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Power Hour: Risk Management at Forefront in 2013

December 27, 2012
2013 outlooks
  

By Jennifer Stewart, Purdue University

One thing is certain for corn farmers in 2013, and that is the importance of risk management amid extreme uncertainty in yields and revenues, Purdue agricultural economist Chris Hurt says.

Three years of below-normal corn yields and ongoing drought in the western Corn Belt have the potential to drive corn prices to record highs in the coming year, but a return to more normal yields nationwide could send corn prices on their largest-ever year-to-year decline. The wide range of possibilities makes growers vulnerable and emphasizes the need for a variety of risk management tactics.

"The key to risk management is to protect against the potential bad outcomes, but still leave opportunities to capitalize on potential good outcomes," Hurt said.

The first way to do that is with crop insurance. Farmers can choose from a variety of coverage types and levels that offer financial protection from low yields and prices. What makes crop insurance so desirable is that it doesn’t limit the revenue a grower can receive if yields or prices are high.

"Crop insurance is hugely important," Hurt said. "Sometimes growers are hesitant to sign up because the premiums have to be paid regardless of whether coverage is used. But I think a lot more people understand the value after the drought this year. If not for crop insurance, it would be depression in many farming communities right now."

Marketing decisions also play a role in risk management. Many farmers forward-contract portions of expected crop production to lock in forward prices. But while forward contracts protect growers from falling prices, they also prevent gain if prices increase between the times contracts are made and when crops are harvested.

"Growers should forward-contract only a portion so that if prices go up they still have money to gain," Hurt said. "It's common to forward-contract 25-30% of expected production for new crop delivery."

Farmers who do forward-contract also can consider purchasing an out-of-the-money call option against their forward contracts. The option allows the opportunity for farmers to gain revenue if prices go up after contracts are made.

An example, Hurt said, is a farmer who opts to sell corn for $6 per bushel in a forward contract. By purchasing a call option on futures at $7.50 per bushel, the farmer could add $2.50 a bushel to their $6 if corn prices ended up moving to $10 because of drought.

"The call option costs some money but provides upside opportunity in case prices move sharply to the up side," he said.

The highly anticipated 2013 Farm Bill could provide farmers with additional revenue protection.

Both House and Senate versions of the bill stop direct payments to farmers but instead withhold that money to give farmers an enhanced safety net in the form of 8-10% more financial protection.

For example, if a farmer elected a crop insurance coverage level of 70% and the federal government offered an additional 8-1%, farm finances would be protected at 78-8%.

"The foundation of risk management in 2013 would still be crop insurance," Hurt said. "But this could add another modest layer of protection and build a little more confidence."

 

 

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