Risk Premiums & the “Three Destructions” of Crops

The following is an excerpt from the 2003 Grain Trader's Almanac.  It is one of only several studies presented which will help you to make more informed decisions in the grain futures markets.

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The grain markets follow a fixed cycle of production, flowing from planting to harvesting at specific times of the year.  The National Oceanic and Atmospheric Administration and the United States Department of Agriculture (NOAA/USDA) Joint Agricultural Weather Facility refer to these stages as moisture and temperature sensitive stages of development.  During these stages of development, the crop is vulnerable to damage from the forces of nature. 

We have coined the term The Three Destructions of Grain Crops as a description of the “irrational exuberance” – to quote Federal Reserve Chairman Greenspan- which occurs in the building and removing of risk premiums.  Understanding the relative risk associated with a crop during certain stages of development can be a useful guide in understanding grain pricing.  The size and extent of risk premium varies greatly from year to year, based on current and perceived supply and usage patterns.  Though there is no guarantee that this pattern will continue in the future, it has served as a guideline in the past.

Spring Planted Crops

Corn and Soybeans are planted in the spring.  Corn planting in the United States typically begins in late March and is completed by mid to late May.  During March and April, possibly in response to planting worries, Corn futures have gained a total of 100 ¾ cents in the last 19 years – see table at right. Soybean field preparation and planting typically lasts from mid March through May.  During the early stages of the planting effort (March & April) soybean futures have gained a total of 357 cents in the last 19 years - see table at right.

The Corn crop typically pollinates in late June and early July.  During the month of June Corn futures have gained a total of 4 cents in the last 19 years.  During August, Soybeans begin to set pods or reproduce.  In the last 19 years, August has seen Soybean Futures gain a total of 116 cents.  Though reproduction is a very weather- sensitive time, even a poor pollination ensures some future production so the market tends to factor in a smaller risk premium than at planting.

Harvest delays, or at least the fear of such, tend to grip the market most years.  Corn is typically harvested in October and November, which in the last 19 years has seen prices decline a total of –32 ¾ cents.  Do note that harvest concerns, like other market worries, tend to happen before the fact when uncertainty is greater.  Soybeans are typically harvested in October and November, which combined have seen Soybean prices increase a total of 5 ¾ cents in the last 19 years.

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Winter Planted Crops

Winter Wheat is aptly named because it is planted in the fall and harvested in the summer.  Winter Wheat tends to exhibit the same type of behavior of building and removing risk premiums as Corn and Soybeans, though the times of the year are different and the reaction to threats is different. 

Winter Wheat is typically planted in September and October.  During planting in the last 19 years Wheat futures have gained a total of 24 ¾ cents.  After planting winter wheat goes into dormancy from November through to March.

Emerging after the dormancy, Wheat is susceptible to a lack of rain, late frosts, and a host of other problems.  This reproductive rally, during heading, is the largest of the three destructions, seeing wheat futures gain a total of 177 cents in the past 19 years.

Harvest for wheat is typically a non event.  Because wheat can sit in the fields for a long time maturing, as long as it remains dry, harvest damage is typically extremely rare.  With harvest typically beginning in July and August, farmers typically have plenty of time to harvest their crops.

Total Gain (Loss) in Last 19 Years

(in cents per bushel)

Past performance is not necessarily indicative of future results.

3- Destructions Vs Rest of Year

(Total gain(loss) in cents 
during past 19 years)

Past performance is not necessarily indicative of future results.

 Notes: the tables above uses futures data provided by GeckoSoftware from 1981 to 2000, or the most current 19 years.  The following futures contracts were used for each month: Jan-Feb (CK,SK), Mar-May (CN,SN), Jun-Jul (CU,SX), Aug-Sep (CZ,SX), Oct (CZ,SF), Nov (CH,SF), Dec (CH,SH).

Conclusions

Understanding the presence of risk premiums can be beneficial for both speculators, as well as hedgers.  The size and extent of risk premiums varies greatly from year to year. However, understanding that this pattern may repeat can definitely help speculators and hedgers position themselves accordingly.

Risk premiums tend to be the largest when current supplies are tight as well, and in years when current supply is abundant it appears that risk premiums aren’t even present.  Like any study, keep the concept in mind when using grain futures, but do not expect the past to repeat itself exactly.  After all, one can’t drive forward looking only in the rear view mirror.

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