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Part I: Target Price Contracts and The Farm’s Perspective
Target Price Contracts – Key Points
● Target Price Contracts (TPCs) – also referred to by other names such as Grain Pricing Orders (GPOs) – can make life easier for farmers by reducing the need to watch markets closely. Used effectively, they can help get better prices. However, there are pitfalls to avoid, the most obvious is that entering into a TPC limits your market exposure, leading to the potential of missing better pricing opportunities. There are better alternatives.
● TPCs are a great tool for grain companies to manage their risk when merchandising grain. They provide a view of the market in terms of where farms are willing to sell, while providing both price and supply assurances. In effect, TPCs are very much like call options – just without the premium.
● From the industry’s perspective, TPCs have a downside. Increased use of TPCs reduces price transparency, fundamental to a functioning marketplace, and they reduce the need for futures hedges, diminishing liquidity. Both these increase market risk and with that, an increase in cost.
Background
Interest in target price contracts has increased in Western Canadian grain, oilseed and pulse markets – now to the point that the majority of grain bought in Western Canada may be on some sort of target price contract. Although they are a great way to park a pricing order at an attractive price so you don’t need to monitor the market, there is a downside too.
They go by different names: Viterra calls theirs a Target Price Agreement (TPA). Cargill’s is called a Grain Pricing Order (GPO). Richardson calls theirs a Market Manager Contract. Paterson Grain has a Target Price Agreement (TPA). And so on. They have different names, but they all do the same thing; to make it easy, we will call them all Target Price Contracts (TPCs).
This three part series provides a closer look at these contracts, showcasing the pros and cons and different perspectives on their use.
The Farm’s Perspective
There are times when farmers believe that prices could move higher over the next few weeks or months – or maybe you just hope they will – and you want to take advantage of those higher prices. But you’re busy and don’t always check the markets as closely as perhaps you should. It would be great if you had a way to sell your grain at the price you want – if the market moves there – without having to watch the market like a hawk. The TPC seems to be just what is needed.
When you enter into a TPC with a grain company, you indicate a price – above the grain company’s current bid price – at which you agree to sell a specified amount of grain for a specified delivery window. Some contracts are open ended; they remain open until they get triggered or are cancelled – whichever comes first. With others, a contract termination date is specified, after which, if the target price has not been met, the agreement is void – you haven’t sold anything. Either way, while the contract is open, there is the possibility that the buyer will accept the price and you will have a binding contract to deliver at that price, in accordance with all other terms of the contract.
Let’s look at an example. Let’s say canola prices at your local elevators are currently around $12.50/bu and you want $14.00/bu. You enter into a TPC with a grainco with a target price of $14.00/bu. Over the next few weeks the market price moves around but the grainco’s published price does not reach $14.00/bu. However, at a point when their price is $13.50/bu, they need to quickly buy more canola to finish loading a train that is about to be spotted. They look at all their outstanding TPCs with targets near the spot price and decide to accept yours (and others) for immediate delivery. By doing this, they are paying more than their street price bid, but they are avoiding the potential for large penalties from the railroads for late loading or shipping less than a full train.
This example shows just one reason why a company may accept your TPC; there are others. For example, if a grain company is negotiating a large sale, they may want to cover that sale (that is, buy the grain needed for the sale) – or a portion of it – fairly quickly. They may feel that once the market hears about the sale, prices will jump. They may accept all TPCs that are close to their current price to minimize the risk of higher prices. Or they may see market factors evolving that they suspect will support prices and they decide to accept TPCs as a quick way to protect themselves from these higher prices.
Perhaps it goes without saying, but if the buyer’s current street bid price hits your target, you get filled – you now have a sale at that price.
But why that price?
I have often wondered why certain prices are chosen as targets. Is it a price where you are profitable? Is it a price that you think is at the top of the near-term price range?
For the most part, the appeal of a TPC is that it gives an avenue to a better price than today’s posted street price. We know that, at times, accepting today’s price carries with it the anxiety of potentially watching the price move higher after you have sold. And approaching it differently where you feel as though you have more control – or that you are not just a “price-taker” – is appealing.
Those that don’t like them would say that by using TPCs you run the risk of a grain buyer taking advantage of you – picking you off when the market is starting a big rally. They apparently don’t like the idea of having a TPC trigger at $12.00/bu as the market moves higher – perhaps much higher – to say $14.00/bu, even though the $12.00/bu target was set on the basis of sound analysis of your own cost structure and acceptable profitability.
I never saw it that way. Hopefully, when you place an order (through a TPC) to sell at $12.00/bu, there were sound reasons for doing that, most importantly, it was profitable. If you don’t like the idea of selling at $12.00/bu because the price “might” go to $14.00/bu, then your approach is more speculative than it should be.
When trading futures, it often pays to sell just below where everyone else is selling. Sage traders will often place their sell orders at say, $639.50/t or $639.80/t when there is lots for sale at $640.00/t. As the market creeps higher, these orders will get filled before those at higher prices, like $640.00/t; and even if the market gets to $640.00/t, there is the possibility that not all offers at that price will be taken. The same goes for selling cash grain and using TPCs. If the magic number for most farmers is say, $14.00/bu, it may make sense to go with a target of $13.80/bu or $13.90/bu – for the same reason as in the futures market. You give up a little bit but greatly improve your chances of getting filled.
One TPC with one company – or one with each company?
For the most part, farms enter into TPCs with one company. But entering into a TPC with just one company limits your market exposure.
What happens when buyers are paying your target price but not the company you have the TPC with? It can happen. First, if you’re not watching the markets closely, you could very well miss the opportunity to sell at your target. But, assuming you do notice, you have to decide at that time whether you still accept the target or decide you want to wait for higher prices. Now the issue of discipline comes in; many enter into TPCs as a way of staying disciplined and not changing their price ideas when the market gets close.
If you still accept that target, you can cancel your TPC and sell your grain to another buyer. If you sell your grain to another buyer first, it is possible that by the time you contact the buyer you have the TPC with, they have decided to accept it – then you’ve sold your grain twice. Best to cancel the TPC first.
Here’s where you can negotiate. When you call to cancel the TPC, tell them what you are doing and why. Give them a chance to match the other bid; they may even pay a bit more, just to keep you on their side of the tracks.
What some farms do is enter into multiple contracts – one with each buyer they tend to sell to. But they are hard to manage, and you run the potential of all of your contracts getting triggered at once.
Alternatives that provide similar results
If farmers are using TPCs to squeeze just a little bit more out of the market, they should also consider other alternatives.
For example, they should check out forward prices. Sometimes the spot price may get close to your target but not close enough to trigger the TPC. At these times, it may make sense to check out the forward (deferred delivery) prices quoted around the same time. For example, let’s say you’re considering a TPC for canola with a target price of $13.50/bu when the spot price is $13.34/bu.
All grain buyers provide bids on forward, or deferred delivery, contracts. When the street price is close to your target like in this example, a forward bid price for later delivery can be above your target price.
Now you have a decision to make. You could enter a TPC with a $13.50/bu target and hope the spot market rises enough to trigger it – or that your buyer jumps at your target for some other reason. Or you could simply sell your canola at $13.50/bu (or better) with a deferred delivery contract and be done with it.
If you wait to see if the market rallies to trigger your TPC, you are taking the risk that it won’t. By locking in with a deferred delivery contract, you will have removed any further price risk while achieving the price you wanted. Either way, you will be waiting to deliver and get paid.
Another alternative is to write (sell) call options. When you enter into a TPC with a grain buyer, you are essentially selling them a call option on your cash grain but without getting a premium (and, the flip side of that is, they are essentially buying a call option without paying a premium). From my perspective, you could get almost the same coverage as a TPC by writing call options with the added benefit of collecting the premium.
Let’s use an example to compare a TPC and a short call position:
● Assume the futures are at $618.60/t and the current basis is $30.00 under; (this makes the current market $13.35/bu)
● Also assume you want $620.00/t; at $30.00 under that means futures at $650.00/t
This example shows how TPCs and call options are similar. Key differences are:
● TPCs can be any amount; options are in discreet tonnages (eg: canola options are 20 tonnes)
● TPCs are available on all commodities; options are only available on those crops with futures
● TPCs can be at any price; options are only at set strike prices
● TPCs can be cancelled at no cost; options usually have a premium
● TPCs can be triggered due to a strong basis; basis has nothing to do with options
Clearly, there are alternatives to TPCs that can be as effective – if not more – such as simple option strategies. Having said that, there are now TPCs on basis only; in other words, the set target is a basis, not a flat price. The combination of using a TPC on basis only and an option can be very effective. And I like the fact that it doesn’t take liquidity away from the futures market.
This has been part one of the three part series on target price contracts.
If there’s more about the grain industry that you want to get a better understanding of, check out The Trading Floor where we provide real time market analysis along with ample background information and analysis about how our markets work. If there’s more that you want to explore, don’t hesitate to contact me.
John De Pape
Farmers Advanced Risk Management Co
John De Pape
