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Everyone knows there is a lot of risk in commodity prices right now. However, people often struggle to figure out exactly how much. We can borrow some basic finance concepts and publicly available information to quantify this risk.

Right now, market prices indicate that Dec’16 corn has a 15% chance of going below $3.00, and Nov-16 soybeans have a 13% chance of dropping below $8.00.
The Chances of Sub-$3 Corn (And How to Reduce Them)
The Chances of Sub-$3 Corn (And How to Reduce Them) (1)

Figure 1 These are corn and soybean price risk distributions (as of April 21st). You can analyze the areas under the curves (you can read more details here) to determine that there a 15% chance of corn going below $3.00/bu and a 13% chance of soybeans going below $8.00/bu.

 
For this analysis, we leverage the fact that known options prices reflect the uncertainty in the price of the underlying asset. For example, on April 21st, Dec-16 corn futures were trading at $4.03. An option to buy Dec-16 corn for $4.30 was trading at $0.24. What determines the price of that option? In part, the uncertainty in corn price. If corn prices are very uncertain, then there is a greater chance that corn prices will go up, and therefore the option would be worth more. If corn prices were absolutely certain (i.e. we knew that corn prices were going to stay at exactly $4.03), then the option wouldn’t be worth anything, since you wouldn’t ever exercise it . Using options prices to calculate price risk is a commonly used procedure in finance, and it is even used to determine crop insurance rates (a great summary article on how it is used to calculated crop insurance premiums can be found here). For now, we’ll just stick with the punchline: option prices can be used as a measure of the market’s estimation of price risk.
One striking thing about the price ranges in Figure 1 is their width: the fact that corn prices could range between $2 and $6 is what makes farming one of the riskiest businesses. However, farmers have many tools to reduce that risk: forward contracts, hedging, and insurance are some of the more common ones. As a simple example, let’s examine the effect of forward contracts on our risk model:
Many growers at this point have already forward-sold a good portion of their 2016 crop. We can use our risk model to calculate their final price risk by combining the known value of their sold crop with the risk associated with the unsold crop. Before the sale, there is a 15% chance that your final price would be under $3/bu. After the sale, you’ve reduced the risk your final crop price being below $3/bu to 0.4%. Of course, you have also limited your potential upside while reducing your downside risk.
The Chances of Sub-$3 Corn (And How to Reduce Them) (2)

Figure 2 Effect of forward sales on price risk on Dec-16 corn, before and after selling 50% of the crop at today’s price for 2016, assuming the same April 21st prices used above.

 
Managing risk is a key component of successful farming – as important as the agronomics and operational aspects. Market prices of futures and options contain a lot of useful information about price risk, and you can use this data to drive real marketing decisions. It is clear that with the current market conditions, the farmers who know how to evaluate risk will be ahead of their peers, and more quickly earn the trust of their lenders.

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 Risk Management is hard no matter how long you’ve been in the industry. Farm Risk Management is even harder because farmers have little control over price.

It’s incredibly tempting to hold out for the highest price and to try to time the market, especially in a climate where profits are razor thin. However, this isn’t real farm risk management, and just like gambling, it can result in spectacular gains or devastating losses. The best farmers are willing to sacrifice revenue in the good times in order to minimize losses in the worst—even if it means watching their peers who don’t manage risk outperform them in temporary bull markets.

This lesson is reflected in a number of other industries that deal with the same challenges. For instance, over the past two years, oil and gas companies have seen their product plummet to a third of its former price. This is even more drastic than the drop we’ve seen in corn and soybean markets over a similar time span. If oil companies didn’t manage risk in some fashion, they would be virtually guaranteed to go out of business.

In the fourth quarter of 2015, small oil producers hedged 77 percent of their production at an average price of $83 per barrel. That is roughly twice as high as they would have received in the open market. Having these positions in place cost those same producers millions in prior years when oil was less than $100 per barrel. Larger companies, like Chevron and Exxon Mobil, had fewer hedges in place, but they could afford them, given the size of their balance sheets and ability to withstand sustained losses. This is not the case for production agriculture.

Other examples come from industries such as manufacturing, transportation, and consumer products, which routinely hedge against increases in input costs. Southwest Airlines has tended to hedge a greater portion of its fuel needs compared to other major U.S. domestic carriers. Southwest’s aggressive fuel hedging has helped the airline partially avoid financial consequences caused by airline industry downturns. Between 1999 and 2008, Southwest saved more than $4 billion through fuel hedging. Learn how to manage risk like a professional.

So, how does production agriculture achieve that level of risk management success?

1. Know your financials. You can’t manage what you don’t measure. Too many farmers don’t even know the average price they receive for their crops over a given period of time or their true breakeven cost. It’s impossible to put a sensible risk management program in place without knowing how much you need to hedge to ensure profitability.

2. Conduct scenario analyses to determine how much risk you can take on. Companies like Southwest Airlines, Chevron, and others invest in sophisticated software and information systems to support better decision making in real time. This technology allows them to automate analysis, look at what-if scenarios, build action plans and communicate across departments.

3. Hedge risks you can’t control and embrace those you can. Back to the examples of the oil and gas and airline industries, hedge those risks that are out of your control. Then embrace the risks you can control, like crop mix, which fields to farm, which products to buy or agronomic practices.

True, farming is risky, especially in bear markets like these.  However, plenty of other industries face similar challenges and there are ways to manage and embrace that risk. Knowing your numbers, testing different scenarios and sticking to a disciplined risk management plan is at the core of any sustainable business.

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