Landmark Time Period
Most crop producers will be operating their farms for the first time without the price
support of a government farm program. They will also be making planting decisions based
primarily on economic factors instead of government farm program provisions. Fortunately,
the government farm price support program is coming to an end at a time when wheat and
feed grain prices are at record highs.
Prices are currently high relative to historical levels, but so are costs of
production. While prices are exceeding 1974 highs, production costs have far surpassed
1974 levels. Greater production efficiencies may have offset part of the increased
production costs, but many farmers are probably not making the higher real net income that
they made 20 years ago. Also, prices are high because of tight stocks brought about in
part by the poor crops produced by the majority of farmers in recent years. For these
farmers, favorable prices have given limited benefits.
Several years of favorable prices are needed, but will they happen? Prices will depend
on what happens to world wide production and total use. How long it will take for stocks
to increase again to more normal levels is a question that has received considerable
attention, but no consensus has evolved. Weather, the crucial factor, is still a random
occurrence.
High prices will likely attract additional resources into production, both in the U.S.
and the rest of the world. Few resources will be shifted from the production of one
commodity into another because the stocks of most commodities are low. Examples of
additional resources include bringing Conservation Reserve Program land into production,
use of more fertilizer and chemicals at the global level, allocation of more funds into
research and development, and improved mechanization, including the availability of parts
in many countries. Adding production resources on a massive scale takes time; however, a
reasonable expectation would be that the higher the prices, the shorter the time period
required to add resources.
A significant rebuilding of stocks in 1996-97 does not appear likely for wheat. The
condition rating of the winter wheat crop in April 1996 was the lowest observed during the
last 10 years, and the planting of spring wheat was getting a slow start. Feed grain
stocks may be replenished more quickly.
Crop prices for the next several years will likely be highly variable but will probably
drift lower, on average. Conversely, input prices will likely continue to increase. Land
rents and values may strengthen for a period of time but they should eventually weaken as
transition payments are depleted and as crop prices diminish.
As a general rule, the higher the rate of return expected on an
investment, the greater the risk of an investment.
Opportunities
Current income-enhancing opportunities need to be captured and wisely used. The current
government farm program transition payment is an opportunity, as are strong market prices.
These uncommon sources of funds offer use-of-funds opportunities that are highlighted in
Table 1.
Table 1. Opportunities
- Debt reduction
- Price and yield risk management
- Build a liquid monetary reserve
- Machinery acquisition
- Land acquisition
- Diversifying into livestock
- Investing in a processing cooperative
Debt Reduction
Many, perhaps most, farmers in North Dakota will use a substantial portion of the
transition payments to reduce debt. Farmers who have enjoyed several prosperous years may
have increased debt through replacement of worn machinery and/or expansion. Financial
statements for a number of other farmers may be dismal because of excess moisture, scab
and midge. In some cases, transition payments are needed just to get operating funds.
Getting debt under control will very likely be a primary objective for many producers.
Price and Yield Risk Management
Producers should consider using a portion of the transition payments to reduce price
risk. Volatile prices often present good marketing opportunities. However, capturing a
marketing opportunity may require use of a marketing tool that requires capital to
implement. Contracts, futures hedges and options are discussed later in this publication.
A portion of the transition payments should also be used to reduce yield risk. Crop
insurance can complement marketing strategies, especially the use of contracts and futures
hedges. With multiple peril crop insurance and/or hail insurance , the risk of forward
selling is reduced because a level of income is assured which means that a higher
percentage of the crop can be more safely priced prior to harvest. In addition, severe
financial losses can be avoided with crop insurance, making possible a smaller line of
credit and/or smaller monetary reserves.
Build a Liquid Monetary Reserve
A pool of liquid investments that may be used to finance the farm operation during
periods of adversity should be established. Investments can be in individual securities or
in a group of securities through a mutual fund. Analyzing investments is time consuming.
For those investors who lack the time or the interest, mutual funds may be the best
investment approach.
Investments vary in risk, in effect, in the possibility that the actual return on an
investment could be less than the return expected. As a general rule, the higher the rate
of return expected on an investment, the greater the risk of an investment.
Common fixed rate investments are savings accounts and certificates of deposits.
Because these investments can be risk-free, the rate of return on them is usually low.
There are investments which are considered to be low risk by financial community
standards but which offer a higher rate of return than fixed return savings. The shorter
the maturity on these investments the lower the risk. Some low risk investments offering
higher returns than fixed rate savings include treasury bills and notes and high quality
AAA corporate or municipal bonds.
Common stock offers the potential for a higher rate of return but puts your principal
at risk of loss. Risk can be reduced by spreading your investment among several companies
and by selecting companies from different industries.
Machinery Acquisition
Machinery very likely needs to be replaced on many farms. Presumably, this need would
rank below the need to manage debt and price and yield risk and the need to build a liquid
monetary reserve. Producers should closely examine alternative ways to acquire machinery.
Buy, rent, lease and custom alternatives are discussed later in the publication.
Consider farm and family goals when making machinery and other investments. Do you plan
to retire soon? Is a family member going to join the operation? Do you plan to expand,
decrease or maintain the size of the farm operation? Answers to these questions will help
you decide on the best way to secure a piece of equipment and determine its size, and to
make decisions on other investments.
Land Acquisition
Land is another resource that can be acquired without buying. The buy or rent decision
can be particularly difficult if the land next to you is for sale. Keep in mind that land
is a very illiquid asset. Land can command a premium value during good times, but its
value can be severely discounted during adverse times. In effect, land can have high
liquidation costs. Land may be a good economic investment in the long-run, but may pose a
cash flow problem if a substantial portion of it is purchased with debt capital. Worst
case scenarios for cash flow over time should be closely evaluated when buying land.
The acquisition of land that is not adjacent to the current operation can be an
advantage. It may be cheaper, weather impacts can be reduced and more efficient use can be
made of machinery and labor if different soil types are farmed.
Diversifying Into Livestock
Diversification has long been recognized as a good risk management technique. A
livestock operation can provide cash flow when crop prices are low and vice versa.
Your aptitude for raising livestock and the availability of suitable resources for
livestock production need to be closely examined before adding or expanding a livestock
enterprise. The purchase of livestock and livestock facilities should be evaluated as a
fundamental, long-term enterprise alternative.
Investing in a Processing Co-op
Producers may choose to invest in a processing co-op. Because it usually takes a period
of time for a new venture to become profitable, this type of investment should not be
counted on for quick returns.
Making Decisions in a Risk Environment
What to produce, how to produce, when to sell and how to use funds are decisions that
must be evaluated in an environment that is now more risky without the government price
support program. However, steps can be taken to reduce the chances of an unfavorable
outcome. Also, steps can be taken to reduce the adverse consequences of an unfavorable
event should it occur. You may not want to eliminate risk, but you certainly want to
manage it. Eliminating risk tends to eliminate profit. For detailed information on risk,
see NCR Extension Publication No. 406, "Managing Risk in Agriculture," which was
the source for a significant portion of the material presented in this section.
Risk Attitude
Your attitude toward risk will influence how you make decisions about opportunities
(Table 2). Some producers will choose to avoid risk, especially if they are older. An
older producer simply does not have the time left to make up for adverse events.
Table 2. Risk Attitudes
- Avoiders
- Calculators
- Adventurers
- Daredevils
Most producers tend to be calculators; that is, they carefully analyze situations
before making a decision. Some producers are adventurers; they enjoy risks but still keep
them at reasonable levels.
Daredevils or plungers may make it big, but they commonly fail. They may be the
producers who specialize in production of risky crops, hold crop inventories for the top
price, and give little consideration to buying insurance.
Risk Bearing Ability
Your risk-bearing ability will also affect how you make decisions. Three financial
factors affect your risk bearing ability: solvency, liquidity and cash flow requirements
(Table 3). The level of these factors will determine your risk vulnerability.
Table 3. Risk Bearing Ability Factors
- Solvency
- Liquidity
- Cash flow requirements
Solvency is the relationship between total assets, liabilities and owner equity. A low
debt to asset ratio would indicate good solvency.
Liquidity is the ability to satisfy financial obligations when they come due without
disrupting the farm business. Liquid assets can be converted to cash quickly with little
or no discount.
Savings accounts, grain in the bin and market livestock are highly liquid assets
because they can be converted to cash quickly and with little cost. In contrast, land is
considered an illiquid asset because liquidating a tract of land on short notice can mean
a substantial discount in sales price.
Cash flow requirements are the obligations for cash costs, taxes, loan repayment and
family living expenses. The higher these obligations as a percentage of total cash in-flow
or expected gross, the less able is a farmer to assume risk. Cost control is essential to
profitability and a favorable cash flow condition.
Responses to Risk
Responses to risk involve a cost. Some costs are explicit, like crop insurance or the
option premium. Some costs are implicit, like the revenue given up when price increases
occur after cash forward contracting.
A risk management strategy should make use of all applicable responses to risk. For
example, a strategy that employs diversification, options and multiple peril crop
insurance will likely reduce risk more effectively than will emphasis on any one response
to risk.
Risk should be balanced. If a producer increases risk in one aspect of the business,
the producer should take an offsetting action to maintain total risk at a predetermined
level. For example, a producer who is planning to plant the whole farm to wheat because of
strong prices should consider an offsetting action like contracting or options. If the
producer is uncomfortable with contracting or options, perhaps less wheat should be
planted than originally planned.
Producers must learn how to respond to risk. Responses to three major sources of risk
are: production, marketing and financial.
Production Responses
A number of production responses to risk are listed in Table 4. In the short-run, that
is, in the situation where the production season is about to begin, the number of
appropriate responses are limited. At the very least, consider growing several varieties
of a crop and using several different herbicides. Better yet, grow several crops. Also,
prepare for diseases and insects. If they cannot be avoided, know how to minimize their
adverse consequences should they occur.
Table 4. Production Responses
- Diversifying enterprises
- Choosing low risk activities
- Choose less risky production practices
- Dispersing production geographically
- Maintaining flexibility
Whole farm returns may not be as high from diversification as with specialization, but
year-to-year income variability can be reduced if enterprise returns do not vary exactly
together. For example, the yields of cereal crops may be good when yields may be down for
row crops, or livestock returns may be high when crop returns are low.
In some cases, returns may be as good or better with diversification than with
specialization. Diversification can lead to greater timeliness of operations and/or the
ability to farm more acres with the same complement of machinery. Wheat, barley and
sunflowers or soybeans, for example, would be a rotation with different planting and/or
harvesting times.
Farmers who do not diversify apparently feel that the profit potential with
specialization more than offsets the reduced income variability of diversification. Also,
those who specialize may have the attitude and financial ability to handle greater risk.
Enterprises and production practices should be selected by producers consistent with
their aptitudes, education, experience and resources. A properly trained producer may
consider specialty crops to be a risk manageable activity. Growing several varieties of a
crop and using different herbicides are low cost ways of managing risk.
Production can be dispersed geographically, which can reduce hail losses and other
weather impacts. Also, the efficiency of labor and machinery can be increased if different
soil types are farmed.
Consideration should also be given to selecting machinery and designing facilities for
multiple uses. The air planter, for example, can be used effectively to plant many crops.
Marketing Responses
A number of marketing responses to risk are presented in Table 5. Marketing responses
are important and applicable in both the short-run and long-run.
Table 5. Marketing Responses
- Spreading sales
- Contracting
- Hedging
- Options trading
Sales can be spread out during the year in various ways to manage price risk. Monthly
sales should enable the producer to achieve about the seasonal average price.
Another way of spreading sales is to sell during those times of the year when prices
are normally at their highs. Seasonal price patterns for most of the crops produced in
North Dakota are presented in NDSU Extension Bulletin No. 61.
A refinement of spreading sales is to scale-up sales during those times of the year
when price peaks are common. Picking a top is impossible. Selling on the backside or
downside of the market is emotionally very difficult.
The cash forward contract and other marketing tools are discussed in NCR Extension
Publication No. 217, Fact Sheet No. 18, entitled "Use of Crop Futures and Options by
the Nontrader." Elevator contracts can reduce price risk in much the same manner as
hedges in the futures and options markets. A difference is that delivery is required in a
contract. Also, the basis is fixed in most contracts. Basis is the relationship between a
futures price and the local cash price.
Hedging in the futures market or the hedge-to-arrive contract is a way to set the
price, which removes most price risk. Basis change is still a risk. While a set futures
price removes risk, it also prevents gain should the futures price increase.
Options in the futures market is becoming more popular with producers. It offers the
ultimate in flexibility -- a floor price and no delivery obligation. However, a premium is
charged for options which must be weighed against the downside price risk avoided. A huge
advantage of options is that potential losses are limited to the cost of the option. You
know up front how much money is at risk, and there are no margin requirements as in a
futures hedge. A counterpart to options is the minimum price contract.
The use of a combination of marketing tools can be very effective. For example, a
contract might be used to establish price protection on the first 20-35 percent of
anticipated production, in effect, on that portion of a crop which will very likely be
realized. Options might be used to establish price protection on that portion of
anticipated production which is less certain, since options do not have a delivery
obligation as do contracts.
Financial Responses
A number of financial responses are presented in Table 6. Financial responses to risk
generally affect solvency and/or liquidity of the farm operation. Several of the responses
are applicable in the short-run as well as the long-run.
Table 6. Financial Responses
- Insuring against losses
- Maintaining reserves
- Pacing of investments
- Acquiring assets
- Limiting credit and leverage
- Working off farm
Insurance is purchased to protect against a loss. Risks which have a low probability of
occurrence and have very adverse consequences are prime candidates for insurance. Multiple
peril crop insurance and hail insurance are carried by a high percentage of North Dakota
producers. How much of this insurance should be carried depends to a large extent on
individual financial conditions. Most farmers carry liability, major medical, disability
and fire insurance even if they are financially secure.
Many farmers have reserves to provide liquidity. A line of credit is an excellent
reserve, one that needs to be worked on for the long-run. Other reserves include bank
accounts, mutual funds, stocks and bonds.
Farmers typically manage their investments so that capital expenditures are made during
the better years and postponed during adversity. Family expenditures for durable goods are
often managed in a similar manner.
Start-up costs need to be carefully evaluated if an enterprise is being initiated or
substantially expanded. A risk cushion of about 20 percent of planned total expenses may
be appropriate.
Assets can be acquired through purchase, lease or rent. The manner in which they are
acquired is an important way of managing risk. Many farmers lease the drill tractor or a
second combine. Crop share leases are also used by many farmers to reduce risks by sharing
them with the landlord.
Growing into an enterprise may be an excellent way of gaining experience while
improving liquidity and solvency. Used facilities and/or machinery can be employed. Some
operations like spraying, combining or swathing can be hired. Using these alternatives may
result in reduced profits, but the reduction should be regarded as the cost of managing
risk.
Credit limits is another financial response to risk. Limits can be self-imposed by the
farmer or imposed by the lender.
Off-farm employment is the latest in diversification. Employment takes many forms. It
can be full time or part time. It can be an extension of farm activities such as custom
work, grain hauling or seed sales. Working off the farm is usually meant to supplement the
family living draw from the business.
