Wednesday, March 02, 2011
Manage Risk Today For Lesser Risk In The Future
It is a four-letter word that no one likes to hear. But it is one that farm operators have to conquer if they are going to be successful. The word is risk, and the world is full of it. Anyone who recently saw market prices drop the limit on the Chicago Mercantile Exchange knows that Middle Eastern dictators can bring risk to the grain markets. But being able to manage risk will allow operators to get the upper hand and obtain the rewards that accompany risk.
“The risk in agriculture today, particularly in crop production, is greater than it has been in the past,” say Purdue economist Mike Boehlje and Brent Gloy, whose analysis of risk management and the ability to capture the opportunity comes in eight steps. Boehlje and Gloy recently appeared on a Purdue webinar, and you may have heard some of their analysis. If not, their research provides a lighted roadmap for many producers who might be groping in the darkness.
The Purdue economists say your risk stems from operations and financing. Operational risk involves prices, input costs, yield fluctuations and the factors that determine your annual revenue. It is not hard to look at great price variations, weather-related yield variability, and unusual volatility in input costs, which have been difficult to predict. Those have all contributed to volatility in your operating margins. The economists say crop producers may have lost at least $50 per acre in 2006, profited over $150 in 2007, profited over $250 in 2008, and then fell to a dramatic loss in 2009.
The other factor is financial risk, particularly if your operation uses debt to fund the operation. That creates a risk that operating receipts will not be sufficient for debt service. However, for many operations, debt use has been low in recent years along with interest rates. The economists warn against variable rate debt with today’s low interest rates that will rise.
To manage your risk, Boehlje and Gloy propose eight strategies to protect current margins and position your operation against the uncertainty in the marketplace.
1) Lock in margins on crop prices with the use of futures contracts, forward contracts, and contracting input prices for fertilizer, seed, and chemicals.
2) Buy crop insurance that will protect against reduced yield and even against price and revenue variability. While higher costs reflect the higher cost of the protected commodity, the economists suggest the use of enterprise policies that can reduce policy premiums. Crop insurance also provides “yield protection” giving a greater comfort to lock in prices.
3) Fix interest rates on long term debt, since rates appear to be rising after having been unusually low. There will be some additional cost because your debt will be financed with securities that will mature in the future which have a higher interest rate. The economists say consider the overall magnitude of the rates, “While it is difficult to predict interest rates, one should ask whether having your entire “portfolio” of debt on variable rates is a sound risk management strategy. Instead, it might be prudent to diversify by changing some variable rate debt to fixed rates.”
4) Pay down debt with expected high crop returns to reduce your overall debt and financial risk. The economists say with strong cash flow, the more highly leveraged farms should consider de-leveraging their operation over the next few years.
5) Hold financial reserves, with more working capital or liquid assets that are available to cushion times of financial stress. Those might result from higher costs, lower prices, lower yields, or higher interest rates.
6) Buy or bid conservatively if you are purchasing farmland or capital assets or paying cash rents. There are implications to long term cash lease obligations or land purchases that may not be able to be met if economic stress resumes.
7) Grow slow with the use of equity, instead of borrowed capital. If you are borrowing, the cost of capital in the future will be more expensive, but the cost of using equity will come at a lesser cost. The economists suggest acquiring assets more through rental arrangements and less through ownership.
8) Invest in operational excellence and cost control to protect against unprecedented price swings. Returns are high now and there may be a tendency to relax cost controls, but making prudent capital investment will increase efficiency and lower long term costs.
Summary:
Risk can be found both in volatility of commodity prices as well as rising costs of production inputs. Farm operators can serve themselves well by considering a number of steps to manage risk and ensure the sustainability of their operation should financial stress continue or worsen. Those steps include costs controls, reducing debt, maintaining working capital, changing to fixed rates of interest, use of crop insurance, and locking in both profit margins on commodities and input costs.
Posted by Stu Ellis on 03/02 at 12:00 AM | Permalink