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Thursday, May 12, 2011

Using Your Crop Insurance To Manage Price Risk In A Volatile Grain Market



 

How many times in the past 6 weeks has the volatility of the grain market caused you to reach for the stomach pills?  There have been some very significant price reversals, both up and down, which should have caused many farmers to lose sleep over their lack of either a marketing plan or some form of risk management plan for protecting their rent payment, production investment, and potential profit.  If you are in that category, and are wondering how to use your crop insurance to protect your new crop revenue, read on.

Have you looked at a chart of the December corn contract to closely examine the price volatility of the new crop?  It is not as volatile as old crop corn, but you may not have much of the old crop left to sell, so we will focus on the new crop.  Look at the December corn chart and identify the days where you said to yourself, “Self, I’d better get something on the books at the elevator.”  Then you said, “But I don’t know how much I am going to raise; I don’t have it planted/pollinated/watered/harvested yet.”  That is the reason you committed all of that cash to buy crop insurance, so let’s make that decision pay off for you.

If you bought crop insurance for the 2011 crop, it probably was Revenue Protection, and you probably purchased 80% or 85% coverage, and for the new crop, your guarantee for corn is $6.01 per bushel.  Look at the examples provided by Iowa State University farm economist Steven Johnson.  Your numbers will be different than his examples, but plug in your Actual Production History (APH) yield and your level of coverage and work through his calculation.  If your APH was 150 and your coverage level was 80%, you have 120 guaranteed bushels worth $6.01 or $721 revenue per acre that is guaranteed.  If you are late getting planted, or the summer dries out, your crop insurance will cover your pre-harvest sales up to $721 per acre if you can’t deliver the 120 bushels that you have already sold.

Your insurance will allows you to manage your revenue risk today as a result of the market volatility, and be comforted that you have your cash rent and production expenses paid (or thereabouts).  If you have the harvest price option and the fall harvest price climbs because the crop is short, then you will benefit from that higher price.  If it reaches $7.50 as an average for the December contract during the month of October when it is calculated, then multiply $7.50 by the number of bushels you produced, 110 for example.  Your calculated revenue would be $825 ($7.50 X 110), but since your guaranteed revenue was $900 ($7.50 x 120 bu.) you will get an indemnity check for $75 for each acre insured.  You can plug your own numbers into this example or the one that Steven Johnson provides.

One factor to check is whether you purchased revenue protection with the harvest price option (which was a higher cost) or with the harvest price exclusion (which was a lower cost.)  The harvest price exclusion will not allow you to take advantage of any price rise, but you know that your guarantee equates to the $6.01 multiplied by your APH multiplied by your coverage level, such as 80% or 85%.

Regarding his example, Johnson says, “Where many farms struggle in utilizing crop revenue coverage and pre-harvest marketing of bushels for delivery is the ability to recalculate the revenue guarantee. The example includes two extreme harvest price estimates. The high harvest price is $8/bu. and generates an indemnity of $160/A. The low harvest price is $4/bu. but creates a much larger Indemnity totaling $321/A. That’s because in the example, the actual harvest yield is multiplied times the higher of the projected or harvest price to create the calculated revenue. To determine the indemnity, subtract the calculated revenue from the harvest guarantee.”

So here is what you need to do, according to Johnson, “If you choose to pre-harvest sell bushels for delivery, consider timing those sales when December corn futures or November soybean futures are higher than the projected price. This way you’re guaranteed that if you come up short of bushels, you can collect a minimum of $6.01 per bushel for corn or $13.49 per bushel for soybeans, respectively.”  Watch your local elevator bids, which are what you will use to make your pre-harvest sales, not futures prices. 

You do not have to sell everything that your insurance might cover, but you can spread your price risk and sell at various times, up to the coverage of your insurance.  For those bushels that you do not want to commit to delivery, Johnson suggests protecting the price of those bushels with either a futures hedge or a put option to lock in a floor price.

Summary:
Periods of market volatility are expected to continue as long as the supply and demand are about equal, which USDA reported they are.  While volatility can provide potential profits, it can also provide potential losses, should a marketer sell more grain that is being produced.  Your crop insurance was purchased for that reason, and a good risk manager will not only have crop insurance, but will use it to manage price risk with the protection it provides for profitable market prices.

Posted by Stu Ellis on 05/12 at 08:47 PM | Permalink

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