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Today’s Theme For Tomorrow’s Successful Farm Business? It’s The Margin Stupid Presented at the Wisconsin Association of Agricultural Professionals (WAPAC)

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Presentation on theme: "Today’s Theme For Tomorrow’s Successful Farm Business? It’s The Margin Stupid Presented at the Wisconsin Association of Agricultural Professionals (WAPAC)"— Presentation transcript:

1 Today’s Theme For Tomorrow’s Successful Farm Business? It’s The Margin Stupid Presented at the Wisconsin Association of Agricultural Professionals (WAPAC) March 2008 March 2008

2 Anatomy of Profits Total Revenues - Operating Expenses = Profit Margin before Overhead - Overhead Expenses = Profits

3 Changing Profit Margins Profit Margins Change if –Revenues change –Direct Expenses change –Overhead expenses change –Or some combination of the above

4 Changing Profit Margins High output price may not be enough Low input prices may not be enough In short: It’s The Margin Stupid

5 In Other Words Farm Business Management will be more of a challenge because –Variability of output prices –Variability of input prices –Variability of the margin Price Risk Management isn’t going to go away But it will likely be more maddening

6 What We Are Going to Talk About The Macro world in brief– –Why these wild prices The big movers of profits Where’s the variability –Where do we need to spend our management time Review of some marketing tools The Macro World in Brief

7 Perfect Storm

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12 World Wheat and Course Grain Ending Stocks

13 World Course Grain Ending Stocks

14 World Meat & Poultry Consumption (1000 MT)

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16 Gross National Income per Capita

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19 So What Does It All Mean High Oil prices Low value of dollar Reduced world stocks World Population increasing World Incomes increasing Impact on Commodity Prices

20 Class III Prices - 1962-Dec 2007

21 Corn Prices 1866-2007

22 Impact on Agriculture

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27 Impact at the Enterprise Level Where’s the Risk

28 Corn Enterprise ($/acre) 1993-2006

29 Standard Deviation, 1993-2006

30 Direct Expenses, 2006 (Fertilizer + Fuel/Oil)

31 Direct Expenses, 1993-2006 (Fertilizer + Fuel/Oil)

32 Standard Deviation, 1993-2006

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35 Dairy Enterprise ($/cow) 1993-2006

36 Direct Expenses, 2006

37 Direct Expenses, 1993-2006

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39 What is the Outlook for Feed Costs? What’s the outlook for oil? What’s the outlook for demand? What’s the outlook for Ethanol? What’s the outlook for the dollar?

40 Better Yet What is the Outlook for Variability of Output and Input Prices? As my five year old daughter would say,

41 It looks more uppy downy!

42 42 Variability

43 43 Price Risk as Variability B A C

44 44 Is There More Milk Price Risk Today? C-III Price Distributions (through Dec 2007)

45 45 What is Price Risk Management? Assuring An Outcome

46 46 Risk Management is Assuring An Outcome Assuring an Outcome

47 47 Price Risk Management: What Happens to the Distribution When You Forward Contract at $13.00 (2.55)? 12.05 13.58 10.51 2.45 2.65 2.25

48 48 Price Risk Management: What Happens to the Distribution When You Have a Floor Price at $10.51 (2.25)? 12.05 13.58 10.51 2.45 2.65 2.25

49 49 What Happens to the Distribution When You Establish a Short Fence from $12.05 to 13.58? (2.45 to 2.65) 12.05 13.58 10.51 2.45 2.65 2.25

50 50 Marketing Tools Farm & Risk Management Team © 2005

51 51 Tools in the Marketing Toolbox Cash Market Forward Contract Minimum Price Contract Futures Market Futures Contract PUT Option (right, but not obligation to sell futures) CALL Option (right, but not obligation to buy futures) And all kinds of combinations of the above!

52 52 Basic Strategies (2 Strategies & 2 Tools) 1.Lock-in a known price. The price you set is the price you will get. 1.Forward contract with your milk buyer 2.Sell a futures contract on the CME 2.Set a Floor price. You will get no less than the floor price, but you may get more. 1.Minimum price contract with your milk buyer 2.Buy a PUT option on the CME

53 53 Basic Strategy 1: Lock It In! August - Forward Contract with milk buyer, or - Sell Aug futures contract at CME for 14.65

54 54 Let’s Practice Selling Futures Aug Futures are trading at $14.65 –What price position have you secured for 200,000 lbs of milk in August? For the 200,000 lbs, what will your Class III August Price be if: August announced at $16.00? August announced at $12.00 Always Ask and Answer – “What am I doing to myself?”

55 55 If you had used a forward contract instead Lock-in price discounted 15-25 cents off of the futures price of $14.65 No margin calls No getting out of the contract Must deliver the contracted amount to the buyer Could have contracted for smaller amounts Outcome is the same, except 15-25 cents less.

56 56 Basic Strategy 2: Set a Floor Price 12.05 12.80 10. 04 14.49 9.11 March 11.75 - Minimum Price contract with milk buyer, or - Buy a PUT Option at the CME (12.20 strike price for $.45) Your floor price is $11.75

57 57 Let’s Practice: Setting a Floor Price via Buying a PUT Option Buy a $14.00 Aug PUT Option for $.54 –What price position have you secured for 200,000 lbs of milk in August ? –For the 200,000 lbs, what will your Class III August Price be if: August announced at $16.00? August announced at $12.00

58 58 Advanced Strategies Want to increase your protection? Take advantage of market gains? Premiums to costly? –Roll up to futures –Roll up to a higher PUT –Forward contract and buy a CALL option –Buy a PUT and sell a CALL –Roll down futures to a PUT

59 59 Focus on Basics first, but a Taste of Advanced Strategies Forward Contract and Buy a Call Option –Why? You don’t want to get less of a price in case markets fall, but you don’t want to miss out if there is a super rally!

60 60 Focus on Basics first, but a Taste of Advanced Strategies –Forward contract May 2008 milk for $16.08 ($16.23 futures price less $.15 discount. –At the same time buy a $16.50 CALL option for $.62 CALL option gives you the right to buy a futures contract for $16.50 and sell it back at the then prevailing price

61 61 Focus on Basics first, but a Taste of Advanced Strategies –What are you doing to yourself? –Any cash price less than 16.50, I will get $15.46 (16.08-.62) –Any cash price greater than $16.50, I will get 16.08 plus the difference (cash price minus 16.50) less $.62. Announced = $14.00: Announced = $16.45: Announced = $16.75: Announced = $21.00: I get $15.46 I get $15.71 I get $19.96

62 62 Focus on Basics first, but a Taste of Advanced Strategies Result if May 2008 goes to $14.00 then Sell milk at your forward contracted price of $16.08 –You gained $2.08/cwt on your forward contract Your CALL option expires worthless (don’t want to buy milk at $16.50 and then sell it at $14.00) –But, remember you paid $.62 for the CALL option –No Marketing price: $14.00 –Your Price: 16.08 -.62 = $15.46 –Forward Contract only price: $16.08

63 63 Focus on Basics first, but a Taste of Advanced Strategies Result if May 2008 goes to $16.45 then Sell milk at your forward contracted price of $16.08 –You lost $.37/cwt on your forward contract Your CALL option expires worthless (don’t want to buy milk at $16.50 and then sell it at $16.45) –But, remember you paid $.62 for the CALL option –No Marketing Price: $16.45 –Your Price: 16.08 -.62 = $15.46 –Forward Contract only price: $16.08

64 64 Focus on Basics first, but a Taste of Advanced Strategies Result if May 2008 goes to $21.00 then Sell milk at your forward contracted price of $16.08 –You lost $4.92/cwt on your forward contract You exercise your right to buy a futures contract for $16.50, sell it back for $21.00 and pocket the $4.50! –But, remember you paid $.62 for the CALL option –No Marketing Price: $21.00 –Your Price: 16.08 + 4.50 -.62 = $19.96 –Forward Contract only price: $16.08

65 65 Focus on Basics first, but a Taste of Advanced Strategies Buy a PUT option and Sell a CALL option (aka: Short Fence –Why? You want to set a floor price, but PUT premiums are too expensive!

66 66 Buy a PUT option and sell a CALL –Buy a $16.50 March 2008 PUT option for $.81 –At the same time sell an $18.00 March 2008 CALL option for $.41 The purchased PUT gives you the right to sell a futures contract for $16.50 and sell it back at the then prevailing price The sold CALL obligates you to sell a futures contract at $18.00 and buy it back at prevailing prices. However, you get to keep the $.41 no matter what.

67 67 Buy a PUT option and sell a CALL –What are you doing to yourself? –The purchased PUT gives you the right but not the obligation to sell a $16.50 futures contract. You pay an $.81 premium to have that right –The sale of a CALL obligates you to sell an $18.00 futures contract if prices go higher than $18.00. You are paid $.41 to take on that risk

68 68 Buy a PUT option and sell a CALL –What are you doing to yourself? –You will receive no less than $16.10 (16.50 -.81+.41). You will receive no more than 17.60 (18.00-.81+.41). Thus you have created a fence around the market with one end being at $16.10 and the other at $17.60.

69 69 Buy a PUT Option and Sell A CALL Result if March 2008 goes to $14.50 then Sell cash milk to your buyer at $14.50 Exercise your PUT option and sell a futures contract for $16.50, close it out by buying it back at $14.50 and thus gain $2.00 The CALL you sold does not get exercised, i.e., nothing happens and you keep the $.41 paid to you. –Cash (no marketing) price:$14.50 –Gain on exercise of PUT 2.00 –Premium paid for the PUT -.81 –Premium received for the CALL.41 $16.10 –NET PRICE $16.10

70 70 Buy a PUT Option and Sell A CALL Result if March 2008 goes to $17.00 then Sell cash milk to your buyer at $17.00 Say thanks for right, but let your PUT option expire The CALL you sold does not get exercised, i.e., nothing happens and you keep the $.41 paid to you. –Cash (no marketing) price:$17.00 –Gain on exercise of PUT 0 –Premium paid for the PUT -.81 –Premium received for the CALL.41 $16.60 –NET PRICE $16.60

71 71 Buy a PUT Option and Sell A CALL Result if March 2008 goes to $20.00 then Sell cash milk to your buyer for $20.00 Say thanks for right, but let your PUT option expire The CALL you sold gets exercised and you are forced to sell a futures contract for $18.00 and then buy it back for $20.00, thus losing $2.00, but you keep the $.41 paid to you initially. –Cash (no marketing) price:$20.00 –Gain on exercise of PUT 0 –Loss on exercise of CALL - 2.00 –Premium paid for the PUT -.81 –Premium received for the CALL.41 $17.60 –NET PRICE $17.60

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73 73 By Selling a Futures Contract Advantages 1) Achieves a “specific” price or profit objective 2) Can get out if markets change 3) Not tied to a milk buyer Disadvantage: 1) Margin account and calls 2) Forgo higher prices 3) 200,000 lb. Contracts By Forward Contracting Advantages: 1) Achieves a “specific” price or profit objective 2) Flexible in terms of quantities of milk to contract 3) Simple to use 4) No margin account or calls Disadvantages: 1) Locked into a milk buyer 2) Can’t get out of contract if markets change, must deliver! 3) Forgo higher prices Locking In a Price


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