The 2012 drought has been a game-changer in almost every aspect of farm and ranch management, including production, financial and marketing, says Darrell Mark, adjunct professor of economics at South Dakota State University, during his Aug. 6 weekly Cattle & Corn Comments on the iGrow Radio Network. "With the widespread and severe nature of the drought, yield losses, while expected to be large, remain uncertain, thereby creating significant market volatility," Mark says.
Because marketing in such times is difficult, Mark says the importance of making sound risk management decisions increases. Here are some tips Mark encourages agriculture producers to keep in mind when making tough marketing decisions in today's market environment.
1. Price Trends Can Change Quickly. "The corn and soybean markets have been on a sharp uptrend for more than one month, which tends to reward sellers for waiting for higher prices," he says. "It's important to remember that prices will not increase forever, and when they do peak, they are apt to drop rather quickly."
He explains further. "Even current 'sell-offs' in the market – which are the result of speculative profit taking – can be 30-40¢/bu. The current daily price limit in the CME Group corn futures contract is 40¢/bu., which expands to 60¢/bu. on a day following a limit close lower (or higher). So, conceivably, the corn market could drop by $1/bu. in two trading days. And, the trading days come quicker than calendar days now that the market trades 21 hours/day," he says.
"While there isn't anything in particular that would suggest this will occur, remember that the feeder cattle producer didn't have much forewarning or early evidence of the more than $20/cwt. drop in feeder cattle futures prices this last month either," Mark says.
2. Forward Contract With Care. For many producers, Mark says physical delivery of bushels will be difficult this year if they lose a significant portion of the crop to drought.
"Be certain to read and understand the non-delivery clauses in any cash forward contract. Almost certainly, it will cost money to settle non-performance of forward contracts, often by the amount of futures price changes from the time the forward contract was initiated until the delivery date," he says. "Some grain merchants may also consider rolling the contracts into the 2013 crop year, but again, it may come at a cost."
He adds that Revenue Protection crop insurance can help offset some of these costs associated with non-delivery of forward contracts. To learn more about revenue protection read last week's Cattle & Corn Comments on iGrow.org.
Mark adds that even ranchers who are forward contracting their calves for fall delivery need to take precautions as they may need to move delivery dates up or decrease delivery weights.
"They might need to consider price slides on both the upper and lower side of the base weight contracted this year," he says.
3. Use options. While options are rather expensive due to the high volatility in the underlying futures markets, Mark explains that put options can be used effectively to create floor selling prices and calls can create ceiling purchase prices.
"Options offer the advantage of not requiring delivery of the physical product, unlike most cash forward contracts," he says. "Additionally, they enable the hedger to benefit from favorable price moves and do not require margining an unfavorable price move in the futures market (beyond the total option premium paid), provided that the hedger has only purchased options (not sold, or wrote, puts or calls)."
Mark says options may also be easier than futures contracts when managing the risk of futures commission merchant (FCM) defaults.
"After the mismanagement of customer hedging funds at two large FCMs this last year, it would seem that maintaining as small of balances in the hedging account as possible would help protect a hedger's money," Mark says. "Because a purchase of an option (put or call) only requires payment of the total option premium (it is a limited risk position), the amount of money put into a trading account held by a FCM can be limited."
Mark says that options may be a more effective way to cover futures positions right now than using a stop loss order. "For example, a hedger with a short futures position might have a standing stop loss order (to his/her broker) to offset/exit the position if the price trades up to a certain level. This practice would limit the losses associated with that short futures position, although it also lifts the hedge," he says.
He explains that in a market environment like this, with large daily price changes and high volatility, it is increasingly likely that these types of stop loss orders could be triggered and the futures hedge is offset, even when the hedger didn't want the hedge lifted (because prices may quickly revert to the lower level, in this example).
"Using a call option, in tandem with this short futures hedge, can cover some of the losses the short futures position generates as price increases and assist with exiting the position," Mark says. "Essentially, this is a synthetic put. The same can be done for a long futures hedge by purchasing a put option to protect the sales (or offset) price of the futures hedge."
"Be certain to pay premiums on time and talk to your crop insurance agent before cutting, chopping, haying, or abandoning an insured crop," Mark said. "For harvested grain, be certain to understand and follow record keeping requirements set forth by your crop insurance company and agent."
4. Crop insurance. Be certain to complete all record keeping and paperwork in a timely manner for crop insurance. Mark explains that while premiums for fall-harvested drops were to be due earlier than usual this year, USDA has worked with crop insurance companies to delay those earlier payments by 30 days.
"Be certain to pay premiums on time and talk to your crop insurance agent before cutting, chopping, haying or abandoning an insured crop," Mark says. "For harvested grain, be certain to understand and follow record keeping requirements set forth by your crop insurance company and agent."
5. Evaluate new alternatives. Many drought-stressed grain and livestock producers are in difficult positions this year, but may be able to help each other. For crop producers without cattle, consider the economics of selling drought-stressed corn to livestock feeders for silage or hay. While there are several nutritional safety aspects to this, Mark says it might be beneficial to both parties in some cases. Kansas State University has an excellent calculator to estimate the silage value of corn and sorghum for both sellers and buyers, available at www.agmanager.info.
6. Manage 2013 margins. High grain prices for 2013 and beyond are enticing sales of next year's expected production. Mark says making small sales of insured bushels at this point might be a good marketing decision. However he says that producers should keep in mind that most of the input costs for the 2013 crop are not yet known.
"Should input costs spike higher, expected profit margins at current 2013 price levels may turn out much lower than expected," he says. "This occurred a few years ago when prices reached then all-time highs. Margin management will likely be most effective when grain sales are timed with input purchases in dollar-for-dollar amounts."
7. Doing nothing is a decision. "In historic times as these, it is easy to suffer from 'analysis paralysis' and not make decisions or take actions," Mark says. "The challenges of this year's drought could cause some to avoid making decisions regarding grain sales or herd liquidation. Often, the advantage goes to the producers that make the difficult decisions first – before production conditions worsen further or prices become more unfavorable. Still, sometimes the best decision is to wait for a certain time or event to occur, just be sure that too is a conscious management decision."
While every farm-management and marketing decision needs to be carefully evaluated, Mark says it is important to actually implement the plan once it is developed.
"Be certain to communicate openly with family members, employees, lenders, brokers and other members of the management team while doing both," Mark says.
To learn more and hear an archived recording of this iGrow Radio Network interview, visit iGrow.org.