23 August 2002

PROFIT MODEL CUTS OUT

MISTAKES IN MARKETING

Grain marketing has

become the most critical

issue in modern arable

farming. Get the market

wrong and all the effort

invested in crop husbandry

is squandered. Charles Abel

takes a closer look at the

HGCAs latest initiative

to help growers improve

their marketing skills

CHILDS play it is not. A few hours spent with the HGCAs "Pricing for Profit" computer model could make the difference between your business returning a viable profit and an overdraft-busting loss.

If you are still not familiar with using call and put options, forward selling, setting a breakeven price and interpreting market signals, then this CD-based computer game is one you should not miss this autumn.

Last years price crash demonstrates just how costly marketing decisions can be, notes HGCA senior economist Gerald Mason. July wheat futures plummeted £29/t over the year, which for an average wheat yield of 8.23t/ha represents a £235/ha loss to the business.

That is equivalent to more than all the variable costs spent on a crop. So with a whole new set of factors influencing the market, including Black Sea competition, uncertain import duties, the US Farm Bill, Chinese farm policy, Argentine currency worries and the $/£ relationship, why not spend more time managing market risks, he asks.

"Im not saying farmers made a bad job of selling their grain. Hindsight is easy. But they did have opportunities to sell at a price they needed for the business."

Have a plan

And that is the nub of the "Pricing for Profit" game. "Building a marketing plan is vital," insists Mr Mason. "Once you know the price you have to achieve you can start to maximise the opportunities for doing something about it," stresses HGCA economist Julian Bell. "The key thing is working out the price you need."

The HGCA game shows how useful that can be, allowing growers to experiment with 10 different market scenarios, four based on actual figures from recent years and six based on hypothetical markets for the future.

It is meant to be quick, easy and fun to use, says the HGCA. Growers can use their own crop tonnages to experiment with different marketing strategies before trying them in the marketplace. As one user puts it: "Its an excellent tutorial – seriously addictive to play over a lunch break."

New features include the ability to use options (see panel). "The best way to understand how options work is to tinker with them in the game, otherwise they can seem confusing," admits Mr Bell.

While the game may not revolutionise a business, it will show what is possible, he continues. "It is not a magic way to turn the farm back to profitability, but it does show things to think about for making the business more profitable and more secure."

"The problem of getting it wrong is now so dire," agrees HGCA crop marketing committee chairman Marie Skinner. "Five years ago a marketing mistake meant the difference between making a large profit and not quite such a large profit. Now it means the difference between a small profit and a loss or a loss and a bigger loss. Farm businesses can no longer stand losses that are avoidable."

&#8226 Copies of the "Pricing for Profit" CD are available free to levy-payers from HGCA. Tel 020-7520 3920, fax 020-7520 3931, email mi@hgca.com

Marketing could have had more of an impact on crop profits this year than the entire amount spent on variable inputs, says HGCAs Gerald Mason.

&#8226 Interactive CD-based computer game.

&#8226 Numerous scenarios to try.

&#8226 Experiment in safety.

&#8226 Available free from HGCA.

Treat options as a form of insurance, to put a floor into the market for future grain sales, urges HGCA economist Julian Bell.

Options can be regarded as a way of getting somebody else to protect the farmer from the risks associated with violent market movements, says the HGCA.

They carry a cost, which can be viewed as a form of insurance to replace the guaranteed intervention market that used to do the same job for free, says HGCA economist Gerald Mason.

"Once youve paid for an option you have prevented any further loss. Without one there are no price guarantees. Prices could go up or down £10-15/t."

There are two options to use in wheat:

&#8226 "Put" options can be used if you want to hold grain unsold, explains HGCA economist Julian Bell. They effectively set a price floor for that grain, giving the grower the right to make a grain sale at an agreed price – the strike price. If the market falls the "put" option is executed at the strike price and the profit generated offsets losses on the physical grain held in store. If the market rises, the option expires and becomes worthless, but the grower benefits from a higher sale price for his physical grain. (The insurance gave him the confidence to wait for the upturn).

&#8226 "Call" options can be used if grain has been sold for cashflow or storage reasons and there is a possibility of the price rising. If the market rises later the "call" option makes money, allowing the grower to have his cake and eat it. If the market falls, the option expires and becomes worthless, but the grower benefits by having sold his physical grain earlier at a higher price. (The insurance gave him the confidence to sell early.)

In both cases the option carries a cost. If the option is unused that is a net cost to the business. If it is exercised, the cost of the option comes off any price benefit that is realised.

The trick is to view the cost of taking out the option in the same way as any other insurance, such as car insurance, says Mr Mason. In both cases a premium is paid in return for somebody else taking on the responsibility for any risks you face.

"Car insurance reflects the history of the driver and car. A 25-year old in a red GTi is going to pay more than a 50-year old in a Skoda. In the same way option costs reflect the expected market volatility. With car insurance the premium reflects the period of cover and the cost of an option is the same, reflecting the time until the option expires. The longer it lasts the more it costs. And the cost of the car insurance reflects the size of any excess that may be payable on a claim. In the same way an option cost will reflect the strike price."

Options – just another form of insurance

The HGCAs interactive marketing game pitted the wits of "prudent" Group A against Group B "speculators". Keen gamesmanship saw the outcome reflect final market conditions, but the scale of the potential difference was dramatic (see panel below).

Just before harvest a group of growers and traders gathered at the Farmers Club in London to give the HGCA "Pricing for Profit" game a live, competitive run through.

Designed to be a fun evening to highlight the benefits of the game it revealed a host of issues as growers grappled with a flood of hypothetical market information, summarising some particularly turbulent price movements.

In April, both groups sold around two-thirds of their crop forward before harvest at £76/t for Sep and £84/t for May. Th0se prices were above their costs of production, but they were not confident enough to sell their entire crop at a fixed price in case the market rose, says HGCA economist Julian Bell.

Group A proved more willing to spend money on options for price protection, recognising the difficulty of interpreting market movements with any degree of certainty. They bought 600t of "put" options to protect the value of their unsold grain. Group B initially decided that buying options would erode their already thin margins at current prices so did not buy any options until later in the game when they had fallen behind.

In September prices fell to £61/t from which Group A benefited as their "put" options paid out compensation while Group B fell behind since they were unprotected.

Group A decided not to sell as they felt harvest pressure would pass, but to protect their decision to hold grain they bought another 600t of "put" options. Group B did sell 200t of grain and bought 200t of "call" options to protect them in case the market then rose.

As the last decision period in December arrived, with the market falling yet further to £56/t, Group A moved well ahead benefiting from their policy of using options for price insurance.

Group A at this point decided that the market would rise at the end of the game so they didnt sell. Group B did sell the remaining 500t of their grain but decided to speculate heavily on the market rising by buying 10,000t of options (6.5 times their crop) in an attempt to catch up.

Group A also bought some "call" options but were keen to limit their exposure as they wished to remain above £70/t and their costs of production even if they were wrong and the market fell.

By the end of the game in May prices had risen £8 to £66/t. So Groups A and B, which had both bought "call" options, benefited as the market rose.

Group B with the highest risk strategy from buying 10,000t of "call" options achieved the best net price of £89.73/t. Group A also benefited from the late season rise in the market, but to a more limited extent with a final net price of £80.90/t.

In summary, Group A made prudent use of options to protect income above its estimated £71/t cost of production, whereas Group B failed to exploit options early on and then swung to a heavily speculative and risky use of options at the end in a bid to catch up.

But what if the market had fallen at the end of the season instead of rising? If the market had fallen to £50/t the situation would have been reversed; Group A would have come out around £15/t higher with a net price of £71.50/t compared to Group B at £56.40/t. &#42

Prudence versus speculation

It shows how to ask other people the right marketing questions. It has helped explain the options opportunity, so now I know enough to ring a trader to ask if it is worth using – Ivan Smith, farmer,

Ware, Herts.

Difficulty with options is they add cost when market price is already so close to, or below, cost of production. When prices were higher growers were more likely to use them. Yet it is now that they need them – Chris Collins, Harlow Agricultural Merchants.

If growers understand the marketing opportunities better it does help us extract the best results rather than trying to deliver the "best price", which may not be achievable –

Mike Adams,

Banks Cargill.

Game helps differentiate between using options for risk management and for speculation – Cathy Simms, farmer, Herts.

The chance to experiment without risk should improve confidence to try techniques for real – Bill Barr,

farmer, Herts.

Farmers need more confidence to use options and need traders to help them

more though the minefield. A little

knowledge can

be extremely

dangerous – Stephen Bumstead, farmer, Northants.

Certainly helps you understand how the markets can act.

If it were easy

there wouldnt be traders going out of business

like they are – Richard Lewis, farmer, Chelmsford.

Just because youve sold your crop it doesnt mean to say you cant use options to take more profit if you think the price is going to go up –

Andrew Dewing, Centaur Grain.