April 5, 2017 Commodity Risk Through the Eyes of an Ag Lender Wisconsin Banker’s Association April 5 th , 2017 Michael Irgang, Executive Vice President 1 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. Commodity trading is not suitable for all investors. There is an inherent risk of loss associated with trading commodity 2 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 WBA Agricultural Bankers Conference 1
April 5, 2017 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 3 COMMODITY MARKET VOLATILITY 4 WBA Agricultural Bankers Conference 2
April 5, 2017 Our New Reality rising La Nina prices low interest rates weather risks rising risk appetite government intervention speculators rising grain EM demand stocks Chinese still food inflation importing controls Trump Stronger Administration rising input US $ 5 costs What is Volatility? 6 WBA Agricultural Bankers Conference 3
April 5, 2017 Volatility by Asset Class Currencies Interest Rates Equity Indices Commodities 70% 60% 50% 40% 30% 20% 10% 0% 7 Commodity Market Volatility Why are commodities more volatile than other asset classes? 8 WBA Agricultural Bankers Conference 4
April 5, 2017 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 9 CASE STUDY: IMPACT OF COMMODITY PRICE VOLATILITY ON FARM-LEVEL CASH FLOW 1 0 WBA Agricultural Bankers Conference 5
April 5, 2017 Illinois Farmer: Impact of Volatility on Farm Cash Flow 2017/2018 Corn Crop February 15 th , 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 1 1 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 $216,594 Debt Service (CFADS) What impact does Corn Price Volatility have on CFADS? 1 2 WBA Agricultural Bankers Conference 6
April 5, 2017 Impact of Volatility on Farm Cash Flow Base + 1 SD - 1 SD Case Price Change 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) ($605,000) ($605,000) ($605,000) Other Non-Land Costs CFADS $216,594 $765,512 ($332,325) 1 3 Impact of Volatility of Farmer Cash Flow Stochastic Modeling $216,594 Conclusion : There is a 38.9% probability CFADS will be below zero. 1 4 WBA Agricultural Bankers Conference 7
April 5, 2017 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 1 5 used for hedging purposes. Only risk capital should be used when investing in the markets. Past performance is not indicative of future results 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. 1 6 WBA Agricultural Bankers Conference 8
April 5, 2017 Basics 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 15 th ). 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 1 7 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 open 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 1 8 WBA Agricultural Bankers Conference 9
April 5, 2017 Basics 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 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 1 9 Futures Symbol – Delivery Months (2017) Calendar Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Month 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 Chicago Corn– CZ17 December 2017 Natural Gas – NGZ17 November 2017 Soybeans– SX17 2 0 WBA Agricultural Bankers Conference 10
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