Friday, May 20, 2011
Using Crop Insurance And A Forward Contract to Guarantee The Marketing Price You Need.
On May 12, the Farmgateblog.com beat the drum fairly hard about the opportunity to use your crop insurance to protect your downside risk in a volatile grain market. Has the volatility stopped? No. Have you used your crop insurance coverage to protect your family’s 2011 revenue? OK, we’ll go on to the next question. If you use your revenue-based crop insurance in combination with a futures hedge, will that protect the revenue that you need to pay your expenses and feed your family? Good question. But you’ll have an answer after you click here…
What cash rent are you paying? What are your production expenses and any other non-land costs? Now that you have a total that needs to be covered, progress can be made. The question is, will hedging your new crop corn now, reduce your downside revenue risk? Helping with the answer are University of Illinois economists Gary Schnitkey and Bruce Sherrick in their recent farm management newsletter. The economists evaluated several scenarios, one of which was for a farmer having no crop insurance. The others were revenue protection with coverage levels of 65%, 75%, and 85%. Using a per acre production cost of $850, (how does that compare with yours?) they used a farm with a 184 bushel expected yield and a forward contract price of $5.95.
1) Without hedging or crop insurance the economists calculated a 32% chance that revenue would be under the $850 needed to pay the bills. There are also a 22% chance of revenue being under $750 per acre and a 13% chance of revenue being under $650 per acre.
2) With no crop insurance, but by hedging the 184 bushel crop at $5.95, the 32% chance of revenue being below $850 is reduced to only 7%, and that is when 71% of the crop is hedged. When more is hedged the risk increases. Schnitkey and Sherrick say the chance of revenue below $750 is reduced from 22% to only 2% when 59% of production is hedged, and the chance of revenue being below $650 per acre is reduced to only 1% when 44% of production is hedged.
3) Adding a 65% coverage revenue insurance policy with the hedging begins to significantly reduce risk even more. The chance of revenue falling below $850 is reduced from 32% without hedging to only 6%, and that occurs when 61% of the crop is hedged.
4) With a 75% revenue protection policy the chance of revenue falling below $850 is reduced from 32% without hedging to only 3%, and that is reached when only 42% of the crop has been hedged.
5) With an 85% revenue protection policy, the chance of revenue falling below $850 is reduced from the 32% level without hedging to 0% when only 7% of the crop is hedged. In fact, the $850 guaranteed revenue occurs with an 85% revenue protection policy when as little as 7% of the crop is hedged to as much as 71% of the crop
What Schnitkey and Sherrick say is, “This large range gives farmers great attitude in pre-harvest hedging without impacting risk. Farmers can use this latitude to price grain without downside risk concerns.”
Summary:
“Many farmers purchase crop insurance policies with 80 and 85% coverage levels. At these coverage levels, most gains of reducing downside risks are obtained when less than 10% of expected production is hedged. Perhaps just as important is that much higher levels of hedging do not impact downside risks. As a result, farmers with high coverage level insurance policies have large latitude in hedging grain without impacting risk.”
Posted by Stu Ellis on 05/20 at 12:00 AM | Permalink