Posted by Andrew Whitelaw.
In many areas of the country the outlook for the crop looks bleak. There are many farmers out there who have forward sold grain and will not have the production to deliver.
Washing out a forward sold grain contract is a stressful action. In this short article, we will look at washouts and rollovers - and why it is so important to look at it early.
When I arrived in Australia, it was July 2010. I had just left a hot Scottish summer of 23°C to arrive into a Perth winter of 23°C. This was my first year in the Australian grain trade and I had brought the worst drought Western Australia had seen in recent times.
A lot of farmers had forward sold wheat early in the season. However, from July onwards the rainfall disappeared. Most of my contact with farmers in this season was to arrange washouts and it was a harrowing experience. washout
In conjunction with the poor season, Russia was also suffering through extreme dry conditions which led them to completely ban wheat exports. The result of these two events was a strong increase in pricing in Western Australia (especially noodle wheat).
It is important for producers in areas with uncertain production who hold forward contracts to consider a risk management plan for washouts.
What is a washout?
As a producer with a forward contract, it is your obligation to provide a contracted tonnage to the buyer at harvest. If your production falls to the level that you are unable to meet the contractual volumes of the contract, the buyer in most cases will instigate a washout.
Many producers feel that washouts are unfair, we do however have to remember that the buyer will likely have their own obligations and may have already sold your grain to another buyer or consumer.
The washout is calculated as the cost of the replacement. The buyer must go into the market to find a replacement parcel to fill their requirements. The replacement cost can either be calculated using an arbitrary figure such as the best advertised bid on the day, or the actual cost of replacing the grain. As we all know the advertised bid and the price you receive can be quite different, especially in a drought year as prices rise above bids.
The difference between the contract price and the replacement price will be invoiced and it will be expected to be paid to the buyer.
Why sort it sooner rather than later?
If a washout is likely to be required, it’s best to get on the case asap. In a year like the present where crop conditions are declining across the east coast, the replacement cost which is applied to the contract is liable to continue increasing.
As an example, prices in Port Kembla for APW have increased $37 since last week. On a 500mt parcel this equates to $18,500. This is a considerable hit in any year, never mind when overall income is going to be down due to lower yields.
It is therefore important to be strategic and lock in your washout early, or when/if there are any dips in the market.
What about a rollover?
There is an alternative which has been offered in the past and this is a rollover. A rollover is where the contract is converted into a contract for the following year. There is still a washout payment which is deducted from the following years price.
Although still having an obligation to ‘pay’ the washout, this is added to your forward contract for 2019/20 and allows you to have a stay on your financial obligation for a season. This is especially important in a season when income is reduced. There may be a financing cost for a rollover, which will have to be calculated against funding the washout from other sources.
A benefit of a rollover is with current high prices, the potential price achieved for a 19/20 rollover contract has a chance of being a strong number from a historical perspective.
Not all grain companies will offer a rollover, however it is worthwhile working with the buyer to determine whether it is an available option.
In table 1 a basic example of a washout and rollover is displayed. The only real difference between the two options is the ability to defer the payment of the washout to a later season.
If you are concerned about your production and you have forward contracts which you may not be able to fill, make sure that you start to think about a strategy for minimising the cost to your business now. If you are in this situation and would like some basic independent advice on washouts