound gain one day.
“We sat around and talked about it when it reached 8 cents and said when do we close the position and put the money in the bank? We decided to call Dunavant and put a stop at 7 cents,” said Borba.
The market slide past seven to 6.75 shortly thereafter. “I thought we were the smartest people in the world until three mornings later the advantage was 10.75 cents. I kicked myself for not waiting three mornings.
“However, this is a business of need and greed…how high is high enough? If you look back and beat yourself for shoulda and coulda, you will never execute any of these plans,” said Borba.
It's all about looking for opportunities to enhancing a grower's position and risk mitigation.
The federal farm program has been that risk mitigation to this point. However, Borba and many other are concerned about the fate of the federal farm program in the future under the weight of the federal debt.
Farm bill concerns are nothing new. They surface every year. What makes the next time around different?
“For one thing, the retirements of the Southern boll weevil Democrats from Congress has me concerned. They have protected the farm bill for their constituents and for all of us. We need to be asking ourselves what is going to happen when those folks are gone,” Borba said. The federal farm program likely will not disappear, but limits could be put on larger farm operations like those in California.
“We hear antidotal comments from Washington, D.C., every year that things are going to change in the farm bill,” said Paggi. “However, we are hearing from people who should know that the next time around things will be a lot different because of the budget deficit and the cost of the war in Iraq. There will have to be federal spending cuts, and unfortunately ag is one area where budget cuts can be found.”
Loss of the federal safety net will make ag financing bankers very nervous.
“Going to a banker to get cotton financing with an historical 30-cent swing in the market each year and no federal safety net is going to force growers to have a cogent presentation of what they are going to do with options and hedging to protect bank financing,” said Borba. “Bankers are not going to be inclined to finance us or anyone else without it.”
The days of riding a roller coaster and hope for the best at the end of the season are coming to an end. Cotton farmers in the San Joaquin Valley are going to have to make decisions to protect themselves, predicts Borba.
“It is about putting in the effort to understand the market and then making decisions to protect yourself,” said Amaro. “It takes a lot of time to develop the information upon which to make decisions. However, the information is out there, from the National Cotton Council, New York Board of Trade and many other sources. It's a matter of taking the time to make market judgments and then acting on them.”
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