Managing Risk in Agriculture Ag. Credit School Ames, Iowa June 6, 2013 Chad Hart Associate Professor/Crop Markets Specialist chart@iastate.edu 515-294-9911 1 1

Iowa Crop Shifts Source: USDA-NASS

Diversification Source: USDA-NASS, 2007 Census of Ag

Diversification Source: USDA-NASS, 2007 Census of Ag

Hedging Holding equal and opposite positions in the cash and futures markets The substitution of a futures contract for a later cash-market transaction Who can hedge? Farmers, merchandisers, elevators, processors, exporter/importers

Short Hedgers Producers with a commodity to sell at some point in the future Are hurt by a price decline Sell the futures contract initially Buy the futures contract (offset) when they sell the physical commodity

Cash vs. Futures Prices Iowa Corn in 2012

Short Hedge Graph Hedging Nov. 2013 Soybeans @ $12.92

Put Option Graph Put Option June 2013 Live Cattle @ $128 Strike Price = $128 Put Option Return = Max(0, Strike Price – Futures Price) – Premium – Commission Premium = $3.275 Commission = $0.01

Call Option Graph Call Option Dec. 2013 Corn @ $6 Strike Price = $6 Call Option Return = Max(0, Futures Price – Strike Price) – Premium – Commission Premium = $0.50 Commission = $0.01

Hog Crush Margin The Crush Margin is the return after the pig, corn and soybean meal costs. Carcass weight: 200 pounds Pig price: 50% of 5 mth out lean hog futures Corn: 10 bushels per pig Soybean meal: 150 pounds per pig Source: ISU Extension

Contracting Basic Hedge-to-Arrive Basis Deferred Price Minimum Price New Generation Automated Pricing Managed Hedging Combination

Ego Greed Fear

Marketing Plan To avoid fear, greed, and ego dominating your marketing, have a plan and stick to it. A marketing plan outlines your market strategy and your marketing objectives. It should examine marketing opportunities before and after harvest.

Marketing Objectives Get the highest selling price Reduce price risk Pretty tough to do More realistic objective: Obtain better than average prices Reduce price risk Cover cash flow needs Minimize tax liability Look at short and long-term goals for your business

Building a Marketing Plan 5 basic steps: Estimate number of bushels/animals to sell Calculate breakeven price Project price and production scenarios Compare pricing tools and analyze market opportunities Develop a pricing plan

Tentative Pricing Plan Outline realistic pricing targets Have periodic price targets and quantities to sell Have patience and be willing to reevaluate price goals Remember it’s hard to lose money when making a profit

Seasonal Pricing Patterns Source: USDA, NASS, Monthly Price Data 1980-2008

New Farm Bill Program? Yield per Planted Acre Year Farm (bu./acre) County Season-Average Price ($/bu.) 2003 2.42 2004 2.06 2005 2.00 2006 3.04 2007 4.20 2008 160 4.06 2009 175 3.55 2010 164 5.18 2011 163 6.20 2012 165 5.00 Olympic Average 4.75 10-year average 3.77

Potential Payout Graph No payments Payment

Crop Insurance One of many risk management strategies Traditionally set up to protect farmers in times of low crop yields Now offers coverage for low prices Available on over 100 commodities

Causes of Loss for Iowa Corn, 1948-2010

Causes of Loss for Iowa Soy, 1955-2010

Federal Crop Insurance Federal Crop Insurance Corporation – 1938 Government’s initial move in crop insurance Federal Crop Insurance Act of 1980 Premium subsidies Federal Crop Insurance Reform Act of 1994 Catastrophic coverage and higher subsidies Agricultural Risk Protection Act of 2000 The 2008 Farm Bill

Federal Crop Insurance

Types of Crop Insurance Individual Yield (YP) Area Yield (GRP) Individual Revenue (RP and RPE) Area Yield - Individual Revenue Combination (GRIP)

Federal Crop Insurance: Total Acres Insured

Example Farm A 100 acre corn farm in Story County, Iowa with a 5-year average yield of 180 bu/acre Purchases insurance at the 75% coverage level Spring price: $5.65/bu (average of Feb. prices for Dec. corn futures)

Individual Yield Insurance (YP) Farmer chooses percentage of expected yield to insure Expected yield measured by average yield Price at which the crop is valued is set up front and does not change If yields are 100 bushels per acre, the farmer receives $197.75 per acre = $5.65/bu * (75% * 180 bu/ac - 100 bu/ac)

Yield Insurance Payout Graph No Payout Payout

Yield Insurance is like an Option

Individual Revenue Insurance (RP or RPE) Farmer chooses percentage of expected revenue to insure Expected revenue measured by average yield times initial crop price Price at which the crop is valued can move with price changes in the market

Individual Revenue Insurance (RP or RPE) In our example, the farmer has insured $762.75 of revenue per acre (75% * $5.65/bu * 180 bu/ac) Final value of the crop determined by average futures prices over harvest period

Individual Revenue Insurance (RP or RPE) If yields are 100 bushels per acre and harvest prices average $4.50, the farmer receives $312.75 per acre 0.75*$5.65/bu.*180 bu./acre - $4.50/bu.*100 bu./acre

RPE Payout Graph No Payout Payout

Rev. Insurance is like an Option

Individual Revenue Insurance (RP) This policy has a “harvest price option” If the harvest price is greater than the planting price, then the harvest price is used in all calculations In essence, the policy is giving you a put option with the strike price at the planting price

Harvest Price Option

Individual Revenue Insurance (RP) If yields are 100 bushels per acre and harvest prices average $7.50, the farmer receives $262.50 per acre 0.75*$ 5.65/bu.*180 bu./acre - $7.50/bu.*100 bu./acre 7.50

RP Payout Graph No Payment Neither Pay RPE Pays YP Pays Both Pay RP Pays

Corn Insurance Prices Harvest prices have been higher 5 out of last 13 years

Soy Insurance Prices Harvest prices have been higher 7 out of last 13 years

What Units to Choose? Optional Units: Each farm is separate Basic Units: Combine owned and cash rented acres in same county Enterprise Units: Combine all acres of the same crop in same county Whole Farm: Combine all crops in county

Current Subsidy Rates 60% 64% 80% 65% 59% 70% 75% 55% 77% 48% 68% 71% Coverage level Basic Units Optional Units Enterprise Units Whole Farm Units 60% 64% 80% not avail. 65% 59% 70% 75% 55% 77% 48% 68% 71% 85% 38% 53% 56%

2013 Insurance Premiums Per Acre Premiums ($ per acre) Cov. Level YP RPHPE RP_ 50% 0.92 0.78 1.08 55% 1.52 1.30 1.89 60% 2.14 1.81 2.85 65% 3.29 2.87 4.63 70% 4.30 4.08 6.78 75% 6.30 6.59 11.06 80% 9.47 10.87 18.33 85% 14.45 17.63 29.89 For our example farm in Story County, Iowa for corn

Choosing Insurance Policy Choice depends on several factors Type of farm and crop mix How well the county average yield represents your farm Your marketing strategy

Iowa Corn Acres Insured in 2012 91% of all Iowa corn acres are insured

Iowa Soy Acres Insured in 2012 91% of all Iowa soybean acres are insured

2012 Corn and Soy Coverage Levels

Coverage Levels for YP

Coverage Levels for RPHPE

Coverage Levels for RP

Thank you for your time. Any questions. My web site: http://www. econ Thank you for your time! Any questions? My web site: http://www.econ.iastate.edu/~chart/ Iowa Farm Outlook: http://www.econ.iastate.edu/ifo/ Ag Decision Maker: http://www.extension.iastate.edu/agdm/