By Wesley S. Regmund, John Robinson, David Anderson and John Park
[highlight]Editor’s Note: Although this study is primarily focused on Texas markets, the authors say the same methods can be used nationwide with presumably similar results.[/highlight]
With cotton being the leading cash crop in the largest cotton-producing state of Texas, the value of whole cottonseed is an important factor in the overall economics of cotton production. The returns from whole cottonseed represent slightly less than 20 percent of the estimated gross returns from total production.
Whole cottonseed has become an important ingredient in livestock rations, especially for dairy cattle, as it is considered a complete supplement that offers 23 percent protein content, 20 percent energy in the form of fat, and 24 percent crude fiber on a dry matter basis. The high energy and protein stem from the kernel of the seed, while the fiber comes from short strands commonly referred to as “linters” that remain on the seed after the cotton, or lint, is removed.
Cotton Incorporated describes one- fourth of U.S. whole cottonseed as being sold directly from gins as livestock feed, and another quarter being distributed as livestock feed products after cottonseed oil mill processing. Given the importance of the Texas livestock industry, the state’s whole cottonseed share being fed to livestock may be greater than the national average.
Planning, Risk Management
Most cottonseed marketing takes place from September to December after the typical harvest period in Texas. The value of whole cottonseed has traditionally been applied to offset ginning costs, and past price swings occurred as a result of inadequate storage capacities.
Historical observations of Texas whole cottonseed price imply that most of the time the price will be within plus-or-minus $65 per ton of the average price. This level of variation is significant enough to expose growers to occasional ginning cost increases. It might also represent a significant risk to the financial position of gins, cooperatives, livestock feeders and other users.
Conventional risk management practices for other storable agricultural commodities consist of longer-term storage, forward contracting, and using futures markets as a means to combat unfavorable price movements.
However, special considerations must be made for storing such products, and no futures market currently exists for cottonseed.
This limits users and growers in their marketing planning and risk- reduction strategies. The purpose of this study is to identify and evaluate applicable cross hedging strategies for whole cottonseed in Texas.
Similar Futures Contracts
Because whole cottonseed market distribution information is not widely available, an online survey was created and sent to cotton gins throughout Texas. The purpose of the survey was to gain a better understanding of distribution and use patterns and assess the risk associated with buying and selling cottonseed for gins, farmers and livestock feeders.
Many respondents, who represent both cooperative and independently owned gins across all regions of Texas, noted there is the risk of fluctuating prices. Longer-term seed storage and forward contracting are used to help mitigate this risk. Cross hedging was mentioned in discussions with gin members as a means to manage price volatility, but this strategy is not typically implemented.
As such, there has been a very limited amount of research on the hedging possibilities for whole cottonseed. With no current contract available for trade on any widely used commodities exchange, cross hedging cottonseed cash prices at the gin or oil mill level might be feasible using futures contracts similar in nature. Possible cross hedging contracts evaluated include soybeans, soybean meal, soybean oil and corn, all of which are traded at the Chicago Board of Trade and act as substitutes for cottonseed as protein in livestock rations.
Additionally, the canola contract offered by the Winnipeg Commodity Exchange was considered. In order for cottonseed cash prices to be hedged appropriately, there needs to be an adequate correlation between these cash and futures price series.
Optimal Hedge Ratios
Correlations between the weekly West Texas whole cottonseed cash price and weekly near month futures prices of the aforementioned CBOT contracts were calculated for the price level, price changes and percent changes in price. Soybeans and soybean meal appear to be most aligned with cottonseed price movement.
With this information, optimal hedge ratios using a simple ordinary least squares (OLS) regression model were calculated at the price level to best select the appropriate number of contracts needed within the futures position to sufficiently cover one’s spot, or cash, position. After estimating the ideal number of contracts, empirical tests simulating cross hedging strategies were conducted to analyze cotton gin returns in both hedged and not hedged scenarios.
Simulated strategies in this study were explored from the viewpoint of a cotton gin or a physical seed seller. Since the Texas cotton harvest begins in late August, gins start receiving cottonseed from the ginning process at this time and seed sales to either oil mills or livestock feeders continue mostly from then through the end of December.
Cross Hedge Scenarios
Gins can employ either a pre-harvest-based cross hedge or one that takes the limited storage time into account. A pre-harvest cross hedge involves taking a short position in the futures market before cotton harvest and then lifting that position after taking possession of and selling the cottonseed. To remove the hedge, a gin manager must buy back an equal number of futures contracts to offset the short position.
Alternatively, in the event of storing and holding cottonseed before the sale date, a short position is taken in the nearest futures delivery month when the seed arrives and the hedge is maintained until the time of sale. In this situation, if cottonseed remains in storage when the futures contract matures, the cross hedge is lifted and simply rolled forward into the next delivery month as necessary.
Both scenarios were tested using soybean and soybean meal contracts. The pre-harvest cross hedge was executed by placing the hedge four months prior to the expected sale date. And then the short position in the futures market was lifted once the physical seed was sold during the September through December time period.
Four months prior to harvest was chosen as the time length because the gin is likely aware of the amount of cotton acres planted and can reasonably estimate expected production and cottonseed volume. Analysis using this approach involved changing the date the hedge was implemented as well as the date when spot market sales were performed so they remain four months apart.
Similarly, a cross hedge was assessed while taking storage into account by placing the hedge in the nearby futures on the first week of July and lifting it at the time of sale between the first week of September through the last week of December.
In this scenario, the date the hedge was applied remained constant as the first week of July, while the selling of cottonseed changed by a week over the four-month time period. Employing the hedge at this time allows the gin to assess its storage capabilities and cotton yields more accurately just before harvest while still being able to protect against falling prices once seed possession takes place.
To calculate the effective net price received by the gin, the revenue from the cottonseed sale was added to any gain or loss associated with the futures transaction to determine the total revenue. This value divided by the amount of cottonseed sold results in the realized price received by the gin.
A cross hedge using this method is deemed successful and effective when a gain in the futures market occurs due to declining prices and concludes with a calculated net realized price greater than the cash price of whole cottonseed that was not hedged.
Gain Or Loss Potential
In the initial scenario, it is assumed that in the first week of May a cotton gin is aware of estimated production from planted acres and can reasonably assess the amount of cottonseed as well. The gin manager anticipates the need to sell cottonseed in the first week of September, which is four months away.
Because the price of cottonseed might be lower at that time due to increasing supplies at harvest, the gin manager protects against downside risk by currently selling the appropriate number of contracts using either soybean or soybean meal futures. If the futures price declines, a gain is made on the short position and offsets a decline in the cottonseed cash price.
On the other hand, a loss is incurred if the futures price rises. Once the gin takes possession and sells the seed in the spot market on the first week of September, the manager buys back the same number of futures contracts to lift the hedge.
The loss or gain on the futures transaction can then be added to the value of the cottonseed sold and a net effective price received by the gin can be determined.
Storage-Like Cross Hedge
Another approach was tested using a storage-like cross hedge that begins with the seed seller taking a short position in the futures market on the first week of July regardless of the expected selling date. July was chosen as the naïve month to place the hedge because a more accurate assessment of storage capacity and cotton yields leading up to harvest could be made around this time. It also exhibited the highest and most frequent profit from the futures transaction of all months observed.
The gin manager will then lift the hedge whenever the spot sale occurs. In this example, cottonseed is priced at $327.50 per ton and nearby soybean meal futures are trading at $350.93 per ton on the first week of July in 2015.
Shorting seven soybean meal contracts is necessary for the gin to protect against a decline in price for 1,000 tons of cottonseed, as mentioned earlier using the optimal hedge ratio. (Note: 100 tons of soybean meal equals one contract.) As ginning begins and new crop cottonseed arrives in the warehouse, the gin manager decides to store the seed until the last week of December with the hope that cash prices will increase later into or after harvest.
Unfortunately, on the last week of December when the physical cottonseed was sold, the spot price had fallen to $265.50 per ton; however, the soybean meal futures price had also declined by $76.60 per ton and was trading at $274.33 per ton. Once the futures position was reversed and the hedge lifted, the transaction had a subsequent profit of $53,620 ($76.60 × 100 × 7), excluding the cost of commission.
The cottonseed was sold to an oil mill or livestock feeder at this time for a total of $265,500 ($265.50 × 1,000). This combined with the gain in the futures resulted in a total return of $319,120 or an effective price of $319.12 per ton received by the gin, which exceeded the not hedged cash price by $53.62 per ton.
See these calculations in Table 2. Placing the hedge using soybean meal futures on the first week of July and lifting the position every week from the first week of September until the last week of December produced a higher realized price relative to a not hedged price by an average of $24.62 per ton. The better price experienced by the gin occurred 67 percent of the time from 2007 to 2015 with an average value of $295.65 per ton.
The same test procedures were implemented for the pre-harvest scenario using soybean meal futures as the cross hedging vehicle and taking a short position four months prior to selling cottonseed. Additionally, soybean futures were assessed while taking storage into account by placing the hedge on the first week of July and lifting it at the time of sale between the first week of September through the last week of December.
Compare Hedging Strategies
Cash and effective net prices for the four different hedging scenarios were averaged over the 2007 to 2015 sample period and reported in Table 6. The storage-like July placed hedge using soybean futures as the tool for cross hedging provided the highest returns and most consistent results over this time period.
The effective net prices were averaged for both cross hedged scenarios and the not hedged approach for the different weeks examined between the first week of September and the end of December over the 2007 through 2015 sample period. See the differences between the strategies in Figure 1 for the hedges using the soybean contract and Figure 2 where soybean meal was the hedging vehicle.
The prices over the observed weeks indicated the storage-like hedge using either the soybean contract or the soybean meal contract will on average result in an effective net price greater than the effective net price found for both the not hedged scenario and the approach where the cross hedge is executed four months prior to selling in the cash market.
As noted previously, there is the possibility of experiencing a loss, or a lower effective net price, as a consequence of hedging. This takes place in instances where price movement between futures and cash markets becomes dissimilar. Although these occurrences were observed less frequently with lower magnitudes using this historical data, the average and maximum amounts when hedged prices were lower than not hedged prices are reported in Table 6.
The average and maximum values for gains when the hedged prices were higher are also represented. Loss threats are notable from a financial risk standpoint because they signify occasions when hedging gins must meet margin requirements. This can reduce operating funds and become a cash flow issue if the losses from short positions stretch over lengthy periods of time. However, the overall results tend to support that on average the probability of more consistent and higher gains outweigh the less frequent and less severe threat of lower realized prices through hedging.
Commissions And Margins
Outlying years in 2007 and 2010 produced no weeks in which any hedges were profitable. This is presumably the result of highly uncharacteristic and unexpected movement in prices due to worldwide factors. The cost of trading in the form of brokerage commissions and margin requirements also were taken into consideration; however, the varying amounts for these costs and their lack of any significant influence on the ultimate outcome resulted in their exclusion during calculations.
Total commission costs would vary slightly between the scenarios as different hedging lengths were used requiring the need to roll contracts into the proper delivery month. Also, different contract quantities were bought and sold depending on the cross hedging vehicle chosen.
In addition, there would be different margin requirements associated with the separate exchange-traded commodities. When selecting the appropriate strategy, if a hedger is not merely seeking the highest return but is concerned with cash flow and liquidity, then these factors are important and need to be accounted for.
Research opportunities to build upon this study exist assuming there are factors affecting cottonseed that do not necessarily have an impact on soybean or soybean meal prices. Outside influences such as government intervention in the form of farm program supports, demand for goods of processed commodities, and available supply of competing crops have an effect on these prices. In addition, protein and dairy markets may have a growing impact on whole cottonseed price movement due to its increasing use as an ingredient in cattle feeding.
Alternative hedging approaches should also be considered in future work. Different hedging horizons and lengths can be explored and dynamic time-varying hedge ratios can be implemented for potentially more effective hedges.
A gin does have the option of selling its cottonseed in the cash market and taking a long position in the futures market thereafter. This would allow it to take advantage of rising prices that were missed due to no longer having possession of the seed. Gins engaging in forward contracts with oil mills introduce a different kind of risk and can be managed by implementing this strategy.
Hedges using options is also a common method to investigate. These derivatives may offer improved price risk reduction but have different cash flow considerations to take into account. Furthermore, using the same approaches with out-of-sample data or simulating future values would also help determine the effectiveness of these methods and could better forecast possible outcomes.
Potential To Improve Profitability
The main objective of this study was to examine cottonseed supply and usage patterns within Texas and to analyze the feasibility of price risk management strategies by cross hedging cash cottonseed with soybean and soybean meal futures.
The relationship between cash and futures prices was deemed to be significant enough to warrant further investigation, and hedge ratios allowing for proper risk coverage for a seed seller were estimated. Additionally, a measurement of hedge effectiveness was considered, resulting in cross hedges using either soybean or soybean meal contracts providing reasonable amounts of risk reduction when compared to a not hedged position.
Practical testing from a seller’s perspective using historical data produced outcomes that showed effective net prices from cross hedging were typically higher than not hedged cash prices over the considered time period (Figures 1, 2). This allows for an additional potential outlet for cotton gins to market cottonseed aside from traditional methods and possibly improve their financial position and profitability.
Wesley S. Regmund is a former graduate student, Department of Agricultural Economics, Texas A&M University. Drs. John Robinson, David Anderson and John Park, are professors and Extension economists, Department of Agricultural Economics, Texas A&M University, and Texas A&M AgriLife Extension Service.