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Risk Premiums and the “Three Destructions” of Crops

The grain markets follow a fixed cycle of production, flowing from planting to harvesting at specific times of the year.  The National Oceanic and Atmospheric Administration and the United States Department of Agriculture (NOAA/USDA) Joint Agricultural Weather Facility refer to these stages as moisture and temperature sensitive stages of development.  During these stages of development, the crop is vulnerable to damage from the forces of nature. 

During planting, too much rain fall can make field work difficult to impossible.  Late plantings can result in loss of acreage or late development which can result in a lower quality crop or lower yields.  Too little rain can prevent seeds from proper germination, resulting in loss of production as well.

During pollination, or the reproductive stage of crop development, excessive heat and a lack of precipitation result in poor pollination and lower pollination.  Extremely low temperatures and/or excessive rainfall can hamper pollination as well, resulting in crop loss.

During the later stages of maturation and/or harvest, excessive heat can cause crop damage.  Prolonged exposure to moisture can reduce quality, allow mold-based diseases to spread, as well as delay the harvesting effort due to the ground being to muddy for fieldwork.  Early frosts can damage crops as well.

Because grains are produced annually (once a year, in most cases), supply is replenished only once a year.  Grain usage, though it ebbs and flows, is spread out throughout the year.  Thus, yearly production must be rationed.  The rationing mechanism is PRICE.

Price is a function of not only current supply but perceptions of future supply as well.  When current supply is plentiful and/or future supply appears abundant, grain prices tend to decrease as consumers become less anxious to secure supply at today’s prices and producers market their crops more aggressively to secure today’s pricing before prices erode more.  When supply is relatively scarce and/or future supply looks uncertain, consumers tend to be more aggressive in pursuing available supply and producers less ready to part with production, which results in rising prices.

The amount of change in price due to future supply perceptions is known as the RISK PREMIUM. When future supply is perceived to be tight or limited, the futures markets tend to “build a risk premium” into prices, with prices tending to be higher than one would expect based on current supply and usage patterns.  As future supply perceptions become more secure, the futures markets tend to “remove the risk premium” from prices, resulting in pricing closer to the lower level that reflects supply and usage patterns.  Hence, the futures markets tend to reflect the marketplace’s perception of future supply by increasing or decreasing the risk premium factored into prices based upon how secure it feels future supply is.

Because crops are most vulnerable to damage at Planting, Pollination (reproduction), and Harvest, futures prices tend to reflect this by increasing in prices to compensate for the uncertainty surrounding future supply.  Because markets are emotional, driven by the forces of fear and greed, prices can reflect irrational expectations about the future… essentially destroying the crops in the pits of Chicago based on these emotions during the three critical stages of development.        

We have coined the term The Three Destructions of Grain Crops as a description of the “irrational exuberance” – to quote Federal Reserve Chairman Greenspan- which occurs in the building and removing of risk premiums.  Understanding the relative risk associated with a crop during certain stages of development can be a useful guide in understanding grain pricing.  The size and extent of risk premium varies greatly from year to year, based on current and perceived supply and usage patterns.  Though there is no guarantee that this pattern will continue in the future, it has served as a guideline in the past.

Spring Planted Crops

Corn and Soybeans are planted in the spring.  Corn planting in the United States typically begins in late March and is completed by mid to late May.  During March and April, possibly in response to planting worries, Corn futures have gained a total of 100 ¾ cents in the last 19 years – see table at right. Soybean field preparation and planting typically lasts from mid March through May.  During the early stages of the planting effort (March & April) soybean futures have gained a total of 357 cents in the last 19 years - see table below.

Total Gain (Loss) in the Last 19 Years 
(in cents per bushel)

Past Performance is not necessarily indicative of future results.

The Corn crop typically pollinates in late June and early July.  During the month of June Corn futures have gained a total of 4 cents in the last 19 years.  During August, Soybeans begin to set pods or reproduce.  In the last 19 years, August has seen Soybean Futures gain a total of 116 cents.  Though reproduction is a very weather- sensitive time, even a poor pollination ensures some future production so the market tends to factor in a smaller risk premium than at planting.

Harvest delays, or at least the fear of such, tend to grip the market most years.  Corn is typically harvested in October and November, which in the last 19 years has seen prices decline a total of –32 ¾ cents.  Do note that harvest concerns, like other market worries, tend to happen before the fact when uncertainty is greater.  Soybeans are typically harvested in October and November, which combined have seen Soybean prices increase a total of 5 ¾ cents in the last 19 years.

Three Destructions Vs Rest of Year 
(total gain(loss) in cents during past 19 years)

Past Performance is not necessarily indicative of future results.

Notes: the tables above uses futures data provided by Gecko Software from 1981 to 2000, or the most current 19 years.  The following futures contracts were used for each month: Jan-Feb (CK,SK), Mar-May (CN,SN), Jun-Jul (CU,SX), Aug-Sep (CZ,SX), Oct (CZ,SF), Nov (CH,SF), Dec (CH,SH)

The most telling evidence that the futures market builds a risk premium into prices during the Three Destructions (planting, pollination, and harvest) can be seen in the table above entitled, Three Destructions Vs. Rest of Year.  Though one can’t say for sure that these tendencies will continue in the future – given changes in farming –but historically the grain markets have experienced the bulk of there gains during times of the year when the crop is susceptible to damage.

Winter Planted Crops

Winter Wheat is aptly named because it is planted in the fall and harvested in the summer.  Winter Wheat tends to exhibit the same type of behavior of building and removing risk premiums as Corn and Soybeans, though the times of the year are different and the reaction to threats is different.

Total Gain (Loss) in Last 19 Years 
(in cents per bushel)

Past performance is not necessarily indicative of future results.

Winter Wheat is typically planted in September and October.  During planting in the last 19 years Wheat futures have gained a total of 24 ¾ cents.  After planting winter wheat goes into dormancy from November through to March.

Emerging after the dormancy, Wheat is susceptible to a lack of rain, late frosts, and a host of other problems.  This reproductive rally, during heading, is the largest of the three destructions, seeing wheat futures gain a total of 177 cents in the past 19 years.

Harvest for wheat is typically a non event.  Because wheat can sit in the fields for a long time maturing, as long as it remains dry, harvest damage is typically extremely rare.  With harvest typically beginning in July and August, farmers typically have plenty of time to harvest their crops.

3- Destructions Vs Rest of Year 
(Total gain (loss) in cents during past 19 years)

Past performance is not necessarily indicative of future results.

Notes: the tables above uses futures data provided by GeckoSoftware from 1981 to 2000, or the most current 19 years.  The following futures contracts were used for each month: Jan-Feb (CK,SK), Mar-May (CN,SN), Jun-Jul (CU,SX), Aug-Sep (CZ,SX), Oct (CZ,SF), Nov (CH,SF), Dec (CH,SH).

Like its spring planted brethren, Winter Wheat tends to gain the most when the crop is susceptible to damage and future supply is uncertain.  In the last 19 years, Winter Wheat futures have gained a total of 84 cents during the Three Destructions while the rest of the year has seen prices decline by a total of –432 ½ cents.

Conclusions

Understanding the presence of risk premiums can be beneficial for both speculators, as well as hedgers.  The size and extent of risk premiums varies greatly from year to year. However, understanding that this pattern may repeat can definitely help speculators and hedgers position themselves accordingly.

Risk premiums tend to be the largest when current supplies are tight as well, and in years when current supply is abundant it appears that risk premiums aren’t even present.  Like any study, keep the concept in mind when using grain futures, but do not expect the past to repeat itself exactly.  After all, one can’t drive forward looking only in the rear view mirror.

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Disclosure of Risk: The risk of loss in trading futures and options can be substantial; therefore, only genuine risk funds should be used. Futures and options ARE not suitable investments for all individuals, and individuals should carefully consider their financial condition in deciding whether to trade. Option traders should be aware that the exercise of a long option would result in a futures position.

SEASONAL TENDENCIES ARE A COMPOSITE OF SOME OF THE MOST CONSISTENT COMMODITY FUTURES SEASONALS THAT HAVE OCCURRED IN THE PAST 15 YEARS.  THERE ARE USUALLY UNDERLYING, FUNDAMENTAL CIRCUMSTANCES THAT OCCUR ANNUALLY THAT TEND TO CAUSE THE FUTURES MARKETS TO REACT IN SIMILAR DIRECTIONAL MANNER DURING A CERTAIN CALENDAR YEAR.  EVEN IF A SEASONAL TENDENCY OCCURS IN THE FUTURE, IT MAY NOT RESULT IN A PROFITABLE TRANSACTION AS FEES AND THE TIMING OF THE ENTRY AND LIQUIDATION MAY IMPACT ON THE RESULTS.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT HAS IN THE PAST, OR WILL IN THE FUTURE, ACHIEVE PROFITS USING THESE RECOMMENDATIONS.  NO REPRESENTATION IS BEING MADE THAT PRICE PATTERNS WILL RECUR IN THE FUTURE. 

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.