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Part II: Target Price Contracts and the Grain Company’s Perspective
The Grain Company’s Perspective
Remember the example in Part I where the grain buyer is negotiating a new sale? It turns out that having TPCs on the books helps out more than you might think.
First, imagine what it’s like offering say 50,000 tonnes of wheat. You have to come up with a price that is competitive, that the buyer will hopefully accept and that will translate into a profit after all costs, including the purchase price. And the purchase price is a big unknown – and can change before you have bought enough to cover the sale. You may have uncommitted stocks in your elevator(s) that you can sell, but more often than not, you will have to go out and buy more. The big question is “at what price can I originate enough to satisfy this sale?” “What price do I need to pay to get farms to sell?”
Without TPCs, the grain trader must rely on his best guess as to the price that will attract the needed grain. Most traders will have a pretty good sense of what that price is, simply by being active in the market, but there is still some risk that they could be wrong. But if the grain company has TPCs on the books, the grain trader can simply look at the book of TPCs they have and get a much clearer picture of what it will cost to supply a potential sale, with little or no risk.
Think about it; if you have 10,000 tonnes of wheat TPCs at $8.75/bu, another 20,000 tonnes at $8.90/bu and another 20,000 tonnes at $9.00/bu, you know that your replacement cost is no worse than 8.91/bu (on average) at the elevator. You haven’t bought this wheat (yet) but you can build an offering price based on your TPCs; if you get the sale, you can start originating the needed grain by paying slight premiums over your public street bid. Say your street bid is $8.50/bu; you may first raise it a bit – say to $8.60/bu or $8.65/bu – to see what comes in. Not only does this increase the potential of fresh deliveries, it also may become the best bid among the competition. But perhaps best of all, you are buying at prices less than what you used to build your price, so any difference is a plus.
In the event that, as time goes by, you aren’t able to buy all that you need, rather than push your publicly posted price higher, you may opt to trigger the lower priced TPCs – the 5,000 tonnes at $8.50/bu. And maybe you tap into the 10,000 tonnes at $8.60/bu. You will go as high as you need to, to cover the sale. The publicly posted street price may never exceed 8.50 but trade was completed at higher levels.
The TPCs on the books is an effective back-stop, giving the grain company a price ceiling. Think of TPCs as call options for the grain company – options without paying premiums.
But beyond that, a book of TPCs gives the grain company a view to the market in general. It is safe to say that if they have TPCs hovering around a specific price, other grain companies will as well. And, by extension, you could surmise that other farms have similar price ideas. Knowing that there is sizeable selling interest in a particular price range gives the grain company a leg-up in how it positions itself in the market. Specifically, when selling overseas, they can be more aggressive sellers based on that price range paid to farms, knowing that, in the event that prices start to rally, there will be stocks available at that price.
Why does a grain company trigger TPCs instead of simply raising its bid price?
Bid prices are market signals – raising the published bid price may send the signal that the market value of the crop has increased. But in reality, it may be that the grain company only has a small and immediate need – and are willing to pay slightly more for it; the general market value hasn’t changed and they don’t want to give the impression that it has. Even so, if they raise their bid price to get a small amount more into the elevator quickly, they would likely drop their price just as quickly once they buy what they need.
But there’s more. Raising your price doesn’t automatically mean you will buy more. In fact, a typical reaction by farmers to higher prices is to pull back on additional sales, thinking that there is more upside to come. In this way, raising the general bid price to get a quick injection of new deliveries can be counter productive. Another approach would be to simply get on the phone and call selected farms to offer a “special” or premium for immediate delivery (this happens even with TPCs in play.) Nonetheless, TPCs are probably the most effective tool the grain companies have to fill these gaps.
Remember, every grain company has a book of TPCs. Through the TPCs on their books, their view and understanding of the market is greatly enhanced. Not only do they have a good idea where their buying customers will opt to step in and buy, with TPCs they also know what price it will take to buy the same crop from farms.
This has been part two 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
