Commodity Risk Through the Eyes of an Ag Lender Wisconsin Bankers - - PDF document

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Commodity Risk Through the Eyes of an Ag Lender

Wisconsin Banker’s Association April 5th, 2017 Michael Irgang, Executive Vice President

2 Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results

Michael Irgang: Bio

Michael Irgang is currently Executive Vice President/Co-owner of Global Risk Management

• Corp. (GRM), a Minneapolis-based commodity consulting firm.

Michael began his career in the Financial Services division of Arthur Andersen & Company in 1987 before joining Bank of America in 1989 where he spent four years in Internal Audit, Economic Research and Global Trading & Distribution. In 1993, Michael began a 20-year career with McDonald’s Corporation in the corporate treasury department initially working on the financial markets team. In 1997, he took over responsibility for McDonald’s foreign exchange hedging program. Working with McDonald’s Supply Chain, suppliers, and owner/operators, Michael provided the vision and leadership behind the growth of McDonald’s commodity risk management program from a pilot initiative to a global discipline which covered a multi-billion dollar annual spend in commodity classes including livestock, agricultural, softs, dairy, energy and paper/packaging. Under Michael’s leadership the commodity risk program provided McDonald’s with a strategic advantage by providing competitive & predictable pricing to the McDonald’s system. Michael was recognized with Treasury and Risk Management magazine’s Alexander Hamilton Gold Medal Award for his accomplishments in building McDonald’s commodity risk management program and was a co-recipient of the Ernst & Young Global Risk Manager of the Year. Michael holds BS degree in Commerce from DePaul University and an MBA from the University of Chicago. Michael also holds a Certified Public Accountant designation as well as a Series 3 license.

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Agenda for Today’s Discussion

• I. Commodity Market Volatility
• II. Case study: Impact of commodity price volatility on

farm-level cash flow (Illinois Farmer Example)

• III. Futures & Options 101

IV.Commodity Volatility & Loan Quality

• V. Benefits of a Disciplined Commodity Risk

Management Program to Ag Lenders & Borrowers

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COMMODITY MARKET VOLATILITY

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Our New Reality

La Nina weather risks government intervention rising prices low interest rates rising risk appetite EM demand food inflation controls rising grain stocks speculators rising input costs Trump Administration Chinese still importing Stronger US $

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What is Volatility?

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Volatility by Asset Class

Currencies Interest Rates Equity Indices Commodities

0% 10% 20% 30% 40% 50% 60% 70% 8

Commodity Market Volatility

Why are commodities more volatile than other asset classes?

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Commodity Market Volatility

Why are commodities more volatile than other asset classes?

 Mother Nature  Institutional and Speculative Investors  Government Policy  Liquidity  Economics 101 as it pertains to inelastic demand

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CASE STUDY: IMPACT OF COMMODITY PRICE VOLATILITY ON FARM-LEVEL CASH FLOW

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Illinois Farmer: Impact of Volatility on Farm Cash Flow

2017/2018 Corn Crop February 15th, 2017 Acres: 2,500 Yield/acre (F) 191.5 Dec17 Corn / bu. (2/15/2017) $3.925 Direct Variable Costs / Acre * $423 Other Non-Land Costs / Acre* $242 Corn Price Volatility 32%

* Department of Agricultural and Consumer Economics, University of Illinois

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Impact of Volatility on Farm Cash Flow

Base Case

Acres 2,500 Yield 191.5 “Expected” Price $3.9250 Total Revenue $1,879,094 Total Direct Var. Costs ($1,057,500) Other Non-Land Costs ($605,000) Cash Available for Debt Service (CFADS) $216,594

What impact does Corn Price Volatility have on CFADS?

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Impact of Volatility on Farm Cash Flow

Base Case + 1 SD Price Change

• 1 SD

Price Change

Acres 2,500 2,500 2,500 Yield 191.5 191.5 191.5 “Expected” Price $3.9250 $5.0716 $2.7784 Total Revenue $1,879,094 $2,428,012 $1,330,175 Total Direct Var. Costs

($1,057,500) ($1,057,500) ($1,057,500)

Other Non-Land Costs

($605,000) ($605,000) ($605,000)

CFADS $216,594 $765,512 ($332,325)

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Impact of Volatility of Farmer Cash Flow

Stochastic Modeling

Conclusion: There is a 38.9% probability CFADS will be below zero.

$216,594

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RISK MANAGEMENT TOOLS: FUTURES & OPTIONS 101

Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the

• markets. Past performance is not indicative of future results

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Futures

Definition: A standardized, transferable, exchange-traded contractual agreement to buy or sell a particular commodity, bond, currency, or stock index, at a specified price and quantity, on a specified future date.

Food companies typically use futures to hedge market risk in wheat, corn, soybean products, cocoa, dairy, energy, and foreign exchange.

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Chicago Corn Futures Contract Specifications

Contract Size: 5,000 bushels Deliverable Grades: ▸ Through December 2018: #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium, #3 Yellow at a 1.5 cent/bushel discount; ▸ As of March 2019: #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium, #3 Yellow at a discount between 2 and 4 cents/bushel depending on broken corn and foreign material and damage grade factors. Price Quote: Cents/bushel Contract Months: Dec, Mar, May, Jul, Sep Last Trading Day: The business day prior to the 15th calendar day of the contract month. Last Delivery Day: Second business day following the last trading day of the delivery month. Trading Hours: ▸ Electronic: 7:00 p.m. – 7:45 a.m. and 8:30 a.m. – 1:15 p.m. Central Time, Sun.-Fri. (As of May 15th). Open Auction: 8:30 a.m. - 1:15 p.m. Central Time, Mon-Fri. ▸ Trading in expiring contracts closes at noon on the last trading day. Daily Price Limit: ($0.25) per bushel ($1,250/contract) above or below the previous day's settlement price. No limit in the spot month (limits are lifted beginning on First Position Day). Ticker Symbol: C

Basics

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Initial & Maintenance Margin

Initial Margin: The initial amount that must be deposited in your margin account to participate in a futures contract (long or short) Maintenance Margin: The minimum amount of equity that must be maintained in a margin account If the amount of equity in the margin account falls below the maintenance margin level, a margin call is issued to bring the amount in the account back up to the initial margin level Initial & Maintenance margin are the same for hedgers Margin levels usually reflect the historical volatility of futures prices

▸ Margin levels will change from time to time as volatility changes to reflect the risk on an

• pen position. Margins will also change in the event of a limit move

Failure to meet a margin call could result in the event of liquidation of the positions in your account

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Open Interest

Definition: The number of open futures contracts outstanding at a particular moment. i.e. the number of contracts that have not been canceled by a offsetting trade Basics Open interest is the total number of contracts held by both buyers and sellers When a buyer and seller of a contract enter into a new trade, open interest increases by 1. The more open interest in a market, the easier it is to execute a trade

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December 2017 Chicago Corn– CZ17

Futures Symbol – Delivery Months (2017)

Calendar Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Grains H17 K17 N17 U17 Z17 Energy F17 G17 H17 J17 K17 M17 N17 Q17 U17 V17 X17 Z17 Oilseeds F17 H17 K17 N17 Q17 U17 X17

December 2017 Natural Gas – NGZ17 November 2017 Soybeans– SX17

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Futures Contract First Notice Day Dates

Calendar Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Grains

2/29 4/29 6/30 8/31 11/30

Natural Gas

12/30 / 2015 1/28 2/26 3/30 4/28 5/27 6/29 7/28 8/30 9/28 10/28 11/29

Oilseeds

12/31 / 2015 2/29 4/29 6/30 7/29 8/31 10/31

First Notice Day – The day after which someone who has purchased a futures contract may be required to take physical delivery of the contract's underlying commodity.

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Delivery Mechanics

Shorts who maintain their positions after the last trading day are

• bligated to deliver the actual commodity against the contract.

Similarly, longs who maintain their positions after the last trading day must accept delivery. In the commodity markets, the number

• f open long contracts is always equal to the number of open short
• contracts. Most traders have no intention of making or

accepting delivery and hence offset their positions before the last trading day. It has been estimated that fewer than 3 percent of

• pen contracts actually result in delivery.

A Complete Guide to the Futures Market by Jack D. Schwager

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Futures Strip

CBOT Corn Futures Strip – March 2nd, 2017

Source: Reuters

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Exchange-Traded Futures: Benefits

 Provides for the transfer of risk from one party to an exchange  Liquidity  Counterparty Credit Risk  Easy to Use

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Call Option - Gives the buyer the right, but not

the obligation, to assume a Long Futures contract.

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Put Option - Gives the buyer the right, but not the

• bligation, to assume a Short Futures contract.

Options on Futures Options = Insurance

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Cash Flow Considerations

Futures & Options

• Premiums - Paid or Received - Debits & Credits
• Margin Deposits - Initial & Maintenance
• Limited vs. Unlimited
• Access to Open Trade Gains

2-5

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Instrument Limited Unlimited Premium rec’d Premium paid Access to trade gains Futures

initial and maintenance margin Yes - excess

• f margin req.

Long Call

premium paid at time of execution used to offset futures margins

Short Call

margin req. if market above strike at time of execution used to offset futures margins

Long Put

premium paid at time of execution used to offset futures margins

Short Put

Margin req. if market below strike at time of execution used to offset futures margins

Cash Flow Matrix

Futures and Options

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Illinois Farmer: Options Contract

• Long / Short * Buy / Sell
• Quantity - in number of Contracts
• Futures Delivery Month
• Strike Price
• Futures Market
• Put or Call
• Premium - in $/cents per unit

2-4

Buy 96 (~478,750 / 5K) Dec 2017 $3.95 Corn Puts $.22/bu.

Language to execute

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Option Premium Components

December $3.95 Put @ $0.22/bu. December Corn Futures = $3.925/bu. Premium = Intrinsic + Time Value $0.22 = $0.025 + $0.195

Intrinsic value is the in-the-money portion of the option's premium.

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Corn Put Option Example: Illinois Farmer

For 22 ¢/bu., our farmer has the right, but not the obligation, to sell corn at $3.95/bu.

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Corn Put Option Example: Illinois Farmer

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COMMODITY VOLATILITY AND LOAN QUALITY

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Goals of Farmers vs Ag Lenders Maximize Cash Flow Loan Repayment

How can Commodity Risk Management Bridge the Goals of Farmers and Ag Lenders?

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Ag Lending & the Credit Review Process

 What questions come up during the credit review process regarding a farmer’s grain marketing practices?  What level of understanding do lenders and credit

• fficers alike have on best practices in managing grain

price risks?  Is there a requirement that a farmer have a disciplined program in place to reduce grain price volatility?

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Illinois Farmer: Cash Flow

Conclusion: There is a 38.9% probability cash flow available for debt service will be below zero.

$216,594

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Illinois Farmer: 50% Short Futures Coverage

• Probability of CFADS below $0 falls to 22.1%
• Standard Deviation falls from $550.6K to $275.3K
• Maximum iteration falls from $4.0 Million to $2.1 Million

$216,594

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Illinois Farmer: 75% Short Futures Coverage

• Probability of a CFADS below $0 falls to 2.2%
• Standard Deviation falls from $550.6K to $137.6K
• Maximum iteration falls from $4 Million to $1.2 Million

$216,594

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HOW CAN GRM HELP: BENEFITS FROM A DISCIPLINED COMMODITY RISK MANAGEMENT PROGRAM

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Corn: Ending Stocks

• Two consecutive years
• f record yields in the

USA.

• Continued expansion of

acres in South America

• Increased competition

from other feed inputs

• US exports have

become less competitive on the global market

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Corn Balance Sheet: Sensitivity Analysis

What If? (Trend -5% ) What If? (Trend) What if? (Record) (Millions) 17/18 17/18 17/18 Planted Acres 90.0 90.0 90.0 Harvested Acres 81.0 82.4 82.8 Yield (bu./acre.) 158.4 166.7 174.6 (Million Bushels) Carryin 2,320 2,320 2,320 Production 12,828 13,728 14,457 Total Supply 15,198 16,098 16,827 Exports 2,225 2,225 2,225 Feed Use 5,550 5,550 5,550 Ethanol 5,400 5,400 5,400 Food/Ind/Seed 1,445 1,445 1,445 Total Use 14,620 14,620 14,620 Ending Stocks 578 1,478 2,207 % Stocks/Use 4.0% 10.1% 15.1% Bullish Supportive Bearish Current % ES/U 15.9% 15.9% 15.9% Production Change vs. 2016

• 15.2%
• 9.3%
• 4.5%

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• 60%
• 40%
• 20%

0% 20% 40% 60% 80% 100% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Percent Change from Prior December

Corn Seasonal: Nearby Monthly Average vs. Previous Dec (1988-2016)

Bear Years Range Bear Years Bulls Years Range Bull Years 2017

Corn Seasonal: Bull Years vs. Bear Years

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What is the definition of “high” & “low” prices for Corn?

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At Global Risk Management we are:

• Focused on commodity risk of our clients for the past 20 years
• Skilled staff of 6 professionals with over 150 years of collective

commodity purchasing and risk management experience

▹ McDonald’s, Pillsbury, Kellogg’s, General Mills, Bunge, CHS Inc., Mission Foods, Stotler and Co., Bank of America, Andersen Consulting

• Broad range of U.S. and International clients from “Farm to Fork”
• Farmers
• Processing
• Packaged foods
• Food Service Distributors
• Quick Service Restaurants

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A Simple Philosophy

Our approach at GRM is simple and influences all that we do: disciplined risk management protocols, strategies, and tactics for sourcing raw materials will lead to sound business operations and competitive cost structures.

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GRM: “Farmer Solutions”

 GRM will offer a grain merchandising program directly to the farmer base for soybeans, corn and wheat  Program will provide guidance on the optimal timing of forward sales for the grains covered in the program  GRM’s guidance will include objective fundamental analysis and disciplined strategies to optimize farmer cash flow  GRM would assume no transactional responsibility for this program

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Contact Information

Global Risk Management, Inc. 3433 Broadway St. NE, Suite 110 Minneapolis, MN 55413

Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity futures and options on futures contracts, even when used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results

Chris Morley Ph: 651-209-9502 cmorley@grmcorp.com Michael Irgang Ph: 651-209-9507 mirgang@grmcorp.com Brian Harris Ph:636-485-6697 bharris@grmcorp.com