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RISK MANAGEMENT

 

     What is one of the largest problems that we face?  If you could give it a term, would you call it RISK?  How can we manage risk?  What risks are involved in our given operations? What are we going to do about them?  When we discussed the area of setting goals what could be some problems that could arise so that those goals would not be obtained?  What actions can you take to increase your chances for reaching those goals?  How can we help circumnavigate around the Risk involved in our own given operations?  7) Green Eggs and Ham. One of the major goals in any given operation or business venture is to generate sufficient cash flow to service our debts and pay all our expenses, plus have a comfortable amount for living expenses and be able to “go again next year”.  Am I correct?  Then we must realize the possibility of events that can jeopardize the fulfillment of our individual and business goals.  That’s the “risk”.  Downside events sometimes occur that do not agree with your middle of the road expectations.  Most of us know all about downside risk like the drought that causes us to only produce half of what we should have, the windstorms that electrify and crisps the leaves of the crops, or the exceptionally cold winters that cause improper calving in the spring.  The list can go on and on, but the main concern in the agricultural world that we are in is SURVIVAL.  Survival after adverse events like those depends on the capacity of your balance sheet to self-insure, the use of formal insurance policies, or offsetting crops or livestock enterprises, which balance out and compensate for the lower earnings from that short fall.  Self-insure, is that a new term to you in your area?  In our particular area, we cannot afford to self-insure.  If you have substantial net worth you may say, “if a particularly adverse event hits, I’ll liquidate some of my assets, or borrow against them to meet the resultant cash flow shortfall.” 

 

     When we talk about difference sources of risk we need to look at the ways to manage those areas of risk.  Perhaps a laundry list of risk will help us better understand this portion more clearly.  We need an organized way of outlining the sources of risk especially if we are going to take actions to manage these risks.  There are 10 areas of risk that we are going to discuss briefly and give areas that we could hopefully use to minimize these risk factors in our given operations.

 

     The first category is PRODUCTION RISK.  Your yields per planted acre will nearly always be different than what you anticipate.  Sources of downside production risk include too little moisture, flood, excessive temperatures at pollination, hail, wind, fire, diseases, etc.  Can you give me others?  Crop insurance is one example of a risk-management tool that can be used to transfer some of the downside yield risk to the insurance industry.  Diversification, growing more than one crop, is another example.  Diversification will reduce your overall cash flow variability if crop yields do not go up and down in exactly the same way for each crop.

 

     The second category is INPUT PERFORMANCE RISK.  Most managers place this risk under product risk, but to sort out pervasive impacts like drought or flood from those more closely related to input choices.  For example, in many areas crop variety choices influence frost risk factors.  Also, herbicide performances are affected by weather, and opportunities for rescue operations will vary. 

 

     The third category is COMMODITY PRICES AND ACCESS TO MARKET.  Prices of corn and soybeans (and most all other commodities) change every day, and certainly from year to year.  Forward contracting is one marketing strategy to shift downside commodity price to someone else.  As in the case of crop insurance, you will have to pay someone for taking some of that risk off your hands.  The cost can be an explicit premium or a reduction in the price received, but many times, you will have to weigh this to make certain that the benefits outweigh the costs.  Forward contracting is one marketing strategy to shift downside commodity price risk to someone else.

          The fourth category is input price and it is a major production risk in today’s economic crunch world.  Those prices and areas that can be scaled back, must be done so in a hurry.  Insect and disease prevention and control are important for all ag producers and areas that can not be slighted.  Producers who plant a number of different crop varieties are helping the availability factors in their given crop production areas.  Bulk buying is another area that can help cut input prices.

     The fifth category is BORROWED CAPITAL PRICE and availability risk.  Interest rates, like commodity prices, have shown tremendous variability in recent decades.  For example, many growers found themselves paying high nominal interest rates long after inflation pressures subsided.   Availability of credit is also relevant.  Some credit sources are very sensitive to agricultural earning cycles.  These lenders enter during prosperity and disappear in tough financial times.  Select a lender who believes in the long run future of agriculture.  Shop around if you have to and ask questions, which are the basic method of learning.

 

    The sixth on the list is TECHNOLOGY RISK.  New technological developments often make current methods obsolete or inefficient.  Choice and timing of investments in new technology can make or break you.  Premature adoption can be risky if the new technology does not work as anticipated or is too costly or too inflexible.  The flip side is that new technology often reduces cost per unit produced.  If you are a late adopter, your neighbors could be producing less expensively than you.

 

     The seventh is PEOPLE RISK.  Owner and family involvement in the day-to-day management and operation of farms characterize most agriculture in the United States.  Have you made provisions for back-up management capacity in the event that a key member of your operation falls ill, becomes disabled or dies?  Similarly plans to deal with ownership dissolution (husband/wife or partner/partner) have become increasingly important in recent times.

 

     The eight is LEGAL RISK.  In our legalistically – oriented society, you need to protect yourself from catastrophic lawsuits. Having a formal liability insurance protection policy can be proclaimed as a necessity for farmers of today and definitely for tomorrow’s world.

 

     The ninth is INSTITUTIONAL RISK.  Agriculture can be profoundly influence by changes in institutions.  Examples include government price and income support programs, tax rules, OSHA, EPA, etc. Are you aware of how these policies influence your farm or ranching business?  Do you have an early warning system to help you anticipate changes in programs?  These changes present eight opportunities to exploit or downside risks that need to be addressed.

 

     And the tenth on this list is MACROECONOMIC RISK.  This category includes factors, which influence inflation, exchange rates, trace and access to commodity markets, access to labor markets, etc.  These risks are beyond your control, but sometimes you can anticipate changes and positions yourself to benefit from them or at least to avoid pitfalls. 

     Perhaps though the two areas that are most volatile to our operations success are marketing and production risks.   Marketing risk concerns price risk and, for some specialty commodities the availability of markets.  For producers of commodities with broadly based markets, a wide array of strategies are currently available to manage price risk.  Besides cash sales at completion of production, farmers can use futures and options markets and various pricing options offered by buyers of the commodities.  While cash forward strategies have been the most popular with farmers, the innovation in this area is rapid.  Among the alternatives are deferred payment for pricing contracts, minimum price contracts, basis contracts, and hedge-to-arrive contracts.  For storable commodities or commodities with variable production periods, such as beef feeders and stockers, farmers can practice sequential marketing at different points of the year rather than delivery at harvest or weaning.  With this wide array of alternatives, diversification among these tools and strategies also reduces risk.   

     While all of these marketing methods have potential, their use by farmers/ranchers are still questionable.  Research on actual use of tools other than cash sales indicate that producers use them much less than agricultural economists would suggest.  That situation exists despite major efforts among agricultural economists to teach forward pricing strategies in the classroom and in extension programs.

     Production as a source of risk concerns variation in output arising from weather, insects, disease, input quality and availability and technological change.  It is the very essence of agricultural risk.  This form of risk is generally more important in crops than in animals.  It is probably more important in horticultural crops than in field crops.  It is also convenient to include input price risk under production risk.  The major production risk for most poultry and livestock operations is the risk in feed prices that arises from production risk in producing theses feeds.  The management responses to feed price risk are similar to those for market risks. 

     Diversification concerns producing combinations of products whose production is not directly related under variations in weather and other causes of production risk.  However, diversification can also include geographical dispersion of production that has been demonstrated to reduce variability.  Generally vegetable and ornamental horticulture producers practice diversification more than field crop producers can.  However, it is worth noting that diversification is one risk response that field crop producers can practice more feely without the production controls of federal commodity programs. 

     Farm risk management is in an era that is receiving more attention.  As farms become larger, more capital, labor and management is used, which can create more financial and human resources risk.  Increasing regulations are creating more legal and environmental risk and also different dimensions to the other sources of risk.  Increasing agricultural trade has also created more price risk for farmers in many commodities.  To that we add the evolution to less price and income risk protection from federal commodities program.  Fortunately, one can identify a number of risk responses that can be utilized to reduce risk.  The increased price risk can be managed with forward price mechanisms, use of marketing contracts and vertical integration, and by reducing production and financial risk,  Most of these responses will reduce expected income-the risk returns tradeoff is effective here.  As a result, farmers need to choose these responses judiciously and not adopt everything mentioned at the coffee shop or in papers that they read.  One guide could be to focus on those risks, such as large liability lawsuits and death or disability of the farm owner-managers, that could bankrupt the business.   The costs of response to these risks seem to be with financial reserves and high equity has limited financial risk and can therefore assume more marketing risk.  In contrast farmers with more financial risk, need to pay more attention to marketing risk as they may not be able to stay in business with several years of low prices.  These trade-offs vary among commodities of course.

     Besides the explicit monetary costs of many of these risk responses or strategies, most also have a significant implicit managerial cost.  Farmers already have stretched their managerial resources thin with the increasing size and complexity of farming technology.  Reallocation of managerial time to marketing risk, for example, will limit time available for production and increase production risk.  Again, this reinforces the need to emphasize certain risks rather than everyone.  In addition, farmers need to augment managerial resources through families or partners and employees for very large farms or vertical integration.  In addition, more growth in management consultants is a method to transfer some management responsibilities from the farm.  Management consulting is a growth area in agribusiness.  Existing businesses that can adapt to this need will thrive in this new economic environment for agriculture.

 

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