By Andrew Whitelaw | Source: USDA, ASX, ACU, Trade
In our article last week ‘The fall from grace of sorghum’. The article concluded that sorghum prices in Australia are quite unattractive, and unlikely to improve any time soon. In this article we look at the opportunities available for hedging sorghum.
The majority of grain growers in Australia, even if they have not personally used them, will be aware of the use of derivatives such as swaps and futures contracts. It is relatively common for growers and consumers of wheat to use derivative products to hedge their production or future purchases. The use of derivatives is an excellent way of managing risk, but what options do we have for crops such as sorghum?
There are Australian sorghum futures and options available through the ASX, and these could be extremely useful risk management tool. Although, life is never that simple, unfortunately the ASX sorghum contracts have attracted very little volume causing issues of limited liquidity. There are a number of banks in Australia which offer sorghum swaps. However, these are based on the ASX contract resulting in the same issue.
It is possible to hedge another commodity as a proxy for the one you want to hedge, such as using soybeans against canola. When cross hedging it is important to find a commodity which has a strong degree of correlation.
At a local level the ASX feed barley contract has a high degree of correlation with Sorghum (Figure 1). The correlation between 2005 and the present day is 0.78 (1 being a perfect correlation and 0 being no correlation), a correlation of above 0.7 would be considered to be moderate.
In figure 1 we can see the relationship between ASX feed barley and sorghum breaking down in 2013, which coincides with an increase in exports to china (figure 2). If we exclude this period and examine the correlation between 2005-2013, the correlation increases to 0.85. The reduced likelihood of major exports to China in the short to medium term is likely to bring the relationship between feed barley and sorghum back together, and we can see this has been occurring since mid-2015.
This moderate to high degree of correlation over long period of time between sorghum and feed barley makes for a good tool for cross hedging. The ASX feed barley contract attracts higher volumes, reducing the liquidity risk, and making sorghum-feed barley cross hedges a reality.
How to: Cash and Call
In figure 3 we can see that sorghum basis (delivered Darling Downs) against ASX feed barley is falling into negative territory for the first time since 2013. The decreased likelihood of major exports, and limited domestic demand are likely to see basis fall further.
Through ASX feed barley options there is the ability to use a cash and call strategy. This strategy involves selling the physical grain and taking out a call option. This gives the benefit of receiving payment now, with the ability to benefit from prices rises, with a known risk.
I recommend reading the cash and call strategy ‘how to guide’ on the link above.
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