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.