Crop and livestock producers have long identified price risk as one of the highest risk management priorities of the farm business. One of the major challenges of marketing is the extreme variability in prices, not only across years, but within years.
A second challenge in making pricing decisions is that future prices cannot be anticipated with a high degree of accuracy. Producers have a long time period in which to price their production. Livestock futures contracts are available 18 months into the future while crop contracts are available four years into the future.
The factors that determine prices cannot be accurately forecast that far into the future. Even limiting the pricing window to a few months before livestock reach market weight or a few months before crops are harvested through the storage period, price-determining factors can and often do change dramatically, making the decision about when and how much to price extremely difficult.
The purpose of this post is to re- introduce a new approach to making crop and livestock pricing decisions. This new "pricing matrix" approach, first introduced in January 2008 for corn and soybeans, is an integrated model of pricing that considers a broader range of strategies than the traditional approach that focuses on "beating the market". This approach is likely more useful for crop producers, due to the annual nature of crop production and the wide marketing window, but can also be applied to pricing of livestock.
The Traditional Approach to Marketing
The traditional approach to making pricing decisions has been to use a combination of analytical techniques (generally characterized as fundamental and technical analysis) to forecast price behavior and then time pricing decisions based on those forecasts. That approach has essentially been one of attempting to "beat the market". In general, producers remain very frustrated by the traditional decision-making process and believe that they often do a poor job of pricing.
The failure of the traditional approach to pricing can be traced to two factors. The first is a narrow focus on market timing (attempting to beat the market) that ignores the potential implications of market efficiency concepts. In basic terms, market efficiency implies that the current price structure reflects all known information, and therefore, the only way to beat the market is to possess information not available to the market or to have superior analytical skills. The second is a lack of differentiation of pricing strategies based on the skills, characteristics, and beliefs of individual producers.
A portfolio approach to making pricing decisions has the potential to make a very significant, positive impact on the marketing performance of producers. Not only is there significant potential to improve pricing performance, particularly for the chronic poor performers, but there is opportunity to reduce price risk for individual producers and to reduce the level of frustration associated with marketing.
The New Approach to Marketing
The first step in this new approach is to select the appropriate time window for pricing crops and livestock. One method of defining the pricing window is the period extending from the initial production planning time to the end of the storage season for crops or until livestock reach market weight.
For corn, soybeans, and winter wheat in the Midwest, production decisions normally begin in the fall of the year when winter wheat is seeded and fall tillage and fertilizer decisions are made for corn and soybeans. The storage season typically extends through July or August of the year following harvest for corn and soybeans and through April or May in the year following wheat harvest. This results in a pricing window about 20 to 24 months in length.
For hog producers, production decisions generally begin with the decision to retain gilts in the breeding herd, with pigs reaching market weight about a year later. The pricing window for cattle being placed in the feedlot is not as clearly defined. Production plannin begins sometime before the cattle are placed, when feeder cattle purchasing and perhaps feed purchasing decisions are made, and the marketing window ends when cattle reach market weight. This may be a period of about 9 months.