Module 1 Managing Risks and Profits Robert Wisner, Iowa State University
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As you watched the wheat and corn markets explode to record highs in 1996, then drop to less than half their spring and summer highs by fall, you may have sensed that you are farming and managing in a different world than in the past. Soybean market action in 1997, a 500-year record flood in the Red River Valley, and record cold in early 1997 followed by an exceptionally mild winter the next year also signal that the world is changing. Other recent events include China’s shift from a large exporter of corn to an importer, and back to an exporter within three years, the European Union (EU) shift from grain export subsidies to export taxes, then back to export subsidies, all within a three-year period. These changes are partly man-made through new global agricultural policies. They also reflect climatic changes that may or may not be man-made. Whatever the causes, the increased volatility in climate and markets has a large potential impact on your profitability and has important implications for the way you manage your business. Managing Risks and Profits (MRP) is intended to help you understand and manage more effectively in a changing global environment. MRP contains an in-depth look at challenges you face in managing the business side of cash-grain and soybean farms. This series consists of 15 modules, each of which is designed to help you better understand the market, production, legal, and financial risks you face and alternatives for managing risks while focusing on profits. We focus on the causes of the changing economic environment, and most importantly, on how these changes impact your management decisions. Emphasis is on concepts and tools you can use to reduce uncertainty and increase profits in your business. Each module ends with thought-provoking questions to help you analyze the significance for your business. The next module (Module 2) focuses on climatic change and its implications for grain farmers. Later, we look at financial considerations in developing a management strategy and analytical tools such as probabilities (widely used in weather forecasting) to help you select among various alternatives. We will look at the components of market risk and the ways that various marketing tools manage or fail to manage these risk components. Attorneys will discuss legal aspects of grain contracting that include tax considerations as well as other legal issues. Four modules (Modules 9, 10, 11, and 12) provide an in-depth look at yield and revenue insurance tools. At least eight different kinds of insurance tools (plus yield futures and options) are available to choose from. Our focus is to provide information that can help you decide if you need protection offered by these tools, and if so, what kind and how much. Other modules discuss pricing methods and tools, including the role of basis in grain marketing decisions. Whenever possible, Managing Risks and Profits aims to provide concepts you can use wherever you farm in the U.S. or Canada. When data limitations prevent using local examples, additional information for your area may available in attached price, yield, and basis files, and through extension specialists at your land-grant university with the addresses and phone numbers in this compact disk (CD). This project is a joint effort of extension services from eight north central states, so look under the "Universities" section for this information. If you have questions about one of the modules, a toll-free phone number is available for your use ( 1-800-678-6269). The phone number will allow you to leave your question as a recorded message. Since the number also is used for classroom teaching, we encourage you to leave your message after 4 p.m. CDT (5 p.m. eastern time). The New Profit and Risk Management Environment for Grain Producers (or go to Topics ) The marketing environment facing feed grain, wheat and oilseed producers has changed dramatically since 1996. Major changes include new U.S. farm programs, trade agreements, climatic changes, economic problems and instability in the Pacific Rim, and new risk and profit management tools. The Federal Agriculture Improvement and Reform Act of 1996 (FAIR; also known as Freedom-to-Farm Act) has eliminated the long-standing deficiency payment mechanism that generated increased government payments when prices declined. The deficiency payments have been replaced by a payments that do not vary with price, and which will continue through 2002. Impediments to short-term shifts of acreage from one crop to another, arising from previous government programs, have been eliminated. The potential for large changes in planting patterns through the FAIR act was illustrated in 1996 by double and triple digit percentage increases in corn planted acreage in a number of southern states. Large increases in 1996 spring wheat acreage and 1997 soybean plantings also are a direct result of new agricultural legislation. Another significant shift in agricultural legislation is the changing emphasis of the Conservation Reserve Program toward targeting environmentally sensitive land, while allowing other land to return to crop production. Stock Policies De-Emphasized (or go to Topics ) New government programs also have eliminated the Farmer Owned Grain Reserve that previously helped to temper the impacts of weather shocks on prices. While a small strategic wheat reserve still is mandated, the FAIR act largely eliminates government grain storage. When crop production is relatively large, the lack of a grain reserve policy may produce a greater downward pressure on prices than in the past. In times of low crop production, a lack of reserve supplies (for example, corn in 1995-96) can be expected to create very high and volatile prices. Figure 1 indicates that world coarse grain (feed grain) stocks dropped to a record-low percent of use in 1995-96, and have remained at a historically low levels since then. Also, note the relatively volatile world production in the 1980s and 1990s. Low stocks have been accompanied by the erratic use of the U.S. Export Enhancement program, a major tool sometimes used to match subsidized foreign competition in wheat markets. Unpredictability in use of this tool adds uncertainty to price prospects. Canadian and European Union policies also have de-emphasized government grain storage programs because of their high cost. That also tends to amplify price volatility. As an example, the European Union (EU) subsidized grain exports heavily in 1994-95. The following year, with reduced production and low reserve stocks, the EU placed a tax on grain exports. In the fall and winter of 1996-97, it reinstituted grain export subsidies to avoid building stocks, with a negative effect on grain prices. Trade Agreements: Market Opportunities, But More Risk (or go to Topics ) The North American Free Trade Agreement (NAFTA) and the General Agreement on Trade and Tariffs (GATT) provide improved access to foreign markets and have set the stage for accelerated growth in Mexico’s economy and grain demand. The other side of the picture is that increased dependence on foreign markets carries risk. NAFTA and resulting changes in Canadian agricultural policy have at times increased the competition U.S. grains face from our northern neighbor, both in our domestic wheat and feed grain markets, and in Mexico. Other dimensions of risk associated with heavy dependence on foreign markets can be illustrated with the following examples: (1) loss of the once-large Soviet grain market, (2) the Mexican peso crisis, (3) China’s cancellation of wheat purchases because of disease concerns (4) China’s abrupt shifts in corn exports in both directions within the last three years, (5) the 1997 swine disease epidemic in Taiwan, the No.3 export market for U.S. corn, and also in the Netherlands, and (6) the Asian economic crisis of late 1997 and 1998 which was accompanied by sharply lower corn exports to the region. Figure 2 illustrates the unpredictable nature of China’s corn exports. China was a net importer of corn in the 1970s and early 1980s, but abruptly shifted to a net exporter in the late 1980s and early 1990s. The shift was partly due to the production response from changing farm policy. In the early 1990s, China was the world’s No. 2 corn exporter. Then, in 1995, it abruptly became a sizeable net importer of corn. In mid-1997, it resumed corn exports. Other examples could be drawn from China’s large imports of soybean oil in 1994, and its large imports of soybeans and soybean meal beginning in 1996. While the long-term outlook for Chinese grain demand looks quite positive, short-term shifts in export positions by a nation that contains nearly one-fifth of the world’s population can dramatically affect prices. The abrupt loss of the once-large Soviet grain market is a caution that risk comes with heavy dependence on exports. Questions such as "Will the Soviet market be restored?" or "Will some former Soviet Republics become continuous competitors?" have no ready answers, but highlight future areas of uncertainty. Other dimensions of world markets include recent longer-term investments in Brazilian agriculture and infrastructure in response to strong soybean prices. Impact of Change on Grain Producers (or go to Topics ) Impacts of these recent changes in the global agricultural economy on individual farmers are difficult to quantify. As a start in that direction, Figure 3 shows what the net return for a corn farmer would have been in southwest Iowa for the 1980-1996 period with and without the government disaster and deficiency payments. The example is an actual farm, with yields taken from crop insurance records and using costs from extension budgets. Adjustments for elimination of disaster program payments are approximations. Disaster benefits were especially important for this farm in 1988 and 1993. In half of the years, most or all of the profit from corn production from this farm came from government payments. Yields were quite low in 1980, 1983, 1988 and 1993. New Tools for Profit and Risk Management (or go to Topics ) Recent U.S. policy changes, while eliminating deficiency payments and ad hoc disaster programs, signaled that Congress is willing to subsidize new types of crop insurance that insure revenue (dollars per acre) rather than just yields. Since the profit equation includes yields, prices and costs, new types of insurance have been designed to help ensure a minimum level of gross income per acre rather than just insuring yields. In later modules, we will give you a detailed look at the various types of crop yield and revenue insurance now available and their potential roles in managing risks and profits. Other new private-sector tools available to help manage risks and profits include the corn yield futures and options markets. A later module will provide an in-depth look at how these tools work, as well as their potential advantages and disadvantages in managing your business. Along with these new tools, we will also focus on ways that more traditional price futures and options can be used in a profit and risk management context. While not addressed in this series, farmers in the last few years also have chosen to increase their use of private-sector marketing consultants to help cope with an increasingly complex marketing and management environment. Considerations in Analyzing Your Business (or go to Topics ) In this series, you will see numerous references to risk, uncertainty, and risk management. These three areas are closely related. Risk sometimes is thought of as an uncertain outcome to which probabilities can be attached. A simple example would be the outcome of rolling dice. Mathematical probabilities can be attached to the result. Crop insurance companies analyze historical yields to calculate probabilities of yields dropping below some predetermined level. Analysis of historical prices can provide some indication of the probability of prices being within a predetermined range. The term Uncertainty is sometimes used to describe events for which no historical information is available to calculate a probability of their occurrence. Examples include the loss of the formerly large Soviet grain market or the hoof and mouth epidemic in Taiwan that may reduce U.S. corn exports to that nation by 20 to 40 percent for a period of time. The phrase risk management is used to denote strategies that greatly reduce the risk of events that would force a farm out of business. We consider risk management as a broader concept that involves development of business strategies to reduce the chances of your profits and/or financial position dropping below some unacceptable level. Notice that we do not define risk management as the elimination of risk. Risk and profits are closely intertwined. If no risk is involved in a profitable enterprise, production would quickly expand to the point where no profits exist. Markets typically (over time) reward business managers for taking some risk. However, a balance is needed so that excessive risk exposure does not jeopardize survival of the business or restrict its long-term growth potential. The appropriate balance of self insurance, crop and income insurance, and marketing approaches will vary considerably from one farm to another. Higher debt farms have a much greater challenge in managing risks, cash-flows, and profits, and in marketing grain than those with little or no debt. These issues are discussed in depth in this series. In preparation for this series of modules, we encourage you to look back over your records of net farm income, crop yields, grain prices received, and government payments. While you may not have all of this information readily available, some of it can be obtained from tax records for the past several years. For some later modules, it will be helpful to have annual cash-flow and financial balance sheet statements. Also, think about your attitudes toward risk. Some individuals seem to thrive on risk, while others sleep better if risk exposure is relatively small. Attitudes toward risk are part of the risk management matrix. Analytical Questions for Your Farm: (or go to Topics ) 1) From yield records, what have been your average, high, and low yields for corn, soybeans, and wheat for the past 10 years? 2) What has been your high, low, and average net income from your crop enterprises over the past 10 years? 3) What percent of your average net crop income has come from government disaster and deficiency payments? 4) What average, extreme high, and low prices have you received for your individual crops for the past five years? Figure the average price received for each year’s crop. Final Comments (or go to Topics ) We look forward to your participation in this educational series. If you have questions, call the toll-free number ( 1-800-678-6269 )and leave us a message. We will do our best to answer your question or questions. Your questions also will help us to make future changes in this series more closely to farmer needs. Thanks for your interest, participation, and feedback. We want to make this series as useful as possible in helping farmers to sort out the complexities of marketing, financial and tax management, and crop yield and revenue insurance. End of Module (or go back to Topics ) |
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