Grain Producers and Risk Management
Row crop farmers are challenged by several potential sources of risk. These sources of risks include production, price, finance, legal, environmental, health, and government policy. The focus here is marketing risk. “Market Risk” is translated into English as – the risk that prices will fluctuate. We plant a crop expecting a harvest and from our perspective – a rising commodity price is typically good. Declining prices, prices below break-even and price uncertainty are often viewed as not-good. This is price risk.
Farmers have several tools available to consider as choices when contemplating managing price risk. The most common tools are cash grain contracts, futures contracts and option contracts. In my mind – the most significant and basic step to managing price risk may be the proper use of a revenue-based crop insurance product.
The concept behind managing price risk is to establish a “safety net”. This safety net is intended to minimize the potential for financial loss. One important point to recognize is that minimizing the potential for loss usually comes at a cost. We must pay for these price risk management tools. Many farmers combine tools to achieve a balanced approach to price risk management.
The price we get for our grains when we deliver them to our normal, local buyers is based off the Chicago Mercantile Exchange (CME) price. The difference between the CME price and the local price is called basis. Basis is all about where and when.
Basis = Local Cash Price - Futures Price
Local Cash Price = Futures Price + Basis
The reason for understanding our local basis is that basis is one signal telling us when to market a portion of our crop. I ask farmers to track local basis on at least a monthly schedule. Write it down and save this information. Over years we start to see a pattern of basis moves. When we are quoted a local price we need to check to see if the current basis is strong or weak (compared to normal for that month). A strong basis is suggesting the price offered is better than might otherwise be expected. A weak basis is signal from the market that they really don’t want our grain at this time.
Trends and seasonal patterns?
From watching over 37 years of farm commodity price levels – we see a definite seasonal pattern. This makes some sense. The buyers of our grains are most at risk of not getting sufficient supply during the late winter and early spring months. Depending on price levels, farmers are making decisions on what to plant for the coming season during this time frame. To entice sufficient planting, and thus harvest, potential prices tend to be highest for corn and soybeans during the February – June window.
Seasonal tendencies are an observation that averages many years price patterns into one index. Any single year may run counter to a seasonal perspective. However, on average, we can detect a seasonal commodity price pattern. Understanding this seasonal pattern and following current prices is one method to also get signals from the market on when to take the current price offer.
Current Farm Bill commodity price support programs are complex and require more space than we have here to get a complete understanding of their applications. Our USDA, Farm Service Agency personnel can help us get a better grip on these opportunities.
O.K. – now what?
Every businessperson eventually becomes involved in finance, production and marketing. These three activities are essential to effective business management. While most farmers describe themselves primarily as producers, they also have to finance and market what they produce.
Fortunately, “good” producers are often “good” marketers because smart marketing begins with an idea of the cost of production (break-even). Managers who market without an idea of their cost of production can only concentrate on enhancing the price they get for their product. Many people use the following to highlight the significance of understanding the cost of production - “It's like driving a car that only has a front window and no side or rear windows. As long as everything runs smoothly, it can be OK. But any setback must be handled with incomplete knowledge.”
Those who market with an understanding of their break-even can make decisions about what is an acceptable price, what price will cover certain critical costs, and what are the risks of not taking a price when it is offered. Again, using a car to illustrate, it provides front, side and rear windows so that the decision maker can make both offensive and defensive decisions.
The marketing plan described here is intended, first, to cover as many of the costs of production as possible and, second, to maximize the price received for commodities produced. Some managers try to maximize price before they have implemented strategies to cover all costs. While marketing in this manner is the prerogative of the farmer, it is not the approach reviewed here. The marketing plan discussed here focuses on relatively simple and available strategies that can be used to increase income and reduce risk.
A business-oriented marketing plan includes the following three steps:
- Estimate your cost of production and expected break-even price per bushel.
- Determine your marketing plan - how much you are going to sell at what price.
- Develop a follow-through plan.
Your Cost of Production
Effective producers can be effective marketers because smart marketing is aided by a thorough understanding of the production process. By analyzing the production process, managers are able to estimate costs of production. Each productive activity involves the use of inputs and services. By listing the activities, you can estimate prices to cover each activity and eventually the whole production process.
An effective cost-of-production worksheet should contain sections detailing the operating and ownership costs incurred in production. An understanding of the nature of the costs (operating and ownership, cash and noncash) helps establish target prices.
The marketing plan, no matter how much thought went into it, may not be able to lock in prices that cover all costs of production. Key target prices that compensate for critical costs are important to have in years where opportunities to cover all costs are limited. In the absence of your own cost estimates, you can use published costs of production, available from Extension and other sources. However, these cost estimates provide only rough estimates of fixed and variable costs of production and do not have the detail necessary for personal business analysis and marketing.
The Marketing Plan
The primary objective of a marketing plan is to cover as many costs of production as possible. Use the cost-of-production estimate discussed above and begin to set target sales prices as follows:
- Estimate the outcome of different pricing alternatives.
- Determine a target price and quantity to market.
Estimate different pricing alternatives.
Consider several marketing opportunities from cash sales to forward contracts to futures and options. Basis information for your local market is necessary to analyze the futures and options marketing alternatives. The result of considering all marketing alternatives is to arrive at expected prices for all marketing alternatives. These expected prices can be compared with the cost of production. Whether the current expected prices exceed or are less than the total cost of production, the decision becomes one of marketing a certain percentage of expected production now or taking a risk that a higher price can be obtained at a future date.
Determine a target and quantity to market
Anytime a manager is waiting for a higher price, the possibility of getting a lower price exists. From this perspective, a marketer needs to have both a defensive and an offensive strategy. The offensive position indicates that you will sell when the price rises to a certain level and you are able to cover pertinent costs. The defensive position is the price at which you will sell some of your production in an attempt to lock in income you might otherwise lose.
The target consists of a price and quantity to sell for both an offensive and a defensive position. The trigger price is the price for each marketing alternative that will create a response from the marketer. When the expected price reaches the trigger price for either the offensive or defensive plan, a sale is initiated. The quantity you decide to sell under each plan determines how much of the expected production you will market at different times. Your goal is to maximize the price you receive while minimizing downside price risk.
The Follow-Through Plan
The markets must be watched to determine when a trigger price has been reached. A key to effective marketing under this plan is to have a method of following the markets. Futures prices can be tracked by having continuous market information delivered to your office, using daily or weekly closing prices, or giving your broker or elevator manager authority to conduct the trade.
Because the trade will be initiated at an unknown time in the future, it is necessary to make arrangements that facilitate quick trading. Open any necessary accounts with a broker and banker. Have forward contracts ready to be signed and delivered. When a trigger is pulled, the decision should be easily implemented.
Stick to your plan
If prices are moving up, the tendency will be to postpone pulling the trigger because a higher price surely is ahead. When prices are moving down, optimism says they will bounce back and you should wait for the rebound. This is not objective marketing. You set trigger prices in an attempt to capture an acceptable price without undue risk. Because you market only a portion at each target, the price expectations experienced at each trigger can be built into future targets.
Accountability can be obtained by having another person know and understand the marketing plan. Spouses and partners are often in a good position to implement a marketing plan because they may not feel as attached to the production as the person producing the commodity. When the target is reached, your spouse/partner can remind you to initiate a trade. Marketing clubs, brokers and business associates can also serve as reminders to trade. Giving authority to grain traders to initiate a trade at certain targets can also be a way of keeping to the plan.
Aim at a second target. Whenever a trigger is pulled, aim at a second target. Select both offensive and defensive trigger prices, along with quantities to be marketed. The process of setting a target, pulling the trigger at key points and aiming at another target repeats until all of the production is sold.
Marketers need to keep track of what percentage of expected production is forward priced so that they do not oversell as they repeat the marketing plan. Portions of a marketing plan worksheet assist producers in tracking what percentage of expected production is already forward priced.
The concepts described here is an attempt to introduce objectivity into the marketing process. Many things need to occur to market production effectively. The following tips should help make your marketing more successful.
- Don't market all of your production at one time - especially anticipated production. Grain in the field is not as sure as grain in a bin.
- Remember your strengths. Most farmers prefer production to marketing. Focus on production. Market as objectively as possible according to plans.
- Keep an eye on your financial position. Leverage and liquidity problems can wreak havoc on your finances and marketing plans. Having to sell to meet financial obligations is not part of the marketing plan and is not usually the best time to sell.
- Don't get greedy. If you can lock in a profit, do it. It may not be the highest profit, but it is a profit.
- Remember profit is a return to risk. You cannot reduce all risk and still expect to excel in profit.