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Managing Risk in Volatile Times

Dan Childs

By Dan Childs
Senior Agricultural Economics Consultant

Posted Jan. 1, 2011

Agriculture input and commodity prices seemed to be on a rollercoaster during the last few months of 2010, with the inclines being longer and more sustained than the short dips down. This left general price levels much higher than forecasts of only a few short months ago. How can price predictions miss the mark by so much in such a short time period? From booths at local coffee shops to conference rooms in land grant universities and USDA offices, agricultural producers and industry experts have asked the same question. Possible causes including weather conditions at home and abroad, a weak U.S. dollar supporting exports and the effect of index and hedge fund trading have all been volunteered as causes for the miscalculations. Regardless of the reason for the price swings, agricultural producers must do a better job of managing their production and price risks to remain successful in this volatile environment.

Not so long ago, producers had few options to manage their risks. Limited insurance products existed, and the ones that were available had expensive premiums. Generally, crop insurance products only insured against the risks of production with little opportunity to insure prices. Futures contracts and options on futures contracts were available through commodity exchanges, but the products received little interest from producers. Not much attention was given to seasonal price patterns of inputs because the differences between the peaks and valleys were very small. As a result, concern was seldom given to managing the price risks of production inputs. When price risk strategies were implemented, only the risk for the commodity or output was considered. Today, locking in only the price of inputs or the price of the output is a recipe for potential failure.

The past few years have seen the addition of many tools to control risk. Several insurance products are now available to insure crop yields and price, forage production, and feeder and fed cattle prices. Premiums for crop insurance are more affordable, especially when production history can be proven. Considerable flexibility exists for insuring forage production as well as cattle prices. Livestock price insurance can be purchased down to a single head of cattle. Futures market information and education is now much more accessible to individual producers. Mini grain contracts of 1,000 bushels rather than the normal 5,000 bushels are also available.

How can these tools be leveraged to help producers manage risks? The first step is for a producer to know their per unit cost of production. Producers need to start with good production and financial records to allow for an accurate calculation of a break-even point. Once the break-even is known, per unit amounts for other items - things such as fixed costs; principal and interest payments; family living expenses; and desired profit - can be added to develop asking prices. After asking prices are determined, a producer can start evaluating different risk management tools to decide which ones fit their individual preferences and risk tolerance. If certain tools, such as futures contracts or options, are used, upward movements in commodity prices may cause producers to miss out on profits from higher prices. This is common in volatile markets and causes many producers to forego risk management. Ideally, risk managers should develop strategies that enable them to benefit from at least some potential commodity price increases.

Risk management can also be used to protect against unexpected rises in input costs. Seasonal patterns show when prices are typically the lowest and highest of the year. Prices are usually lowest when a particular input is in the least demand, such as fertilizer and feed prices in midsummer. When combined with prudent production practices, students of seasonal price patterns who take action at appropriate times can lower their per unit cost of production.

No one size fits all in risk management tools and strategies. However, diligent study and use of the available tools and strategies can turn volatile markets into good pricing opportunities.