Financial tools: More farmers look to manage the boom-bust cycle

AG ALERT
Issue Date: June 23, 2010

By Ching Lee
Assistant Editor

Kings County dairy farmer Dino Giacomazzi is looking to the future, or more accurately, to the futures market.

After weathering one of the most financially tumultuous years in 2009, he and a growing number of dairy producers are increasingly turning to commodity futures and options to try to minimize their risks against the boom-bust effects that have pummeled the nation’s dairies during the current global recession.

Giacomazzi said he’s been taking classes for the last year and a half to learn the ins and outs of financial risk management, including how to hedge his feed costs and milk price through market futures and options, and forward contracting.

He said this knowledge will be invaluable as farmers and ranchers try to adapt to progressively more unpredictable economic conditions in the future.
“I think things were not as volatile in the past and so we’ve been able to survive the cycles thus far without risk management,” he said. “But now the cycles are much deeper and the low periods of the market are longer, so it’s something that we’re going to have to learn to do in order to survive.”

Lending institutions also are starting to encourage farmers to adopt risk management practices. In a recent report, Wells Fargo, the largest commercial agricultural lender in the U.S. and a major dairy lender, weighed in on the rising economic volatility farmers and ranchers face and the impact that will have on agricultural financing.

Using the dairy sector as a case study on margin volatility and how lenders are responding, the bank warned that the business of financing agriculture will need “to change to deal with this increased price and margin volatility.”

Michael Swanson, an agricultural economist for Wells Fargo and author of the report, said it’s not so much that lenders are requiring farmers and ranchers to do more risk management as a lending criterion; it’s that changes in agriculture and the economic environment are forcing farmers to have better business acumen and greater financial sophistication.

“And lenders are going to come to the realization that what was an appropriate debt-to-equity leverage before, in a less volatile environment, is not appropriate anymore, unless it’s accompanied by sophisticated risk management and good production practices,” he said.

While some producers are beginning to use risk management tools such as futures and options, forward contracting and insurance, Allison Specht, an economist with the American Farm Bureau Federation, said these strategies, for the most part, are still not very popular among dairy farmers around the country.

“It’s difficult to learn,” she said. “It’s not something that producers have a great deal of experience with. But it’s something going forward that might be a good idea for the industry to look at.”
Up until 2007, dairy producers’ feed costs were relatively stable, Swanson said, so they didn’t worry much about the price of their milk falling significantly below their cost of production.

Also, producers were often rewarded for prioritizing their cost of production and labor management above everything else, he added, so there was little incentive for them to develop their hedging and financial analyses.
Aside from the complexity of futures markets, Giacomazzi said many farmers may still be reluctant to use them because of horror stories they might have heard about those who got burned.

Futures markets, however, are not new to agriculture, said Leslie “Bees” Butler, a dairy economist at the University of California, Davis. In fact, it was agriculture that first inspired the modern concept of futures trading, a process that was started in the 1840s in Chicago, which had become a major center for sale, distribution and storage of grain.

Before futures trading came about, farmers were often at the mercy of dealers when it came to selling their commodities. So a system was set up to allow farmers to lock in a price for a commodity early on and deliver it much later. This also allowed farmers and buyers to hedge their risks and speculate on the future price of the commodity.

“That’s what a futures contract is—a guarantee to sell at a certain price at a future date,” Butler said. “What you’re doing in the futures market is offsetting what you’re actually doing in the actual market.”

He said even though dairy farmers are used to futures contracts, such as when they forward-contract their feed to ensure a set price, many of them may not be hedging their purchase and managing their risks properly.
For example, when corn prices rose to record levels in 2008, many dairy farmers entered into feed contracts when prices were high, and then got locked in to those prices even when the price of milk came tumbling down in early 2009.

“What they should’ve done is once they bought that feed at that price, then they should’ve also gone to the commodity market, purchased a put option so that if the price of corn were to come down, then they would get some money back,” Giacomazzi said.

Butler said they also could have hedged their milk against the possibility of a price drop on the futures market.

“If you buy something today and you’re stuck with that price, you have risks—the risk of the price going up or down,” Giacomazzi explained. “But risk management is opening yourself up for an opportunity to capture some of the money back if the price goes up or down.

“When you manage risk, you fix a minimum price for your milk and a maximum price for your feed, and then you take advantage of any increase in milk or decrease in feed,” he said.

Butler said these financial tools are nothing more than insurance policies for the farm. He and Swanson agree that using these tools is too vital a function to outsource to consultants and recommend farmers learn to do it themselves.

They also stressed that having a strategy to reduce risk is important regardless of an operation’s size. And with increased volatility hitting every sector of agriculture, risk management is not just for dairies.
“If you’re going to be in the business, this is a core concept of agricultural production—the ability to look for risk mitigation in the futures market,” Swanson said.

Giacomazzi said while he’s glad to hear banks such as Wells Fargo are trying to promote risk management, he would like to see agricultural lenders “actively participate,” because ultimately they will have to provide the financing needed for farmers to implement their risk management plans.

“I think these banks are starting to look at it now because the dairymen are asking them,” he said.

Leonard Van Elderen, CEO of Yosemite Farm Credit in Turlock, said agricultural lenders such as the Farm Credit system are getting involved to the extent that they are providing seminars to educate farmers about what’s available to them.

“But there’s a fine balance there of encouraging education and lender liability,” he said. “We’re lenders. We’re not managers. And each of our members needs to make a decision for their own operation that suits them best.”
(Ching Lee is an assistant editor of Ag Alert. She may be contacted at clee@cfbf.com.)

Permission for use is granted, however, credit must be made to the California Farm Bureau Federation when reprinting this item.

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