In the first of a series of academies looking at how farmers can get the most out of the grain market, HGCA economist Michael Mendelsohn looks at managing price risk.
Price volatility is generally accepted as a fact of life. The key to risk management is to accept the inherent nature of price volatility. The essence of uncertainty in the agricultural market is the natural variation in supply in global cereal markets. It is impossible to predict the yield and production of crops accurately enough to stabilise markets, and this creates uncertainty in the price.
Traditionally, governments provided support for farm prices that usually included stabilisation and protection from currency. Most countries are now moving to free trade systems so that local markets are exposed to world market pressures. This leaves farmers exposed to market volatility, and it is therefore increasingly important for farmers to take action to ensure a minimum acceptable price for their grain.
But many farmers view the use of futures markets and option contracts as a necessary speculation, rather than risk management. And for most, a lack of technical expertise creates barriers to using such market-based tools. But, if used as part of a robust strategy, these tools can significantly reduce farmers’ market exposure.
Risk management tools
There are many ways to look at price risk, and ultimately how you manage it will be determined by your appetite for risk, the nature of that risk and the impact to your business. There is no one right answer, as in most cases risk is personal and so are the mechanisms to manage it.
A range of physical tools are available to farmers to help them manage price risk. These solutions have a direct relationship to the physical product which is being marketed.
Do Nothing
This strategy is as legitimate as any other, as long as it is a thought-out plan, and not just waiting in the hope that the market will move in your favour. Doing nothing will leave you exposed to the market whichever way it goes – you have both the downside risk and the upside opportunity.
Selling Forward
The key aspect of selling on fixed terms whether you sell for immediate delivery or at a future date is that you have an obligation to supply in accordance with the terms of your contract. Once a forward sale is made, there is no downside risk (as long as you meet the contract terms) but no upside opportunity. You will not benefit if the market rises, or lose if it falls.
Managed Pools
The premise behind this strategy is to pool your grain with other farmers to effectively increase the amount of grain you have available to market. This approach can enable growers to benefit from economies of scale and gain access to specialist marketing. It is also usually beneficial to enter a pool that specifically meets your business needs. Ultimately the quality of the organisation that you choose to pool with will determine the benefits you will gain from the pool.
Contract Growing
This type of tool is becoming more popular following recent reforms to the Common Agricultural Policy. Processors are offering contracts linked into specific crops. Growing contracts are an excellent way of locking in margins even before the crop is sown. While you do still have risks associated with quality and quantity, this approach gives you a method of fixing the price and the market on terms that meet your own needs.
Futures-Related Tools
These tools have a direct link to the futures markets and require an understanding as to how the futures market works.
Futures contracts
Futures provide a longer-term alternative to forward sales. As Euronext.liffe wheat futures contracts are for feed wheat, any sale will not protect against fluctuations in quality premiums. As futures values generally move in line with physical values, futures enable you to lock into a price for your grain in advance of any physical sale. Any loss on the physical sale will be recovered through an equivalent gain in the futures and vice versa.
Options (“Calls” and “Puts”)
Options are contracts that allow you to choose whether or not you wish to go through with the purchase or sale of a futures contract – quite simply they give you the option. There is a price to pay for this option (the premium) and it is always payable.
A “Call” option gives you the choice to buy futures. Typically you would buy a call option if you had sold your crop and you still wanted to gain some benefit from any potential rise in the market. This would set the minimum price of your grain as your sales price, minus the option premium.
A “Put” option gives you the choice to sell futures. You would usually buy a “Put” option if you had not sold your grain and wanted to protect yourself against any fall in the market while staying open to benefit from any market rise. A “Put” option effectively sets a minimum price as the strike price of the option (minus a premium).
Other Tools
Over-the-Counter Options
OTC options are alternatives to futures contracts or options. OTC options are not traded on futures markets and can be tailor-made to suit individual purposes. This is a good example of how a futures-related contract can be linked into a physical sale such as a minimum price contract with a merchant or even a growing contract. One example of an OTC option would combine a forward sale, probably based on futures, and a “Call” option.
Min/Max Contracts
These contracts offer growers a secure minimum price, while limiting the upside opportunity to a pre-determined range. These contracts involve the indirect use of options, as a merchant will typically have offset the risk involved by trading options himself. It is therefore important for farmers to understand how these contracts are structured to ensure they are getting sufficient value from them.