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by Bob Parsons, UVM Extension
E-mail: bob.parsons@uvm.edu
We are continuing our series of articles on farm business risk by examining
some actions farmers may take to reduce the impact of market and price
risk on their farm operation. All farmers face some risk from their markets
because prices change and can drop unexpectedly at the wrong time.
Market risk management involves making efforts to limit the impact of
unfavorable and unexpected price movements on your farm business.
Defining Market Risk
First off, let's define marketing as the activity that occurs when you
sell your product and receive a payment commitment from a buyer. This
can include cash at the time of the sale, a check in the mail, or a written
contract defining future price and payment conditions.
Market risk management practices are those activities that the farmer
can use to reduce exposure to unplanned external forces (e.g., weather,
trade, government actions) that can result in adverse downward price movement.
Through the use of insurance, storage, contracting, futures contracts,
and other marketing tools, farmers can reduce their risk to unexpected
price swings.
Reducing Market Risk In Practice
An example of a farmer who reduced price risk is an individual who uses
a pre-season contract that guarantees a certain price for the total quantity
produced of a speciality crop. There is no market risk because the farmer
has made efforts to guarantee an outlet for the crop and has locked in
a price before the growing season, enabling him to estimate sales and
profits.
Now think of the other extreme. I heard of one individual who bought a
property in the country and decided to raise sweet corn. He planted one
variety all at one time and didn't think about where to sell it. You guessed
it-the sweet corn matured all at one time, forcing him to rush around
to find farm markets and other produce outlets for it.
He was at the total mercy of whatever price the buyers offered, even if
they were interested-a total disaster with most of the corn left in the
field or overripe on his truck. To make matters worse, one store that
did take his sweet corn never paid. Now he knew why the store didn't buy
from other local farmers. He wasn't happy, his banker wasn't happy, and
his spouse was ready to file for divorce.
By the next year, however, he had learned his lesson. During the winter
he made contract arrangements on quantities, prices, and payment conditions
with several outlets. He staggered his planting to assure corn throughout
the season. He also made arrangements to rent a cooler that could keep
corn for a short time. Now he had outlets for his production, knew when
he was to be paid and how much, could plan debt repayment, and was on
better relations with his banker (and his spouse).
How much marketing risk an individual farmer can absorb depends on the
individual. The question for most farmers is "can you withstand changing
market forces?" If not, the second question is "what can you do to protect
yourself against market swings?"
Knowing What Is In Your 'Toolbox'
There are an assortment of "tools" that farmers may use to weather market
downturns. Farmers need to keep in mind that reducing price risk has costs
that restrict their ability to capture higher prices. It is this tradeoff
that farmers must balance for their own survival.
Storage
Storage is one alternative that apple, hay, syrup, and grain producers
have used for years to avoid selling at harvest when prices are generally
lowest. As many farmers can testify, this strategy generally works but
is not a sure thing.
Firstly, putting crops in storage costs money and takes time. Secondly,
there are times that farmers lose money putting crops into storage because
the price change does not rise enough to cover the costs. In recent years,
apple producers question whether the price advantage they may gain pays
for the storage and cooling costs. And there have been years where I have
gotten "free" exercise from putting hay in the barn, only to take it out
again the next winter to sell at a lower price!
Storage does not work as well for dairy and livestock farmers. But feed
costs rise when livestock are kept off the market while you wait for a
higher price and who has ever tried to store a month's worth of milk?
Contracting
Another tool that is more common with specialty crops and is now becoming
more widely available to dairy farmers is contracting. The farmer and
buyer make a prior agreement that determine price based on quantity, price,
and/or other conditions and specify when payment will be received. Many
vegetable cannery operations use these type of contracts.
In the past 2 years, some dairy cooperatives and processors offered contracts
that would guarantee a base price for a certain quantity of milk. These
contracts provide both parties with some security and assurance of price
and an outlet for the product.
But there is a downside to contracts. While providing price protection,
contracts prevent both parties from taking advantage of more favorable
market conditions that may emerge.
For example, a farmer may contract some of his milk with his coop at $12/cwt.
The farmer knows what he is getting for his milk and the coop knows what
they have to pay it. If the milk price drops to $11, the farmer is assured
of $12. But if the milk price goes to $13, then the farmer only gets paid
$12.
The farmer gave up the opportunity to receive $13 by getting protection
that he didn't receive $11. The coop received protection from paying $13
but gave up the possibility of paying only $11. Both parties benefit from
knowing the price but give up any potential market advantages.
Adjusted Gross Revenue Insurance
Another option is the use of Adjusted Gross Revenue Insurance. For farms
where livestock accounts for less than 35% of the gross income, the farmer
can take out insurance to guarantee that a base level gross income is
achieved. Although this is just a pilot program, it presents an opportunity
for Vermont farmers who do not have dairy cows.
The Options Market
Another risk management tool available for crops, and recently for dairy
farmers, is the use of put options.
Put options establish a floor price while allowing the farmer to capture
some of the price gains that may occur. The beauty of options is that
you can have the best of both worlds-price security and ability to capture
higher prices.
For a simplified example, a farmer purchases an option to sell his milk
for $12/cwt. If the milk price goes to $13, then the option expires unused
and the milk is sold at $13. But if prices drop to $10, then the farmer
uses his option and receives $12/cwt., less the option cost.
Of course, there is a downside. Put options are not cheap and they do
not guarantee high prices. Vermont dairy farmers have a unique opportunity
to learn more about options through the USDA Dairy Options Pilot Program
(DOPP) this fall. This program pays for 80% of the trading costs and provides
free training on options to farmers in certain counties. Check with your
local extension office for details on training sessions which will be
held August 12-15.
Using Your Tools To Build Something
After exploring the above risk management alternatives, many farmers may
likely become confused how using some of these tools may apply to their
own situation.
Below are some basic key points that need to be the background of every
marketing plan.
1. Product knowledge - What are you selling, what does it cost to
produce, what is your expected production, when is it available, can
it be stored, and is storage available?
2. Price history and what are the local, regional, and national supply
and demand conditions that affect local price.
3. Know your financial considerations and obligations. When is cash
needed to meet debt repayments and family living needs? Can you afford
to take the chance of getting a lower price in the effort to wait
for a higher price?
4. What marketing tools and avenues are available for your product
and how do they normally operate.
With this information you are ready to begin a marketing plan. How you
sell, when you sell, how much you get for your product, when you get paid,
and when do you need the payments are all pieces that make up a customized
marketing plan.
But the degree of risk you are willing to absorb depends on your specific
situation. In addition, remember that market risk management does not
assure receiving higher prices. Market risk management reduces the probability
of receiving lower than expected prices.
Let's go back to the sweet corn farmer. After a disastrous initiation
into farming, he came up with a marketing plan. Now he knows how much
he can sell and where. He can notify stores if he doesn't have enough
corn. He also knows what stores may take more if he has a bumper crop.
He knows what he is getting paid and when. He can use his cooler to hold
corn a few days.
In addition, he carries crop insurance to assure revenue to meet production
costs. With this approach, he can better manage production, labor, and
cash flow.
Click here for a list of local companies
that offer federally supported crop insurance policies.
For more information on risk management and crop insurance you can contact
Louise Waterman at the Vermont Department of Agriculture at (802) 828-6900
or e-mail waterman@agr.state.vt.us
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