With product prices now much more exposed to the world market, Farmcare’s David Gardner explores the tools available to protect businesses and price volatility
Risks associated with the market place are still relatively new to UK farmers. Since 1947 there has been a floor in the market – first, guaranteed prices and standard quantities and later the CAP’s intervention buying and export restitution systems.
But that started to unravel with the MacSharry reforms in the early 1990s and progressed with the 2005 CAP reform package.Broadly speaking, the essence of uncertainty in the agricultural market is the natural variation in supply that is inherent in biological processes. Even with improved genetic stock and husbandry practices it is impossible to predict the yield and production of crops, and most livestock, accurately enough to stabilise markets.
Therefore, the closer link between EU and world prices, as well as increased market volatility, is motivating food producers to look increasingly at alternative means of managing price and yield risk. These can range from land and crop diversification to the use of forward contracts, futures trading, derivatives and insurance.
Target price
Calculatng your target price rests on what return on investment is needed to cover the business’s costs and trading risk (see graph). If a return of 20% is needed then here is how the target wheat price is calculated assuming
- The direct costs are £241/ha
- The fixed costs to grow the crop are £341/ha.
As a rule of thumb, the average investment over the growing season can be calculated as half of the fixed and variable costs combined (£291). That’s because costs are incurred progressively over the season, not all on day one.
To achieve the target 20% return on investment, the business needs to make a profit of £58/ha of winter wheat (20% of £291).
The cost of production for wheat is £65.46/t and average wheat yield is 8.89t/ha. Therefore, to cover costs and make the 20% return on investment, the winter wheat needs to be sold for:
(£58/ha ÷ 8.89t) + £65.61/t = £72.13/t
Storing the wheat would require an additional premium over progressing months to cover the cost of holding the grain on the farm. Having established a target price it is now possible to sell in a structured fashion – taking advantage of those opportunities that arise to sell when the price exceeds the target. On many occasions those periods can be covered when the spot market price drops below your requirements by using one of the management tools.
Selling forward
The wheat crop can be sold forward about 16 months prior to harvest and then throughout the year following harvest. The marketing season for each crop is about 28 months in total. During this period significant fluctuations will occur in most seasons and at any time during this period it is possible to sell and “lock in” to the wheat price on offer.
A structured but flexible selling programme for the crop is essential. This will be based around the target price. Over the selling period, constantly monitor the market and make decisions about how much to sell as the season progresses.
A farm manager may decide that by the end of March prior to harvest he would like to sell at least 30% of his crop, but no more than 60%, at the target price. He would then seek opportunities to sell the 30% when the market reached target and take opportunities to sell up to 60% when the market significantly exceeded it.
If the market was constantly depressed he might be flexible enough to resist selling as much as 30% during this period. But if the market appeared to be on a real high he might decide to exceed his upper limit of 60%.
Futures markets
Futures markets exist around the world for a variety of different agricultural commodities. They are traded on exchanges. In London the euronext-liffe exchange trades a variety of different commodities including feed wheat in pounds, and rapeseed, milling wheat, corn (maize grain) and potatoes in euros.
A futures contract is a commitment to buy or sell a commodity in the future at a price agreed today.
Arable farms
The crop is sold on the futures market for delivery at a future date at a price agreed today. In doing so you are “hedging” – protecting yourself from future price uncertainty. For example:
- Feed wheat sold at £70/t delivery in April 2006
- Farmer subsequently delivers grain to a futures store and receives £70/t
- Transaction costs are in the order of £0.20/t
This price is a delivered price not a farm gate price, however in most cases the grain isn’t actually delivered to the futures store but the contract is sold back on the futures exchange. For example:
- 500t Feed Wheat is sold at £70/t for delivery in April 2006
- Spot price in April 2006 is £65/t
- The futures contract is sold back on the exchange and makes a £5/t profit on the contract
- Farmer sells his grain at £65/t
- Total receipts are £70/t.
On the futures market there is no risk of the purchaser going bust and defaulting on payments. The “insurance premium” is therefore about £0.20/t.
Both cereal producers and intensive livestock farmers can use the exchanges to lock in both the upside and the downside of price volatility – allowing them to budget against firm prices of either their sales or purchases while still having the freedom to benefit from movements in their favour.
The world of futures, options and derivatives is challenging and complex, but they are the tools of market management that will come more into play as market volatility increases. Information on all aspects of cereals market management can be found on www.euronext.com/commodities or www.hgca.com
Livestock farms
Managing price risk on dairy or extensive livestock farms is more difficult. Input prices can be managed to some extent through the use of forward buying, futures and derivatives.
Volatility in exchange rates can also be managed on derivative markets, but in many cases these transactions may be complex and best handled, at least in the first instance, by financial experts.
However, when it comes to livestock products, the main management tools are production contracts or greater involvement in the value chain through direct selling, on-farm processing or co-operation with other farmers in marketing groups.In the dairy sector, contracts are essential, but there is the opportunity to switch.
Contracts aren’t for life and, particularly in the dairy sector, all farms should constantly monitor which buyers for which market sectors are active in their area so they are confident they are selling at the best available price
The Risk Aware programme is designed to ensure that no business manager is complacent about risks, but is constantly “auditing” to identify what can be done to ensure profitability and sustainability.
PLEASE NOTE: The test yourself does not have right or wrong answers and is for guide purposes only.