Pre-selling is supposed to be all about reducing risk. It’s supposed to be about locking in a profit so you can sleep at night. So why do so many farmers feel so worried?
The answer is simple. Risk management can create its own risks. What if prices go up? Or what if there’s a crop disaster and you can’t meet your forward contract obligations?
Dan Caron senses farmers are gun shy about forward selling this winter after locking in prices a year ago that seemed attractive and profitable at the time, but then turned out to be well below the big record highs that came later.
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Now he wonders if they’re simply talking themselves into an even bigger risk. A business development specialist with Manitoba Agriculture, Food and Rural Initiatives in Starbuck, Man., Caron knows many farmers who have slammed the bin doors shut for the time being.
“I always try to remind farmers that by having grain in the bin unpriced and uncommitted, you’re doing no more than speculating,” Caron says. It may feel like you’re safe because you aren’t in the market. But it isn’t.
Grain in the bin isn’t like cash in the bank, says Caron. It’s more akin to shares in the stock market.
“You’re not holding cash, you’re holding a commodity that’s traded on the open market and valued on the futures market, which is no different than holding Petro-Canada (shares) when it was worth $45 and watching it drop to $22,” Caron says. “It’s no different than gold or oil or anything in the market that is openly traded.”
Deferred delivery contracts are the most common contract, says Charlie Pearson, Alberta Agriculture and Rural Development crop analyst. They let farmers
lock in the futures price and basis, providing a fixed net return on a given tonnage. Other options include locking in either the futures price or the basis.
Locking in a futures price covers the most risk because it swings more widely than the basis does. (Basis, the difference between the futures and cash price, reflects handling, currency and other grain buyer costs.)
What worked last year…
It’s tempting to lock in a favourable basis without locking in a price. But this strategy presumes there will be an opportunity to lock in a good price before the crop is delivered. If grain prices are rising, it works in the farmer’s favour, but not the other way.
“Then it’s like having a gun to your head,” says Caron.
Basis contracts can be rolled over to another futures month and the spread in value between the old and new futures added to the basis already locked in. The end result can be a wide basis and a less than attractive futures price. In other words, it’s mission not accomplished.
“Last year with that bull market… if you took an unpriced basis you looked like a genius,” says Caron. “Now we’re back down to reality and it has cost a lot of farmers.”
As tempting as it is to lock in every expected bushel of production when prices are high, it’s best to be conservative if the crop isn’t already safely in the bin. That’s advice that University of Manitoba agricultural economist Derek Brewin gives his students.
If there’s a crop failure, he warns, pre-selling even average production at a high price could leave you worse off than in a year of both bad prices and low production. If you pre-sold and don’t have a crop, it’s likely your neighbours won’t either. Spot prices could exceed the locked-in price. Without the crop to deliver, the farmer must buy back the contract at a higher price than he or she sold for. It’s a fast way to go broke.
“We always recommend that you don’t sell more than half of your crop without having it in the bin,” says Caron.
Some ethanol plants are offering farmers deferred contracts two years out. Each farmer has to consider the risk benefit, but two years is a long time.
“The price could look attractive but we don’t know what our input costs will be two years from now,” says Caron. “Maybe that won’t be a good price.
“It boils down to what a person is comfortable with and knowing your own operation.”
Do your due diligence
Counterparty risk — the possibility a buyer might not pay or be in business at delivery time — is another consideration, says Terry Betker, director of agricultural services for accounting firm Meyers Norris Penny.
“This isn’t a new risk, but with the (economic) volatility, it was causing the trade as much financial challenge as farmers were facing,” Betker says.
“I think there will be some hangover effects from this,” Betker says. “Farmers, when they contract, may do some more due diligence on who they’re contracting with.”
Farmers need to take a second look at offers that seem “too good to true,” Betker adds. “The same holds for doing business with companies you know are shaky, even if they are offering a higher price.”
When it comes to knowing when to pull the trigger, historical prices can be a guide. In 2007, most farmers locked in when prices hit new highs. True, prices continued to rise, but the locked prices were still profitable.
Knowing break-even costs and cost of production are prerequisites to a pricing strategy. But Betker wants farmers to look beyond that.
“We want to get fair compensation for management and you want to get a return to ownership,” Betker says. “I don’t think the farmer is shooting for a return that even starts to compensate them for the risk they take on. A proper target to ownership, like 10 to 12 to 15 per cent, will come close to compensating for risk. Whether they can get it out of the market is another thing, but for a lot of people it will be a new way of looking at it.” CG
