Introduction to Risk Management

Understanding Marketing Risks

Marketing is that part of your business that transforms production activities into financial success.

Unanticipated forces, such as weather or government action, can lead to dramatic changes in crop and livestock prices. As agriculture moves towards a more global market, these forces stem increasingly from world factors. Other farmers" weather and other governments can affect your prices. When these forces are understood, they can become important considerations for the skilled marketer.

To be successful, you should take an informed and balanced approach to making marketing decisions. Focus on long-term profitability, not short-term windfalls. Academic studies indicate that marketing strategies that depend on price chasing or speculation have not been shown to be consistently profitable. Also, those strategies that do not consider financial and production risks will likely prove to be poor.

Marketing agricultural products involves information, objectivity, attitude, and skill. You should develop marketing plans and strategies that work for you. Here are three important considerations in developing a marketing plan:

1.  Know what level of risk you are comfortable with.

Inability to control market forces and difficulty in predicting those forces and difficulty in predicting those forces make marketing an inexact science. A better understanding of you financial situation and the possible consequences of your decisions will remove some of the uncertainty from marketing decisions. Obviously, marketing involves understanding your level of risk tolerance. It also involves a good understanding of your current financial position.

2.  Be willing to increase the number of skills in your marketing toolbox. You may need to pay for professional help in developing your marketing plan.

Successful marketers are continually updating their abilities by learning new skills. Such efforts should be undertaken without the expectation of an immediate payoff. There are many professional who can help you. These include futures brokers, elevator operators, financial planners, and farm consultants.

3.  Develop an integrated management approach to your business.

Marketing decisions should not be made independent of other farm business decisions. They should be planned according to the impact they will have on the production, financial, legal, and human resource aspects of your business. Marketing decisions often involve contractual agreements that have important legal consequences. These contracts can significantly affect financial plans.

Managing marketing risk begins with a marketing plan. The goals and objectives of your business should drive the marketing plan.

An accurate understanding of production costs is a critical part of a sound marketing plan...for you and the professionals who work with you. There may be times when the market price fails to cover all of the costs associated with production. A break-even price should serve as an important reference, even though it is not usually not your desired price.

An analysis of supply and demand is important in developing targets for your marketing plan. Supply and demand projections are published by the U.S. Department of Agriculture and by private firms. Early in the growing season, expectations are highly uncertain. However, commodity markets respond decisively to these projections, so you should be aware of them.

You should also be aware of prices received in your area and know the average prices received in previous years. Again, you have a choice of learning these skills and monitoring this information yourself, or hiring a professional to help you.

Financial considerations such as cash flow requirements, including family living needs, should be incorporated in your marketing plan. Financial circumstances and other personal factors help determine your ability and willingness to tolerate market risks. Marketing plans should be as unique as the financial, production, and management characteristics of each individual producer. What works well for a neighbor may not be appropriate for you and your family.

Marketing involves emotion, science, discipline, and analysis. The best marketing plan will fail without the self-discipline to stay on track. Unfortunately, letting emotions rule is easy when prices are moving. When prices rise, it is hard to resist trying to squeeze an extra few cents from the market. And, it is easy to panic when prices fall. In marketing, not making a decision is a decision. A marketing plan is of little or no value if actual decisions deviate from the plan. Having a written marketing plan will help ensure discipline.

Contingency plans, as part of the basic marketing plan, will also help. What to do if the price doesn"t reach the desired level and what to do if the crop is not as large as expected are important contingency actions when the market does not develop according to your general expectations.

Learning about the full range of price risk management tools will allow you to become a better marketer and risk manager. Selecting the right tool to use at the right time will not only reduce risk, it could increase your profit. Following are a basic overview of more commonly used pricing strategies and guidelines for determining when to use each.

Storage (with no protection). Storage is a way if avoiding seasonally low prices. When prices are below the level anticipated in the marketing plan, storage may be justified, assuming that you have adequate financial resources. Storage may be warranted when there is a realistic expectation of a market price increase. Historical data indicate that the market is often willing to pay your storage costs. However, stored grain can go out of condition and is subject to theft.

Cash Sale. When prices are favorable and at levels anticipated in the marketing plan, direct cash sale is warranted.

Deferred Payment Contracts. Deferred payment contracts allow for the current pricing and delivery of the crop, but can delay the receipt of payment. They are often used as an income management tool for tax planning purposes. A deferred payment contract makes the seller an unsecured creditor of the elevator. This has implications both for legal and for financial risk exposure.

Fixed Price Contract for Deferred Delivery. This contract allows producers to establish a price for later delivery. A fixed price contract, also known as a cash forward contract, may allow you to schedule deliveries at times of the year that better fit with labor, grain quality, and logistics. Having an adequate amount of crop insurance allows you to comfortably contract the insured portion of your crop. These contracts often work well when crops are large, when storage is tight, or when the market price reaches the objective in your marketing plan.

Basis Contract. Basis is the difference between the local cash price and a futures contract price. Basis is typically more stable and predictable than either the underlying futures contract or the local cash price. However, basis does change in response to local supply and demand factors. A basis contract allows you to fix the basis, but allows the final cash selling price to be determined at a later date by subtracting the fixed basis from the futures price. This strategy works well when the basis is strong (cash prices are high relative to futures) and there is some potential for an increase in futures prices. MPCI or revenue insurance can give you the confidence to enter into basis contracts without the concern of not having a crop to deliver.

Deferred of Delayed Price Contract. A deferred or delayed price contract transfers title of a crop to the buyer at delivery, but allows the seller to set the price later. It is commonly used when storage is tight. At these times the local elevator wants to move more grain into the marketing channel, but the seller may not be satisfied with current prices. When producers have crop insurance, they have a guaranteed, minimum production level. They can, therefore, safely use deferred price contracts early in the growing season.

Minimum Price Contract. A minimum price contract establishes a floor price for the duration of the contract. The floor price is typically several cents below the cash price at the beginning of the contract. A producer could net less with a minimum price contract than with a fixed-price contract if prices fall, but will benefit from a rise in market prices. This contract eliminates much downside price risk.

Hedge-to-Arrive (HTA) Contract. This contract has risk management properties similar to a short futures market position. It is the opposite of a basis contract. It permits the seller to set the futures price level by the delivery date, but the basis is determined later. The seller is responsible for delivering the contracted amount on the delivery date.

Short Futures Hedge. Selling futures contracts to protect the value of grain or livestock in inventory or the value of grain or livestock in inventory or the value of expected production is a short futures hedge. A short futures hedge reduces downside price risk. On the other hand, it also reduces the ability to capture upside price movements.

Put Option Purchase. This tool is similar to a minimum price contract. It sets a floor on the crop or livestock price throughout the life of the contract. If prices rise during the period, the seller can capture upside price gains.

Contracted Production. Many variations of this type of contractual arrangement exist. Historically, production contracts have been used for specialty crops, poultry, and livestock. Purchasers have been willing to offer such contracts to fulfill the need for highly specific agricultural products. Recently, contracted production has been offered on an increasingly broader range of crops and livestock. Contract production reduces flexibility and the opportunity to capture upside price potential. But, it assures a relatively reliable cash flow.

Marketing Cooperatives. Forming and participating in marketing cooperatives provides members the opportunity to benefit from volume sales or purchases. Benefits may be in the form of enhanced prices received or reduced costs. There has been an increased interest in marketing cooperatives for both crops and livestock.

Direct Sales. For some producers, selling directly to final consumers is a way to enhance profitability and reduce risk. Smaller farms near population centers may especially benefit from direct sales. Examples include the sales of fruits and vegetables through roadside stands and "you-pick" operations. Also, some producers can increase profits and reduce risk with specialty livestock products, like "all-natural" beef, which reach a specialized market niche.

It's a Whole New Ball Game
Understanding Goals and Risk Tolerance
Understanding Production Risks
Understanding Marketing Risks
Understanding Financial Risks
Legal Issues Associated With Agriculture
Human Resources Issues