Managing risk

When you hear the phrase “risk management” what comes to mind? For most people insurance will be near the top of the list or perhaps the only thing on the list. However risk management for farm businesses consists of much more than simply buying or not buying crop insurance or property insurance. You manage risk in a host of ways – when you swath canola with the prevailing winds, when you spread chaff, when you bury power lines or when you purchase machinery. The topic for today is a narrow segment of risk management related to pre-buying crop inputs.

Pre-bought inputs have obvious tax advantages if you are taxable. They also have risk management implications. The two important risks are price risk and capital risk. Price risk is the one that farmers most often think about. “Should I buy in August or should I wait until December?” sums up the thinking for most farmers. I have already discussed taking advantage of the lower retail margins at year end. To put it in risk terms, your risk of paying too much due to retail margins is lowest at yearend. That doesn’t mean that yearend pricing will always be better than spring pricing, just that the margin component of pricing will likely be lower at yearend than in the spring.

For western Canadian farmers the power of manufacturers to control price increases as spring approaches. As it gets closer to seeding time it gets less likely that you can arrange offshore shipments and accordingly more likely that a manufacturer can successfully impose a last minute price increase. All these factors tend to support lower pricing at yearend but don’t guarantee it.

If we had access to a futures market for fertilizer this would be much easier. Grain companies can purchase grain from you and then forward sell it through the futures market. From the point where they buy the grain from you and sell the futures contract all they have to do is keep their costs down, prevent the grain from spoiling and deliver it on time in order to make the profit they locked in when they hedged it. You could do the same thing if you had access to a fertilizer futures market but you don’t. “IF” is such a big word – if the queen just had balls she’d be the king. So what to do?

One technique that would have worked well last fall when fertilizer prices were jumping every week would have been to back to back fertilizer purchases against crop forward sales. A typical grain farm will have a contribution margin of 30 or 40 percent. (if you don’t know what your own contribution margin is watch for a future column but for now think of it as what’s left over after you pay your variable costs) So for every $100 that a typical grain farm earns in revenue they will have spent roughly $60 in variable costs. Therefore you could have said “I want to pre-buy $60,000 of fertilizer so maybe I should simultaneously forward contract $100,000 of grain sales.” It’s by no means a perfect hedge but it would have been a lot better than having your ass hung out last October the way many farmers (and dealers) did.

Of course last October you would have looked at the available contracts and said “I don’t want to forward contract grain at these prices.” Which then would have logically led to the question “well then, why the hell do you want to buy $100,000 of fertilizer?” It’s not a perfect system but it might have helped you take a second look at the options available. And you might have gone ahead and not signed the grain contract but still bought the fertilizer. At least in that case you should have clearly understood that you were making a speculative decision rather than a business decision.

Next time we’ll talk about the other risk element of pre-bought fertilizer – capital risk. In the meantime try to think about the components of your business decisions that are speculative and those that are managerial. That in turn will help you better understand the risk profile of your farm.