Athletes who are stiff, tight and inflexible risk injuries. So do farmers and ranchers whose market strategies are stiff. And let’s face it, some producers are downright rigid in their approach to marketing.
That’s understandable because farmers and ranchers are a conservative lot. They’re most comfortable with things the way they’ve always been, doing things the way they’ve always been done. Unfortunately, that’s not always a good idea, on either the production or the marketing side of agriculture.
What I’m about to suggest will serve as a good test of a producer’s mental flexibility. Perhaps I’ve been hanging out too long with economists, but I’m going to just hint that sometimes producers might be better off if they capped their potential for profits instead of holding crops in hopes of better prices down the road.
“Whoa!,” you say, “I’m not making enough profit now.” Indeed, too many producers aren’t making any profit at all. There’s no disputing that, but economists still say that sometimes farmers would be better off if they didn’t try to maximize revenues.
Matthew Benson, a Washington State University graduate student in agricultural economics, wrote his master’s thesis on hedging white wheat futures. He says most farmers say, “The price is the price and I can’t do anything about it.” Benson answers, “But you can do something about it. You can say, ‘I’ll try to protect my revenues.’
You do that by hedging, which is a mechanism by which producers trade some profit potential for reduced risk of losses if prices drop.
The concept is pretty old. In the 16th century there was a precursor of hedging in tulip bulbs in the market at Antwerp. The modern practice of hedging in agricultural commodities in America is a more recent invention.Futures contracts, the instrument for hedging, was devised by the Chicago Board of Trade in 1865.
In hedging, producers establish a profitable price that they would be willing to accept for their crop, then buy futures contracts at that price. This protects them from a drop in prices. On the other hand, if prices go up, producers don’t benefit from the increased profits; but they’ve still made a profit.
This, of course, is a just a kindergarten explanation of the concept. Hedging is a complex economic principle, one that goes against most producers’ basic instincts. If there is any prospect that prices will rise, producers are tempted to hold onto their crop, hoping for still higher prices.
Back in the 1970s when wheat prices threatened to reach $6 a bushel, some Palouse country wheat growers found themselves in a world of hurt as they held and held and held in hopes that prices would hit $6. Instead, prices fell precipitously.
Worst hurt were those who had bought land or expensive machinery on credit, based on expectations of high wheat prices only to have the bottom fall out of the market.
Just how good an idea is hedging, anyway?
Benson’s study covered five marketing seasons to determine how producers would fare financially if they hedged white wheat crops. “Over time, even if you hedged over 20 years, you will make less profit than someone who doesn’t,” Benson concluded.
But that’s good if hedging allows a producer to avoid a catastrophic loss from falling prices. “Although you may not become the richest guy on the block, you’ll still be on the block,” Benson says.
If there’s a time when hedging may not be good strategy, it’s when prices are very poor. “How much lower can price fall?,” Benson asks. If it can still fall, hedging makes sense, but if the risk of further declines is very small, this might be the time not to hedge.
Debt is a major reason to hedge. When growers buy a $200,000 tractor, a $300,000 combine, or buy land, they need to reduce their risk in the market place. Benson believes these circumstances argue strongly for a hedging strategy.
If you think hedging is worth taking a look at, Benson recommends a little education. “Like a lot of things in life, all it takes is a little effort,” he says.
You could take a correspondence course, attend class at a community college, or read a book or two. But be careful what books you read. Ask your broker or accountant for a recommendation.
You might start by exploring the Chicago Board of Trade site for basic information on how futures work.
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