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Thursday, March 03, 2016

Taking advantage of low input costs

By Andrew Whitelaw  |  Source: World Bank, AAA

Key points

  • Crude oil is sitting at the 11th percentile, and the market may be reaching the bottom.
  • Global urea prices are at the 34th percentile at the end of January.
  • Input swaps are more common in other countries and industries. However, uptake has been limited in Australian agriculture.

2016-03-03 Input Hedging Fig 1

2016-03-03 Input Hedging Fig 2

The decline in commodity prices over the past year has resulted in considerable falls in the costs of fertilizer and fuel for farmers. The reduction in costs for these major inputs will be beneficial for farmers for this year, but how can we extend the benefit to future years.

In February we ran an article examining the relationship between Natural gas and fertilizer, which showed a high degree of correlation between the two. We also published an article examining the impact of the collapse of crude oil on local fuel prices.

The market for fertilizer is sitting at a 34.8% and 52.6% (figure 1), and crude oil is 10.9% (figure 2). It is hard to predict where prices will be. However, based on the current percentiles we are likely to be close to the bottom of the range on oil. In contrast, fertilizer may have some room to fall further. What are the options for securing fuel and fertilizer prices for the longer term?

Physical hedging

The most obvious option for locking in your fuel and fertilizer for long term is to physically purchase large quantities to tide you over for the future. This may sound like a good plan. However, it requires that you have adequate storage for large quantities. In a similar vein to storing grain on farm, holding inputs for the long term requires storage to be adequate to minimise the risk of degradation.

In addition to potential extra costs for storage, there is also the large upfront costs of purchasing a sizable volume of inputs above your typical annual requirements. This would be a sizeable drain on a budget, although with low interest rates available it may be a justifiable approach if it saves costs in the future.

Derivatives

The alternative to physically buying large volumes of inputs is to use derivative products. Most grain growers will be aware of grain swaps. However, many will be unaware of the other derivatives on offer for inputs.

In Australia there are a number of banks which are able to offer diesel/energy swaps. These work in a similar way to grain swaps (swap guide) in that they lock in diesel prices for a future date. These contracts tend to be based on the Singapore tapis gasoil in A$, which will maintain an element of basis risk between the swap price and the physical purchase price. These contracts are available from a number of banks including NAB and Westpac, they do however require relatively high volume requirements but this may be open to negotiation.

In relation to fertilizer, there is a growing use of fertilizer swaps in the US & Europe. There has however been very limited uptake in Australia at present. These swaps work in the same way as the energy and grain swaps, although as they are priced in the US there is both exposure to currency* and basis. 

In time the hedging of inputs for producers will become common practice in Australia, as a strategy for protecting against increased input costs.   

*It is possible to hedge the currency, which would then provide cover from all but basis.  

What does this mean?

If you were to put ten oil and gas analysts in a room and asked where prices would be in a year, you would likely get ten different answers. It is likely that we are close to the bottom of the market in oil (fuel) and gas (fertilizer).

It is advisable to examine farm inputs in the same way as our outputs, in order to create strategies to reduce costs.

Mecardo information is provided to assist in your marketing decisions. It contains a range of data and views on the current market. It is not intended to constitute advice for a specific purpose. Before taking any action in relation to information contained within this report, you should seek advice from a qualified professional. The information is obtained from a variety of sources and neither Mecardo nor Ag Concepts Advisory will be held liable for any loss or damage whatsoever that may arise from the use of information or for any error or mis-statement contained in this report. 

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