Price Risk Management for Canola
Producers in the Northern Plains - Continued
EB-74, November 2000
Market Planning
Development of a plan for marketing is as important as plans for production, finance and other farm operations. It is needed to make acceptable farm management decisions, i.e., decisions that are acceptable to you, to those who depend on you, and to your lender. A plan will help you make correct decisions in the midst of volatile prices. Instead of letting emotions make the decision, the information used to assemble the plan will guide decisions.
Developing a marketing plan is challenging. Time must be devoted to collecting and analyzing the information relevant to the plan.
One feature that must be examined is the goal of the marketing plan, that is, what should the plan accomplish? Other features include evaluating the economic fundamentals about the crop the plan is being constructed for, the price needed to break even on production costs, the technical characteristics of the corresponding futures market, the establishment of price objectives and a contingency plan.
The plan can be changed as the market situation changes. When one or more of the features change, the plan may need to be modified. It is fairly easy to modify a plan once it is in place. Deciding what is a genuine change versus a short term price movement is more difficult.
Goals
Marketing plans can be formulated with a number of goals in mind. Consider risk factors when deciding on a goal or combination of goals. Attitude toward risk and the financial condition of the farm operation are the risk factors which are discussed in Appendix A.
The overall goal in managing risk is not to eliminate it, just to reduce it, leaving a chance to benefit from favorable events. Risk and benefit usually involve a financial tradeoff. Production risk, storage availability, price trends, and potential basis change are the key marketing factors to keep in mind when taking steps to reduce risk.
One marketing goal may be to sell for the marketing year average farm price. This would involve selling the Canola crop produced in equal amounts during the months of August through July. This strategy would require the least amount of knowledge about the market and marketing alternatives, but may result in a higher average price for the crop than selling all at harvest and a higher average than achieved by many producers.
A modification of this goal would be sell the canola crop during those times of the year when prices are at their highest, on average (Figure 8). The seasonal price patterns for canola indicate that the months of April-May would be key months for making sales. This goal would likely yield higher but more variable returns over time than averaging sales during the entire year.
Selling during traditional seasonal peaks could be a preharvest marketing strategy as well as postharvest. As a preharvest strategy, the goal could be modified so that preharvest sales would only be made during those years following a short crop year. A short crop year is where prices increase to ration limited supplies, which usually attracts additional resources into production and ultimately leads to lower prices. This goal may be very relevant where preharvest pricing is usually not profitable.
Another goal would be to sell for prices that exceed costs of production. Costs may include cash costs or economic costs (see "Breakeven Prices"). For some crops during some years, this may be an impossible goal. Minimization of costs may be all that is achievable. Nevertheless, knowing breakeven prices only makes farm management sense, and when prices exceed them, every consideration must be given to selling.
Selling at prices below breakeven is understandable in some situations, when yields are unexpectedly low, for example. If it is known during production planning that profitable sales are highly unlikely, than look for ways to cut costs or produce a different crop.
Selling at prices considered to be likely, given supply and demand fundamentals, is another goal. This goal must have a contingency plan in case the price projections are not achieved. A typical backup is to sell by a time deadline determined by seasonal price pattern peaks. A certain amount of the crop must be sold if a specific price objective has not been reached by the time deadline.
Another goal may be to plan sales for those times of the year deemed most profitable by futures prices and basis projections (see "Storage"). This goal could be relevant for preharvest and postharvest strategies and could involve cash sales, a futures hedge or put options.
A combination of goals may be followed in constructing the marketing plan. The best combination will be unique to individual situations.
Fundamental Analysis
Evaluation of supply and demand factors to determine the direction and magnitude of price changes is called fundamental analysis. Supply and demand information for canola and related commodities is provided on a regular basis by USDA (http://usda.mannlib.cornell.edu/), Agriculture and Agri-Food Canada (or Ag Canada as it is commonly called) (http://www.agr.ca/policy/winn/biweekly/English/index2e.htm), Oil World and others.
Supply and demand information for Canadian canola will be the primary data analyzed for several reasons. Canada is a major component in the world canola market. The fundamentals of Canadian canola strongly influence the U.S. canola situation. The fundamentals of Canadian canola are best reflected in the canola futures market.
The global situations for canola and competing oilseeds are reflected in the Canadian supply and demand canola balance sheet. The reflection is in both the domestic use and export categories. For example, reduced production in U.S. soybeans or South American soybeans or Malaysian palm oil means increased Canadian crush and exports of canola seed and oil.
The stocks/use ratio is a frequently used statistic to summarize fundamental information. It is often used to project the direction and magnitude of price changes. The ratio is equal to ending stocks divided by total use. It is usually the only calculation that needs to be made when reading a supply and demand table (such as in Figure 27) for Canadian canola. The data presented are the August 2000 estimates of supply and demand by Ag Canada.
Figure 27.
The supply and demand table in Figure 27 is presented along with a chart that relates the canola stocks/use ratio to the price for canola. The price is the Velva marketing year average price. The stocks/use ratio reflects the Ag Canada final projection of supply and demand. Each point on the chart represents a ratio and a price and is identified by the year in which it occurred. For example, "98" identifies the ratio (8.4 percent) and price ($10.07) that occurred in 1998.
A price line is drawn on the chart that best fits the data. The price line can be used as a guide to project the price for ratio estimates. For example, the stocks/use ratio in the table along side the chart shows a ratio of 23.6 percent. On the chart, move from the ratio on the bottom to the price line and then over to the side to find the price. The ratio correlates with a price of $8.00-$8.50. For this stocks/use ratio, a Velva marketing year annual price of $8.00-$8.50 can be projected.
The fundamentals can be adjusted to answer a number of "what if" questions to determine potential prices. Such an analysis should be done frequently throughout the year.
Technical Analysis
Short term price movements in futures prices can be analyzed using technical analysis. It is the study of past price behavior to determine where prices are likely to go in the future. Trends, resistance and support levels, retracements, moving averages, and other price indicators are the tools of the technician. A detailed explanation of technical analysis can be found in a fact sheet by William Uhrig (Technical Analysis, Fact Sheet No. 20, NCR 217, NDSU Extension Service).
Technical analysis should be used to supplement fundamental analysis. For example, price objectives can be specified in a marketing plan using fundamental and technical analysis, and technical analysis can be used to refine the objectives as they are about to be achieved.
Breakeven Prices
Costs of production need to be adjusted for family living and government farm program payments when deriving breakeven prices. Cash costs and economic costs of canola production are presented in Table 18 for the North Central region of North Dakota. The budget is for canola produced in 2000 (Swenson).
Table 18. Projected 2000 canola budget for North Central North Dakota.
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Profitability Cash Flow
Per Acre Per Acre
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Market Yield, Pounds per Acre 1300 1300
Market Price, Price per Hundredweight 9.99 9.99
Market Income 128.70 128.70
Direct Costs 76.04 76.04
Indirect Costs 55.72 40.87
Sum of all Listed Costs 131.76 116.91
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Farm Business Management records indicate that typical family living costs including income taxes
were about $35,000 per year in 1999. This amounts to about
$20 per cropland acre for a typical size farm.
Government farm program payments in 2000 included an Agricultural Market Transition Act (AMTA) payment, a Market Loss Adjustment (MLA) payment, and Loan Deficiency Payments (LDP). A typical total AMTA and MLA payment in Ward County was about $17.50 per cropland acre in 2000. On September 1, 2000, the LDP for canola in Ward county was $3.69 per hundredweight. For an average yield of 13 hundredweight per cropland acre, the LDP would be $47.97 per cropland acre.
A survival breakeven price (O'Connor) is equal to all cash obligations, including principal payments and cost of living, less government farm program payments, divided by the average yield. This breakeven price must be achieved annually if the farm is to survive without renegotiating loan payments. For an average yield of 13 hundredweight per acre and realized costs and government payments, the survival breakeven price was:
$116.91 + $20.00 - $17.50 - $47.97
------------------------------------ = $5.50
13
The breakeven before the loan deficiency payment was known would have been $9.19. This would be the more relevant survival breakeven price for planning purposes.
An acceptable breakeven price differs from the survival breakeven in that economic costs are included in the calculations instead of cash costs. Depreciation and interest on investment are substituted for principal payments. This breakeven price must be achieved in the long run for the farm to remain viable over time. The acceptable breakeven price was:
$131.76 + $20.00 - $17.50 - $47.97
------------------------------------ = $6.64
13
The acceptable breakeven before the loan deficiency payment was known would have been $10.33. This would be the more relevant acceptable breakeven price for planning purposes.
The Government Farm Program loan rate for canola in Ward County was $9.80 for 2000. From a risk management viewpoint, this would be the lowest acceptable price to use for pricing prior to harvest.
Example Marketing Plan
A marketing plan for canola can be constructed based on goals, fundamental and technical analysis, and breakeven price information. An example marketing plan is presented in Table 19.
Table 19. Example canola marketing plan.
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Production or Time Canola November/
Inventory Deadline Nearby Futures Price
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Percent $US/Cwt $C/Tonne
10 Harvest 10.55 344.14
25 11/15/00 11.00 358.82
30 12/13/00 11.25 366.97
25 3/21/00 11.75 383.28
10 5/23/01 12.75 415.90
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Price objectives are matched with time deadlines.
At least five objectives and corresponding deadlines are usually specified in a marketing plan.
A percentage of the crop is sold when either the first price objective or time deadline is reached, another percentage of the crop is sold when either the second price objective or second time deadline is reached, and so on. The largest percentage is specified in the middle of the price range for this example. Alternatively, equal percentages or progressively larger percentages could be specified.
Time deadlines for preharvest sales would usually be based on the seasonal price pattern for cash canola prices at Velva (see "Seasonal Price Patterns"). Those times of the year when cash prices are usually the highest would be picked as selling deadlines.
The time deadlines were modified in this analysis because prices were below the loan rate. The earliest deadline was set at harvest instead of May. Later deadlines were set to take advantage of strength in the seasonal price pattern and previous best months for sales.
Price objectives are specified in the Canola November/nearby futures contract. The November contract would be used until November 1 and then the next nearest futures contract would be used. Canola prices are specified in U.S. dollars per hundredweight and equivalent Canadian dollars per metric ton. Futures prices rather than Velva prices are specified to facilitate the use of technical analysis and alternative marketing tools such as hedges and options.
If the goal is to sell above the loan rate, the lowest price objective, adjusted for the basis, would be set at about that level. The other price objectives would be set at progressively higher levels. Fundamental and technical analysis should be used as a guide in setting these other price objectives.
For the example marketing plan, sell 10 percent of the anticipated canola crop by harvest or when the November futures price reaches $10.55 on the WCE, whichever comes first. Sell an additional 25 percent by November 15, 2000 or when the price reaches $11.00, sell an additional 30 percent by December 13, 2000 or when the price reaches $11.25, sell an additional 25 percent by March 21, 2001 or when the price reaches $11.75, and sell the final 10 percent by May 23, 2001 or when the price reaches $12.75. After October 31, use the next closest futures contract instead of the November contract.
An alternative marketing plan could be constructed where some or all price objectives are set below the loan rate, anticipating that prices will be lower at harvest and that an LDP will be received. Put options would be the safest tool for implementing this plan since only floor prices have been established. Prices have not been locked in below the loan rate.
A common problem for many producers is to ignore the time deadlines for selling when prices fail to reach stated objectives, a serious blow to the finances and credibility of the farm manager. Even if price objectives have been set unrealistically high relative to outlook information, the time deadlines make the plan realistic. Since the time deadlines are based on a recognized marketing concept (seasonal price pattern), the plan is acceptable to professional farm managers and those working with them. Producers can feel that they have made a good decision, even when price objectives are not reached.
Marketing plans need to be reviewed and adjusted as new information becomes available. Ag Canada reports and USDA reports generally provide the basic information for updating the canola marketing plan. This information can be supplemented by news reports of crop conditions throughout the world, weather reports, and so on. A revision of the marketing plan should occur in August-September when U.S. and Canadian production levels are known with greater certainty.
A marketing plan can be implemented using a number of marketing tools. The best tool to use depends on the situation. The use of elevator contracts as part of your marketing strategy makes farm management sense, especially on that portion of production that can be produced with near certainty, probably the first one-third in the case of preharvest sales.
Cash forward contracts, hedged-to-arrive contracts (sometimes called futures fixed contracts), and minimum price contracts are elevator contract alternatives that should be looked at for making preharvest sales. The best contract for a producer to use largely depends on current and expected futures prices and basis (see Figure 28).
Figure 28.
The put option is an attractive marketing tool (see "Options") because it leaves upside price potential open and does not require delivery. But, that flexibility costs something which must be paid for at the time of purchase. Consider using put options where uncertainty is the greatest, in effect, where uncertainty involves not only price uncertainty but production uncertainty, most likely the second one-third of production or more sold prior to harvest.
In general, selling one-third of anticipated production using a cash forward contract or a futures fixed contract and one-third using put options manages an enormous amount of price risk. A floor price can be established on two-thirds of anticipated production while the price is still open to the upside on two-thirds.
The sell or store decision table (such as in Table 2) needs to be consulted when making sales. The best price may not be at harvest but at some distant calendar month. The elevator contract, hedge or option needs to reflect that "best" month.
Making marketing decisions based on a marketing plan should improve the producer's marketing performance. Farm management and marketing concepts will be the guide instead of emotions.
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References
ADM. "Canola Cash Price Series." ADM, Velva, North Dakota, 2000.
Federal Reserve Bank of St. Louis. Foreign Exchange Rate Data: Canada. H.10 Price Series Federal Reserve Board of Governors. http://www.stls.frb.org/fred/data/exchange/dexcaus 2000.
Flaskerud, George. "Impact of Basis and Storage Costs on Marketing Decisions." Journal of the American Society of Farm Managers and Rural Appraisers 56 (1992):7-17.
Flaskerud, George. Farming Without A Safety Net. Publication No. EC-1109. Fargo: North Dakota State University, Extension Service, June 1996.
Flaskerud, George. Basis For Selected North Dakota Crops. Publication No. EC-1011 (Revised). Fargo: North Dakota State University, Extension Service, April 1997.
Flaskerud, George, and Demcey Johnson. Seasonal Price Patterns for Crops. Publication No. EB-61. Fargo: North Dakota State University, Extension Service, August 1993.
Flaskerud, George and Richard Shane. Use of Crop Futures and Options by the Nontrader. Fact Sheet No. 18, NCR Publication No. 217. Fargo: North Dakota State University, Extension Service, June 1994.
Good, Darrel. Deferred Pricing Alternatives for Grain. Fact Sheet No. 2, NCR Publication No. 217. Fargo: North Dakota State University, Extension Service.
Minneapolis Grain Exchange. Power of Options Workbook. 1991.
National Agricultural Statistics Service. Crop Production 1999 Summary. U.S. Department of Agriculture Report, February 16, 2000.
North Dakota Agricultural Statistics Service. North Dakota Agricultural Statistics 2000. Ag. Statistics No. 69. Fargo: North Dakota State University, Extension Service, June 2000.
O'Brien, Daniel M. Grain Marketing Plans for Farmers. Publication No. MF-2458. Kansas State University, July 2000.
O'Connor, Carl and Kim Anderson, "Understanding Basis," Business Management in Agriculture: Volume III, Joint Project of the Cooperative Extension Service, Farm Credit Services and Chicago Mercantile Exchange, 1989.
Purcell, Wayne D. Agricultural Futures and Options Principles and Strategies, Macmillan Publishing Company, New York, 1991.
Shane, Richard and George Flaskerud. Sunflower Marketing Strategies. Report No. 2, North Central Extension Producer Marketing Committee Publication. Fargo: North Dakota State University, Extension Service, April 1994.
Swenson, Andrew. Projected 2000 Crop Budgets North Central North Dakota. Farm Management Planning Guide, Section VI, Region 2. Fargo: North Dakota State University, Extension Service, December 1999.
Uhrig J. William. Cost of Grain Storage. Fact Sheet No. 19, NCR Publication No. 217. Fargo: North Dakota State University, Extension Service.
Uhrig J. William. Technical Analysis. Fact Sheet No. 20, NCR Publication No. 217. Fargo: North Dakota State University, Extension Service.
WCE. Canola Futures and Options Price Historical Data. Winnipeg Commodity Exchange. Winnipeg Manitoba. http://www.wce.mb.ca/market/_activepages/market.htm 2000.
Appendix A. Managing Risk
Risk is the chance of an unfavorable outcome — the possibility of prices falling to a lower level than where they are today or crop yields next year falling below average. Because an unfavorable outcome can be financially devastating, risk needs to be managed.
Managing risk means defining the potential range of outcomes and taking steps to reduce the chances of an unfavorable one. The goal is not to totally eliminate risk, just to reduce it, leaving a chance to benefit from favorable events.
The appropriate level of risk to carry depends on an individual's situation. How much risk an individual is able and willing to take is the appropriate amount for that individual. This means that there is not a single strategy that is right for everyone.
Attitudes toward risk are a strong determinant of how decisions are made. Some producers will choose to avoid risk, especially if they are older. An older producer simply does not have the time left to make up for adverse events. Plungers may make it big, but they commonly fail. They may be the producers who specialize in production of risky crops, hold crop inventories for the top price, and give little consideration to buying insurance. Most producers lie between these extremes in that they make every attempt to carefully analyze situations before making a decision.
The financial condition of the farm/family operation is another major determinant. The operation's level of solvency, liquidity and cash flow requirements affect risk bearing ability. An operation that has a high debt/asset ratio, few assets that can be readily converted to cash without taking a loss in value, and revenue that just covers cash flow requirements cannot afford to take risks. This may be the unfortunate situation for many producers.
How should risk be managed? Actions to reduce risk are usually categorized by the organizational areas of the farm business — production, marketing and financial. This publication focuses on managing the risk of marketing canola.*
Market risk can be managed by using strategies that integrate various marketing alternatives and methods. Marketing alternatives include cash sales, elevator contracts, futures hedges, options and storage. Sales can be initiated with any one or combination of alternatives.
One marketing method is to spread sales over prices and time. An example is to spread sales over those times of the year when prices are normally at their highs. A refinement of spreading sales is to scale-up sales during those times of the year when price peaks are common. Picking a top is impossible, and selling on the backside or downside of the market is emotionally very difficult.
Strategies should be specified in a marketing plan. The plan needs to be developed on the basis of supply and demand fundamentals, technical analysis and breakeven prices. The plan needs price objectives and a backup when those prices are not achieved.
Implementation of the plan needs to consider the direction of futures prices and basis when selecting the relevant marketing alternatives. A combination of marketing alternatives can be effective. For example, elevator contracts or futures hedges might be used to establish price protection on the first 20-35 percent of anticipated production, in effect, on that portion of the canola crop which will very likely be realized. Options might be used to establish price protection on that portion of anticipated production which is less certain, since options do not have a delivery obligation as do elevator contracts.
* For additional information on managing marketing risk as well as information on managing production and financial risk, see Flaskerud, 1996.
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This publication was produced
with support from the
Northern Canola Growers Association
EB-74, November 2000
