As our historic bull market rumbles to a possible end, producers find themselves traveling down two very different marketing paths. One will prove to be extremely dangerous with each season bringing the risk of a marketing catastrophe, while on the other path producers enjoy unprecedented long-term stability. Some may be able to move to the safer path in time, but others will not.
As a marketing advisor with over 30 years of experience, I believe we are headed for a difficult sorting out period in agriculture. Much like the mid-80s, we may see good producers fall by the wayside and our ag lending community severely stressed.
This time the test will come on the marketing side, and it promises to be quick and brutal. Once the wreckage is cleared away, I expect the way farmers manage marketing risk will be forever changed.
The path taken comes down to financing, the access to one particular marketing tool and a producer’s attitude toward risk.
The dangerous path — This is the one most farmers find themselves on. The marketing toolbox they carry is very light and their marketing season is short. The focus is on one crop at a time.
Producers on this path continue to market their crops the way they always have. They will wait for their local buyers to offer a price and then decide at some point to sell. Most of their sales will come in a three- to four-month period, close to harvest.
Considering what happened last season, they will be reluctant to forward contract much of their production. The tendency will be to hang on, stay at risk and see what happens.
The train wreck scenario — Prices for all crops fall well below cost of production and stay there during the three- to four-month period around harvest when most producers are willing or able to price.
Due to increased production costs, loan levels provide little protection. Absent a bumper crop, the majority of producers do not come close to covering expenses. Many find it difficult, if not impossible, to secure financing the following spring and auctioneers once again get very busy.
Producers traveling this path will face this career-threatening risk anew each season. For many, it will just take one.
What could alter this train wreck scenario? Sharply lower input costs or a dramatic shift in government support might postpone the day of reckoning, but it looks like that train is headed in the other direction.
Taking the other path — Producers on the other path are able to take a longer view. Instead of a three- to four-month marketing season, their marketing seasons run three to four years for every crop except rice. That gives them a long time to look for pricing opportunities. Most importantly, they are able to lock in their futures prices at any time.
Since their marketing plans cover two to three production seasons at a time, chances are they have already protected profitable prices at least two crops ahead. They are carrying much less marketing risk going into 2009 and 2010 than many of their neighbors.
Their marketing tool box is full of marketing strategies and alternatives, and they are less interested in trying to figure out which way prices are likely to go and more concerned with managing risk.
There are not many producers currently traveling this path, but there are a few. Having three to four years to price each crop gives these producers an important competitive advantage. It is much like a dryland farmer competing with a neighbor who has irrigation.
Considering that success in business tends to flow to the efficient, that competitive advantage will likely have long-term consequences.
The key to the safer path is having direct access to the futures market. Buyers are no longer willing to hedge a farmer’s risk beyond the next season. That may change, but for now at the local elevator, it is one crop at a time. The futures market on the other hand is offering a price for the next three crops.
In order to have access to the full marketing season offered by the futures market, a producer must have the ability to do what buyers used to do for them, hedge in the futures market. They must have the ability to short futures and put on their own “hedge to arrive” contract.
Being able to go directly to the futures market gives the producer three years of pre-harvest price quotes versus one. That is a tremendous advantage.
There is also leverage and flexibility to consider. Producers who hedge market risk themselves are not locked in to a particular buyer, which means they have leverage when it comes to negotiating basis. They also do not have to worry about the buyer going out of business and not honoring their contracts.
If prices are below the hedged price at planting time, a producer has the flexibility of easily being able to move to a more attractive crop while capturing all of their futures gain. When used properly, futures can be a very powerful marketing tool.
The primary risk of using futures to lock in a price is no different than the risk a producer takes when a “hedge to arrive” or a straight booking contract is negotiated with a buyer. It is a production risk. If the futures market trades above the hedged price and the producer does not have a corresponding amount of crop to deliver to the cash market, the producer will suffer a loss. The loss will be the same whether the contract is held at the elevator or in the producer’s brokerage account.
It’s the margin risk that gets the most attention when talking about a futures hedge. If a producer sells futures and prices go above the hedged price and stay up, the producer will have to tie up capital over a period of time, offsetting his losses in the futures position.
As long as the producer is able to cross the scales with a corresponding amount of production, the margin money (adjusted for basis) will be recovered. The result would be an interest expense. We have just witnessed an extreme example of that scenario.
On the other hand, if prices trade below the hedged price, the producer is able to access the unrealized futures profit.
It turns out short hedgers in the grain markets have access to free money more often than they have to worry about margin calls. History tells us when markets are high enough early in the season to entice producers to hedge, they tend to trade lower into harvest.
Prior to the 2008 market, margin would have been an issue three of the previous 10 seasons. Seven of the 10 seasons, short hedgers were able to pull money out.
It comes down to access to capital. A producer must have the ability to come up with money outside what is needed to produce the crop when prices do go up. That ultimately determines who can use this valuable tool and who can’t. It may not be fair but it is the current reality which brings us to the Ag lender.
Ag lenders share the risk. Traveling the dangerous path right along with the producer is his or her lender. With most of their farmers working with a limited pricing window, insufficient loan safety nets and a general reluctance to pull the booking trigger, ag lenders find themselves in a very precarious position. If prices happen to be below cost of production at harvest and stay there for a while, a lender could find the entire loan portfolio in real trouble. That train wreck could happen any season.
It will be frustrating for our lenders to look back and see what should have been done. The fact that the markets may have put profitable prices on the table months or even years before the wreck will be of no help if producers were unable or unwilling to protect those prices.
That’s when things will change. In my opinion, it is after this marketing catastrophe that things will change. Ag lenders may come to the conclusion it is too risky financing producers who do not have access to the full marketing season and who continue to take unnecessary marketing risks.
From that point, producers still in the game will think two and three crops ahead and will routinely hedge their price risk in the futures market. Ag lenders will do all they can to make that possible. Limiting marketing risk will be everyone’s ongoing objective.
For some, the change has already taken place and they look forward to a more secure future. Unfortunately for others, the change will come but only after the train wreck. Producers may be traveling down two marketing paths today, but I expect, sooner or later, there will only be one.
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