Hedging is an important risk management tool for any agricultural commodity as it can allow producers to plan adequately for the future. Here at Seed, we identify emerging agricultural commodities in need of these risk management tools. As a relatively new commodity within North America, industrial hemp has been identified as one of those commodities in need of these financial tools.
To understand the role of hedging, one needs to start with understanding the concept of risk and what risks are involved in the industrial hemp industry. Within the world of agriculture, there are many unforeseeable factors that will impact production and price, which can lead to volatility within the market. These factors include things like weather and public policy; however industrial hemp faces unique, idiosyncratic risks from a legal standpoint. For instance, if Canada were to legalize the extraction of cannabidiol (CBD) this could potentially lead to shift in supply, leading to rapid changes in the price. In addition, dry weather can lead to industrial hemp testing ‘hot’, meaning testing above the proscribed federal THC limit of 0.3%, which is a form of crop failure. Seed provides access to hedging tools that will allow those within the industrial hemp industry to reduce these risks in order to allow for long term business plans and peace of mind.
Hedging is the act of locking in a price using a variety of financial tools, most notably futures, forwards or swaps. A hedge is an investment to reduce risk of price movements in an asset. Seed’s research paper on CBD price index looked at price movement over the last year within one of industrial hemp’s major derivatives, CBD. Figure 1 provides a break down in this price movement. A significant downward trajectory has been observed over the last year with the value of CBD decreasing 33% overall. Additionally, in recent months, large price swings can be observed.
This price volatility can create problems for those within the CBD industry as they try to plan for the future of their business. This is where Seed comes into play. Graph below shows a simple supply chain in the industrial hemp market, and Seed’s position in protecting industry participants’ businesses.
For example, suppose a CBD producer bought 1,000 pounds of 10% CBD content hemp material at the price of $300/lb. He knows that he will extract around 45,000 grams of CBD from this material. His costs for plant material comes in at $300,000. He knows his breakeven point is $7 per gram, therefore if the price falls below that he will make a loss. This represents a significant risk to the producer. However, the futures price is $10 per gram. To mitigate this risk, the producer decides to cover his cost by entering into 60 forward contracts on Seed SEF (60 contracts*500gram /contract=30,000 grams), which is two thirds of his entire production (30,000/45,000=2/3). Hedgers normally do not hedge a hundred percent of their products. In this case, the processor is no longer subject to the risk brought on by price volatility with using only two thirds of his production and he can benefit from the sale of the rest of his products.
Seed has created a secure environment for producers to enter these contracts as a way of risk mitigation. The Seed trading platform offers forward and option contracts for CBD extract and hemp seeds in order to help industry participants manage their risk and lock in price.
The forward contracts offered on Seed SEF are agreements between two parties to buy or sell an asset at a specified price on a future date and call for delivery of the underlying product. For example, a hemp seed producer can enter into one of these contracts to help lock in price. Additionally, the processors of hemp seeds can lock in price using these contracts to adequately predict future costs i.e. the hemp material they buy. This will enable farmers to lock in a price well before harvest and be able to plan ahead for managing business, which also ensures farmers’ profitability, despite any declines in the market price. For processors and manufacturers, these contracts help guarantee a delivered supply for a desirable price at a future date.
Seed also offers options as a financial tool to help mitigate risks. These contracts behave slightly different than forwards but ultimately accomplish the same thing, risk mitigation. Options are contracts that give buyers the right to buy (call) or sell (put) an underlying product at a specific price on or before a certain date.
A call option gives the holder of the contract the right to purchase a good at a specified price from whoever issued the contract. For example, suppose a CBD bottler and retailer needs 5,000 grams of CBD extracts to ensure production in January. To ensure that product is delivered to them and to avoid any potential price changes that may happen between now and January, the hedger can buy ten January call option contracts (the notional amount of Seed’s CBD contract is 500 grams) on Seed SEF at a specified price, commonly referred to as the strike price. In this example a strike price of $80/gram is used. This would give the hedger the right or option to buy 5,000 grams at $80 on the designated expiration date.
However, the buyer must pay a premium for this right. If the quoted option price is $1, the premium for each option contract is $500, then the total cost of hedging ten call options would be 10*$500=$5,000. Contract specs of CBD extract can be found here. If the market price of CBD extract falls below $80/g, the options will not be exercised and expire worthless. The loss would be $5,000 for the premium paid. On the contrary, if the spot price goes beyond $80/g, the options are exercised and hedger would gain a profit if the price is above the breakeven price. The breakeven point would be a price of $81 at expiration as the hedger ‘lost’ $5,000 by paying the premium of ten call options. Figure below shows the payoff diagram of the call options.
A put option give the holder of the contract the right to sell a good at a specified price to whoever issued the contract. Considering the possible decline of CBD prices, CBD processors need protection from the potential loss. Perhaps a processor will have 5,000 grams CBD in stock in January that needs to be sold. This processor could enter Seed’s market place to purchase ten January put option contracts on Seed SEF with a strike price of $ 80/gram. This would give the hedger the right to sell a total of 5,000 grams for the price of $80. This would lock in price and protect the processor from negative market fluctuations.
However, as will a call option, the processor must pay a premium for this right to force the counterparty to purchase their product. If the quoted option price is $1, the premium for each option contract is $500, then the total cost of hedging ten put options would be 10*$500=$5,000. The strategy costs $5,000 but guarantees that the CBD products can be sold for at least $80 per gram during the life of the option. If the market price of CBD extract falls below $81/g, the options will be exercised, so that a revenue of $400,000 ($80*500g*10) is realized with a cost of the premium paid for options. On the contrary, if the spot price goes beyond the breakeven point of $81/g, the options are not exercised and expire worthless. Products can be sold on the cash market Seed provides. Figure below shows the payoff diagram for the put options. With options, not only the hedger locked in a fixed price, he also can choose not to exercise the options, and sell products on the cash market to gain more profits.
Trading on Seed offers many benefits that simple bilateral transactions could not offer.