By Mike Preiner, Granular Co-Founder and VP of Data Science
With another historically tough year ahead for farmers, it is worth spending some time looking at one of the most important financial decisions farms will make for 2017: which crops to grow.
A lot of factors go into this decision: crop rotations, landowner agreements, and in particular, financial projections. In a previous post, we looked at how profitability has varied for corn and soybeans in the past...in any given year the difference in profitability is often $50/acre or more. In other words: choosing your crops is important! However, it isn’t easy...deciding on crops for 2017 means making assumptions about price and yield, and a few bad assumptions can completely wreck a budget. In this post we show how to run a simple sensitivity analysis to illustrate how you can figure out how to get a handle on how “sure” you can be of making the right choice.
The Easy Part: Expenses
Estimating your costs (even down to the field level) is relatively straightforward if you are using modern farm management software. There is always some uncertainty in how much herbicide or fungicide may be needed, but these effects are small compared to our next topic.
The Hard Part: Revenue
The real uncertainty in planning comes from price and yield assumptions (i.e. revenue!) for the upcoming year. While nobody knows exactly what prices and yields will be next November, the best farmers know how to play the odds: insert your favorite poker or baseball reference here.
Price: there is obviously a lot of uncertainty in crop prices, and trying to predict them often involves trying to outguess the market..something we don’t advise! However, there are two things to keep in mind when planning for the next year:
- The futures/options markets provide tools to estimate price risk. The value here is similar to knowing that the odds of getting a full house in poker is 2.6%. With those odds, it would be crazy to count on getting dealt a full house; similarly, right now it would be crazy to count on $5/bu corn.
- Prices of crops are strongly correlated (e.g. when corn prices go up, soybeans usually do too), which means that if you are careful, picking the most profitable crop is actually quite a bit easier than estimating the final price of any given crop. More on this later in the post.
Yield: the story is very similar to price: there is a lot of uncertainty here! The upshot is:
- Your historical yield data can give you a lot of information about the odds of various yield scenarios, and
- The yields of various crops are correlated to each other in a way that is very similar to price.
Putting It All Together
If you have a good handle on all of the above, making that critical decision on what crops to plant (and where!) can be be surprisingly clear. For example, it is easy (and true!) to say that even with today’s prices corn will be more profitable than beans if corn yields are really high and bean yields are low. However, that is a pretty unlikely scenario. How unlikely? That can be understood with the sensitivity analysis shown below in Figure 1, where you can see that soybeans beat corn in every single historical year given the current cost assumptions. Of course, your yield and cost structures will be different than the Illinois university budget, so it’s important to run these numbers on your own.
Figure 1. Sensitivity analysis showing the relative profitability advantage of corn over soybeans as a function of yield. Costs are taken from the University of Illinois 2017 crop budget, and we assume prices of $3.86/bu for corn and $9.94/bu for soybeans. We have overlaid historical trend-adjusted state average yields to illustrate how corn and soybean yields are correlated. For example, from the historical yield data, we can see that it is unlikely to have a year of 200 bu/acre corn and soybean yields less than 50 bu/acre.
Now what the effect of uncertainty in crop prices? While this uncertainty can be estimated via analyzing options prices, here we’ll use historical crop prices in our sensitivity analysis. The results are shown below in Figure 2. You can see that only in 3 years (2011, 2012, and 2013, all years of extremely high prices) did marketing year average prices end up in a regime where corn would be more profitable than soybeans given our current costs and yields.
Figure 2. Sensitivity analysis showing the relative profitability advantage of corn over soybeans as a function of price. Costs are the same as Figure 1, and we assume yields of 180 bu/acre for corn and 55 bu/acre for soybeans. We have overlaid historical inflation-adjusted state average prices to illustrate how corn and soybean prices are correlated. For example, from the historical price data, we can see that it is unlikely to have a year of $5.00/bu corn and soybean prices less than $10.00/bu.
What does this all mean? If your cost and yield structure is similar to the University of Illinois budget, the answer is clear: history suggest that it is very unlikely that corn will be more profitable than beans for you this year. Keep in mind, though, that basis can vary a lot from region to region, and every field has its own cost structure and yield expectations. Because of this, you should make sure to run your own numbers...it could easily mean $50/acre to you!