Farming is full of risk. In any given year, growers face numerous weather perils ranging from droughts and floods to hail storms, windstorms, tornadoes and the occasional hurricane. Even when producers escape those extremes, growing conditions must be favorable at critical periods in the growing cycle, like planting, germination, pollination and so on. After the crops are grown and harvested producers still encounter risk. But the greatest risk of all may not be associated with producing commodities, but in marketing or selling them.
Two methods that are commonly used to sell commodities are:
- Cash Marketing
- Forward Contracting
A Farmer has always marketed his crop according to his father’s old adage. Don’t sell something you don’t own. So that farmer has built plenty of storage bins to hold all that he produces each year. The farmer usually sells his grain several months after harvest on price rallies.
His practice of storing his entire crop assures he won’t be forced to take the harvest price, which typically is among the lowest of the year. He can store the crop until the price reaches the point where he wants to sell it for cash, usually at a local elevator.
By storing his grain he hopes for a favorable price sometime in the future. He has not entered into any kind of contract to deliver the grain at a certain time or at a certain price and his primary risk is that prices could move lower while he is holding his grain. Farmer also stores most of his crops on the farm. But for some of his crops, he establishes.
A forward contract is an agreement to deliver a certain amount of a certain commodity at a certain time in the future because no one really knows whether prices will go up or down. A forward contract locks in a price that is higher than the current cash price.
A strategy of forward contracting with his local elevator guarantees him a known price for some of his crop. But the agreement restricts his flexibility to change his mind and sell directly into the cash market. Your primary risk is if prices are higher at the delivery date. You can still obligated to deliver the contracted grain at the lower price he agreed to earlier.