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Importance of risk management for grain farmers

 

University of Kentucky College of Agriculture, Food and Environment

LEXINGTON, Ky. – Grain farmers in Kentucky and throughout the nation have had a long run of highly profitable years, starting around 2006 and continuing into 2013. Even with the disastrous yields in 2012, most farmers with good revenue insurance policies made out well. During this time, risk management and forward contracting were probably looked at more from the standpoint of profit maximization or profit retention. However, the 2014 crop year looks to be the first year since 2006 where risk management and forward contracting could mean the difference between breaking even and going into the red.

 

I did not realize the extent of the potential problems for grain farmers until early January, when I started updating my profit projections for the upcoming 2014 crop year. What follows is a brief overview of what I’ve been highlighting in presentations throughout the state in the last few weeks. For the sake of tractability, I needed to make an assumption on location. Since most of our grain is produced in western Kentucky, this is where the analysis is based. Central Kentucky farmers will typically have somewhat higher costs due to the use of urea rather than anhydrous, and longer trucking distances for grain (in some cases over 100 miles one-way). Therefore, the following estimates need to be adjusted for central Kentucky grain farmers (it will look worse for them).

Table 1: Fertilizer Price Projections 2014

Fertilizer:

$/ton

$/unit

   Anhydrous (N)

$650

$0.40

   DAP (P2O5)

$520

$0.41

   Potash (K2O)

$450

$0.38

Currently, in late January, future’s prices for fall 2014 are around $4.50/bu for corn and $11.10/bu for soybeans. Cash prices for fall delivery near river ports in western Kentucky are around $4.25/bu for corn and $11/bu for soybeans. These cash prices will be used to estimate profit for the baseline scenario in this analysis. Table 1 shows estimated cost for the various fertilizers in 2014.

 

Table 2 shows estimated costs for 150-bushel corn ground and 45.5-bushel soybean ground.  Phosphorus and potassium application rates are assumed to be at the rate of removal of the crop.  Machinery/labor costs account for unpaid family labor and depreciation/overhead of equipment.  A 15-mile one-way trucking distance was assumed for hauling grain.    

 

Table 2: Projected 2014 Costs (per acre)

Inputs:

Corn 150 bu

Soybeans 45.5 bu

   Seed

$90

$65

   Nitrogen

$64

$0

   P, K, and Lime

$55

$42

   Pesticides

$50

$40

Total Inputs

$259

$147

Machinery & Labor

$121

$85

Other:

 

 

   Drying Grain

$17

$0

   Crop Insurance

$20

$20

   Misc.

$20

$20

   Land Rent

Variable

Variable

   Operating Interest

$8

$5

Total Other

$65

$45

Total Costs

$445+Rent

$277+Rent

Note: 15-mile one-way trucking included in machinery & labor costs.

Using these costs, the gross return is estimated for corn and soybeans at various yield levels in Table 3. These are expected yields, so they should be the long-term average for a particular farm. The “Gross Return Rotation” assumes a 50-50 rotation of corn and soybeans, so it is simply an average of the gross corn and soybean return. This gross return does not account for land rent. For example, the 150-bu corn and 45.5-bu soybean gross return for the rotation is $217/acre. If you had a $200/acre land rent on this farm, then you would expect to make $17/acre profit. If you had a $250/acre land rent, you would expect to have a $33/acre loss on this farm. Thus, in areas of western Kentucky where land rents are relatively low (under $200/acre), we would expect small profits in 2014 at current commodity prices. Conversely, in areas of western Kentucky where land rents are relatively high (over $250/acre), we would expect small losses in 2014 at current commodity prices. On a cash flow basis (not accounting for family labor or depreciation/overhead), these farms in high-rent areas would likely not get into trouble if the losses are small.

Table 3: Baseline Scenario 2014 (per acre)

$11.00 Soybeans (elevator) 

$4.25 Corn (elevator)

$.40-N; $.41-P; $.38-K

 

Gross Return Corn

Gross Return Soybeans

Gross Return Rotation

125 bu corn

39.0 bu soybeans

$114

$168

$141

150 bu corn

45.5 bu soybeans

$203

$233

$217

175 bu corn

51.5 bu soybeans

$290

$294

$292

Note: Subtract land rent to get Net Return.

There is, of course, a possibility that commodity prices could fall between now and fall 2014. Farmers need to be prepared for this and have risk management strategies to protect themselves. However, a basic crop insurance policy may not provide the protection needed by many grain farmers this year. Table 4 shows a 70 percent revenue guarantee policy in terms of the guaranteed minimum revenue, converted to a gross return per acre basis shown in Table 3. We don’t know what the price guarantees will be until the end of February, so I simply use the average futures prices that have been experienced so far in January. These are roughly $4.50/bu for corn and $11.15/bu for soybeans, using a $.25/bu basis to adjust to cash prices.

Table 4: 70% Crop Insurance Guarantee

2014 (per acre)

$11.15 Soybean Guarantee (estimated) 

$4.50 Corn Guarantee ( estimated )

$.40-N; $.41-P; $.38-K

 

Gross Return Corn

Gross Return Soybeans

Gross Return Rotation

125 bu corn

39.0 bu soybeans

-$55

$34

$10

150 bu corn

45.5 bu soybeans

$0

$76

$38

175 bu corn

51.5 bu soybeans

$54

$117

$85

Note: Subtract land rent to get Net Return.

Thus, if revenues dropped to or below these crop insurance guarantee levels, a grain farmer on 150-bu corn ground would have a gross return to rotation of about $40/acre. If they had a $250/acre land rent, they would lose over $200/acre on this farm. There are some farmers, particularly beginning farmers, who might not survive such a scenario.

Table 5 shows the guaranteed minimum revenue for an 80 percent revenue protection policy in conjunction with forward contracting 25 percent of the crop at $4.25/bu corn and $11.00/bu soybeans. As can be seen, this provides a substantial improvement in baseline protection.

Whether this would provide enough protection will depend on the specific cash rents being paid and the risk tolerances of the individual farmer. Each farmer essentially needs to determine what that base protection needs to be and adjust their risk management plan accordingly.

 

Table 5: 80% Crop Insurance Guarantee and 25% Forward Contract 2014 (per acre)

$11.15 Soybean Guarantee (estimated) 

$4.50 Corn Guarantee ( estimated )

$.40-N; $.41-P; $.38-K

 

Gross Return Corn

Gross Return Soybeans

Gross Return Rotation

125 bu corn

39.0 bu soybeans

$30

$99

$65

150 bu corn

45.5 bu soybeans

$102

$152

$127

175 bu corn

51.5 bu soybeans

$173

$203

$188

Note: Subtract land rent to get Net Return.

These are just two examples of combinations of crop insurance and forward contracting. There are many other possibilities that should be evaluated. This analysis has been simplified somewhat to make it tractable in this short space. There are, of course, tradeoffs with forward contracting in terms of reduced upside price opportunities if the market increases, and extremely high levels of forward contracting carry the risk of yields falling short of the contracted volume. These both need to be balanced with the increased downside protection in the context of a specific farmer in a specific risk-tolerance situation. Contact the author at Greg.Halich@uky.edu or (859) 257-8841 to help evaluate specific situations. (Greg Halich)

This article was written by Greg Halich, an agriculture economist in the University of Kentucky College of Agriculture, Food and Environment. The article first appeared in the January 30 edition of Economic and Policy Update.