Commodity Futures: Agricultural

Updated: Sep 21, 2020

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Traders can use agricultural futures contracts to transact various commodities, livestock such as: cattle and hogs, agricultural grains such as: corn, wheat and soybeans, soft agricultural commodities such as: coffee, cotton and sugar, and others such as whey and lumber.

Supply, rather than demand is the primary driver and relationship to determine commodity future price. Agricultural products have a unique production cycle since most of them are produced during a certain season and consumed until the next production cycle. This differs from other non-agricultural products which can be produced throughout the year. Once crops are planted, no more can be planted until the following season. This creates a situation where product supply is extremely important, and any changes in anticipated yields may have an extreme effect on price. There is a supply and demand cycle where analysts are required to forecast uncertain supply as crop and yields vary each cycle. Sometimes yields are higher than expected but sometimes they can be lower.

Weather is the most important factor effecting supply and price for most agriculture products and it influences the entire crop production cycle: planting, growing and harvesting. The weather during each phase of the growing cycle can be tracked and opinions formed on how it will affect yields. The weather during planting, growing and harvest seasons can reduce expected yields, which will impact prices of the futures contract. For e.g., if weather during planting is too hot or too wet, seeds will not germinate properly, so yields may be lower than average for acreage of planted crops. This will affect supply and therefore price of futures contracts.

Analysts will study weather reports as well as crop reports produced by the United States Department of Agriculture (USDA) to study crop yields and livestock. These are detailed reports from the US government that provide status updates on the supply of agricultural products. The crop progress report offers a country-wide assessment of how crops are progressing through growing cycles and whether yields are predicted to be lower or higher than anticipated. The report is updated weekly every year from April to November by the National Agricultural Statistics Service (NASS).

Traders interested in soy products can review information from National Oilseed Processors Association (NOPA), while traders of livestock can view information from National Grain and Feed Association (NGFA).

Other factors, besides weather, affecting pricing of agricultural futures include:

· Land use of farming and inventory levels

· Government subsidies availability for farming

· End uses of crops

· Changes in end use of crops

The price and demand from the previous season can manipulate the type of crops planting in the following year for the same farm area. For e.g., a corn farmer might switch to soy if they believe they can generate higher profits from growing that crop. If farmers have excess inventory, they might not want to farm as much the following year, limiting supply and increase prices. This leads to increased production and supply in the next following year, causing prices to drop. This cycle can repeat, causing discrepancies in the crop yield forecasts.

Government subsidies are common in the agricultural market. These subsidies will change over time and can enable one crop to be more advantageous for farmers to grow than another, i.e. there might be incentive for farmers to grow a different crop that might be more profitable. For e.g. if soy is being heavily subsidized, farmers might be interested in growing the crop since it might have lower production costs due to subsidies. The excess supply can lower prices as more producers grow crops that are subsidized.

The analyst will study secondary uses for a agricultural commodity in addition to the primary use when building price forecasts. The profitability of these extended uses may shift supply from one less profitable use to a more profitable use. For e.g., corn used as food directly and in its processed form, and it is also used in ethanol production. If the demand for ethanol increases sufficiently high, and these producers are willing to pay higher prices for corn being used for ethanol production rather than for food, this will change the fundamentals of the corn market and the price drivers.

The agricultural futures market contains many exchangeable or substitute products within the market. For e.g., soy, corn and wheat can both be used for livestock feed or food production for humans. If one commodity increases in price, farmers may be able to switch to the other commodity to feed their livestock for a cheaper cost. Some commodity can be easily substituted for another. If so, supply issues might have large price impact since customers who cannot obtain the commodity can easily switch to another.

The differences in the ratio of prices between different stages of production for a commodity can be analysed. For e.g., a trader can choose between soybeans, soy meal and soy oil. Since costs to refine soybeans remains constant over time, the ratio of price between each stage of refinement should remain fairly steady. The trader can analyse this ratio change to help determine if one soy products is relatively overvalued or undervalued compared to another.

In conclusion, agricultural products are unique as only limited amounts can be produced at certain times of the year. These products are perishable and require storage facilities to match seasonal supply to demand that occurs all year-round. The market is challenging with different variables, so very specific models need to be applied to make future price assumptions.

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