Risk and Reward

February 23, 2011 09:33 AM

At a time when world stocks of many agricultural supplies are dwindling and global demand for these products is strengthening, risk might seem like a relic of the distant past. But for some, the old adage "what goes up must come down" comes to mind and fear escalates. There is no way to eliminate the fear that prices will head south, but there are ways to manage risk in relation to market timing.

"Selling your grain when you think prices are as high as they will get and are about to fall presumes you know the market top," says Carl Zulauf, ag economist with The Ohio State University. However, overwhelming evidence shows very few people possess the ability to successfully time the market. There’s nothing wrong with trying to maximize profits, but managing risk is not about obtaining the highest price.

Volatile Times. In today’s bull market, it’s important not to get lulled into thinking the only volatility that exists is to the upside. By definition, volatility means prices can fall as quickly as they rise. That proved true in 2008 when commodity and equity prices crashed following the worldwide financial crisis.

"As volatile as the market is today, in general, you want to keep downside risk coverage in place for potential outside occurrences," says John Melius, farm market risk manager with Hurley & Associates, Brookings, S.D. These potential risks may include food inflation that cuts into worldwide demand, trade protectionist policies, sovereign debt issues in the eurozone, a slowdown of economic growth in the developing world and changes in regulation that cap food commodity futures contracts for investors.

Today’s volatile markets will likely provide producers with ample opportunities to try to maximize 2011-12 profits this spring. "If you look at a 20-year price seasonal, the highs have been in late spring and the lows at harvest," says Ben Parks, risk management consultant with FCStone, Kansas City, Mo. "We have a major dilemma with acres and a whole season of weather ahead."

If this year plays out like most others, producers will also have opportunities in late March, April and May to manage risk by getting downside protection in place.

People have different risk tolerances based on their financial situation, such as whether they own land, their debt-to-equity ratio, on-farm storage capacity and available capital. The more highly leveraged producers are, the lower their risk tolerance. A producer who owns land and pre-books lower-priced fertilizer can handle more risk than a producer who rents land and buys fertilizer on the spot market.

Risk management is not without its own risks, so it’s important to understand the risks that can increase when choosing a particular strategy, Zulauf notes. Some producers may choose to self-insure against risk with strategies such as diversifying revenue sources, building capital and having off-farm income.

Forward contracts are easy to understand and in that regard seem to be one of the least risky of all risk management strategies, but they can backfire. "If you do a forward contract, you have to come up with the crop," Zulauf says. If a calamity wipes out a producer’s crop, the forward contract is still binding.

When using futures and options to manage risk, Zulauf recommends, have an exit strategy even before taking a position. And when undertaking risk management strategies that entail futures, producers also need to ask themselves whether they can psychologically handle a substantial margin call or, more importantly, whether they have the reserve funds to actually pay it.

Options function more like an insurance policy. While selling options requires a margin deposit, buying options involves paying a premium that decays to zero at the time the option expires. "The closer you get to the expiration of the option, the faster the premium decays," Zulauf says. This is an example of when having an exit strategy could pay off. If you exercise or exit the option prior to expiration, some value could still remain.

Finally, locking in revenue alone—regardless of which tools are used—leaves a producer open to plenty of risk. "By locking in only one side of the equation, you may actually take on more risk if input costs rise," Zulauf says.

Plan to Buffer Emotions

Keeping tabs on your emotions is paramount to good risk management.

"You need to set price targets based on technicals or what you fundamentally think the market will do, and, most importantly, execute those price targets," says John Melius, farm market risk manager with Hurley & Associates. "Don’t let emotions take over."

When developing a risk management plan, Melius and his clients first determine cash flows and cost of production. "Once we know what we need, we can devise a plan of attack," he says.

In an up market, producers need to devise strategies to protect downside risk while leaving the upside open. "We then monitor the market and set red flags," Melius says. "If we get to a profit level that is higher than is realistic—say, over 30% profit on revenue—it’s a red flag telling us we should get more downside coverage and make more sales."

Melius likes to think of risk management as a three-legged stool, with the banker, producer and risk manager each representing a leg. An open relationship with his/her banker can help a producer manage fluctuations in market carry and basis.

"Producers need to pay attention to basis when they are doing their market plan," Melius says. "Basis fluctuations can change their bottom lines immensely."

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