No. 691 Winter 1998
Price Risk Management by Minnesota Farmers
Darin K. Hanson and Glenn Pederson
The management of market price risk is an integral part of operating a successful farm business. Its importance has recently increased. Increased price volatility associated with shifts in export demand and in international monetary conditions is expected to result in substantial variability in annual farm income.
By managing price risk, farmers are better able to stabilize farm income and to ensure that funds will be available to fulfill both business- and family- related financial obligations. In this article, we summarize the price risk management decisions and strategies of farmers who are dealing with this situation.
Two traditional ways to manage price risk in grains are forward pricing and participation in government programs. Forward pricing includes the use of forward contracts, futures contracts, and/or options contracts. By using these marketing tools, farmers can either “lock in” a specific price or guarantee a minimum price level when the crop is ready to be sold.
In the past, the target prices and loan rates of the government subsidy programs could be used like forward prices. Because there were no transactions costs, such as margin accounts or option premiums, the price risk management advantages embodied in government programs were attractive substitutes. This advantage was confirmed in a 1984 survey, which found that farmers considered government programs to be a more important method of managing grain price risk than was forward pricing.
Passage of the Federal Agricultural Improvement and Reform Act of 1996 (FAIR) fundamentally changed the relationship between grain prices and government support to farmers. In effect, FAIR decouples government commodity payments to farmers from market prices. In addition, FAIR calls for an end to direct government subsidies by 2002. Given the demonstrated importance of government programs in farmers’ price risk management plans, dramatic changes in the use of the various forward pricing tools could occur if government support is in fact eliminated.
We report here the results of a 1997 survey of southern Minnesota grain farmers. We sought to identify the major factors influencing farmers’ forward pricing behavior as well as their views about future forward pricing behavior as changes in government programs occur. Finally, we wanted to evaluate farmer interest in consulting services that assist in the development of grain marketing plans.
A mail survey was sent to a random sample of 800 grain farmers in southern Minnesota in March 1997. A total of 378 responses were usable. Farmers were asked about their use of price risk management methods and their views on issues regarding grain marketing.
Eighty percent of the responding farmers indicated that at least half of their total farm sales were from grain (principally soybeans and corn). The large number of respondents using forward, futures, and options contracts suggests that managing commodity price risk is an important objective (Table 1). About 74% of the respondents use forward contracts, 22% use futures, and 18% use options to control price risk.
| Method |
Percent of All Respondents |
Average Percent of Total Grain Production Contracted |
| Forward Contracting | 74 | 35 |
| Futures |
22 |
22 |
| Options | 18 | 19 |
*Measures the percentage of total grain production.
The types of forward contracts are summarized in Table 2. Cash contracts are used by more farmers by far than any of the other forward contracting methods. About 73% report using forward cash contracts. The forward basis contract is the next most popular type, accounting for 14% of all the farmers using forward contracts. The least popular forward contract is the minimum price contract.
In general, futures and options can be used to lock in grain prices in two different situations. The selling price can be locked in before the grain is actually produced to ensure a favorable price at the time of harvest—a “harvest hedge.” Alternatively, these marketing tools can be used to lock in prices for grain that is stored for a period of time after harvest—a “storage hedge.”
| Method | No. Using | Percent |
| Cash Contract | 276 | 73 |
| Basis Contract | 54 | 14 |
|
Deferred Price Contract |
34 |
9 |
|
Hedge-to-Arrive Contract |
43 |
11 |
|
Minimum Price Contract |
29 |
8 |
Of the 378 farmers responding to the survey, 15% report using futures contracts for harvest hedges and 14% report using futures for storage hedges. We found that similar proportions of farmers use options contracts for these same purposes.
Farmers were also asked whether they will use futures and options during the next five years. About 28% report that futures contracts will be used and 26% said that options contracts will be used.
How do the characteristics of farmers and their farming operations affect their decisions to use forward pricing? Based on previous studies of farmer marketing behavior and on our perception of what was measurable, we selected a few key characteristics for examination: annual gross farm income, level of farm debt, farm operator age, and farm operator education. The survey results show that forward pricing is indeed influenced by each of these characteristics.
| Gross Farm Income | % Using Forward Contracts |
% Using Futures Contracts |
% Using Options Contracts |
| $0 to $100,000 | 62 | 9 | 6 |
| $100,001 to $250,000 | 74 | 20 | 15 |
| >$250,001 | 84 | 37 | 32 |
| Debt-to-Asset Ratio | |||
| .0-0.30 | 63 | 14 | 9 |
| 0.30-0.60 | 83 | 29 | 27 |
| 0.60-1.00 | 87 | 32 | 26 |
| Age Category | |||
| <31 years | 91 | 27 | 18 |
| 31-40 | 81 | 28 | 26 |
| 41-50 | 75 | 24 | 19 |
| 51-60 | 75 | 23 | 18 |
| >60 years | 58 | 9 | 6 |
| Education | |||
| 8th grade | 50 | 0 | 0 |
| some high school | 64 | 7 | 0 |
| high school grad | 69 | 16 | 12 |
| technical/vocational | 74 | 23 | 23 |
| some college | 87 | 28 | 29 |
| college grad | 82 | 39 | 23 |
Annual gross farm income is a general indicator of farm size, since it reflects the total amount of revenue generated during a given year. We found that a greater proportion of the larger farming operations use forward pricing than do smaller farms (Table 3). This is particularly true for the use of futures and options contracts. Nearly 40% of the farmers reporting gross farm income greater than $250,000 use these forward pricing tools, compared to 10% of the farmers with gross farm incomes less than $100,000.
Why might the relative frequency of using these forward pricing methods increase along with gross farm income? There are several alternative explanations. Farmers running larger farming operations may carry more debt, they may be younger and have larger nondebt fixed obligations, or they may have a better understanding of these marketing tools. Thus, the size (as measured by gross farm income) is clearly related to marketing strategy, but the economic meaning is still not clear. To help, we explored other factors that may be related to size.
We measured farm debt level by the traditional total debt/total asset ratio. Our survey suggests that as debt levels rise, a greater proportion of farmers use forward pricing (Table 3). About 32% of the farmers with debt/asset ratios of 0.60-1.00 use futures contracts to manage price risk, while only 14% of the farmers with debt ratios less than 0.30 do so.
One possible reason is the necessity for farmers carrying higher debt levels to guarantee a level of revenue that is adequate to cover business expenses and scheduled amounts of debt repayment. Increasingly, loan contracts require borrowers to use some form of forward pricing in order to get a loan or to qualify for a lower interest rate. This is because of the implied reduction in credit risk.
Our analysis suggests that the age of the farm operator also affects forward pricing decisions. In general, older farmers use forward pricing contracts less frequently (Table 3). This is especially true for farmers over the age of 60. We found that no farmers older than 65 used futures or options.
The education level of the farm operator also seems to influence the decision to use forward pricing, especially futures and options contracts (Table 3). Among farmers who had graduated from college, 39% use futures contracts, while only 16% of the farmers with a high school diploma use either futures or options contracts.
Farmers were asked about their knowledge of, and opinions about, the use of futures and options contracts as hedging tools. Farmers currently using these tools indicate an understanding of the mechanics of these markets, feel comfortable in dealing with commodity brokers, feel that the use of these tools can reduce risk in their farming operations, and believe that these methods can increase farm income. Table 4 summarizes farmer responses.
| Percent of those respondents now using futures to hedge | Percent of those respondents not now using futures | |||||
| Agree | Disagree | Not Sure | Agree | Disagree | Not Sure | |
| I understand how to use futures as a method for marketing my grain | 97 | 0 | 3 | 51 | 29 | 20 |
| I feel comfortable developing a relationship with a commodity broker | 85 | 7 | 8 | 36 | 39 | 26 |
| The pressure of maintaining a margin on a futures account is too great | 36 | 58 | 6 | 56 | 23 | 21 |
| I approve of the futures market | 92 | 6 | 3 | 52 | 28 | 20 |
| My 'local basis' is too unstable to effectively use the futures market | 15 | 78 | 7 | 32 | 36 | 33 |
| Futures restrict me from taking advantage of rising commodity prices | 17 | 78 | 6 | 28 | 47 | 25 |
| I receive a fair price from my local elevator/co-op in comparison to the price I would receive from the futures market | 44 | 39 | 17 | 56 | 16 | 28 |
| The use of futures in my marketing plan would result in higher farm income | 57 | 22 | 21 | 25 | 32 | 43 |
| The use of futures in my marketing plan would reduce risk in my farming operation | 67 | 24 | 10 | 39 | 30 | 31 |
| The possibility that my local elevator/co-op Will go bankrupt makes futures contracting A better marketing alternative | 13 | 75 | 13 | 14 | 56 | 29 |
| Futures (and options) are too restrictive Because they only allow me to contract Increments of 5,000 (and 1,000) bu. | 21 | 69 | 31 | 34 | 35 | 10 |
| I understand how to use options as a method For marketing my grain | 95 | 5 | 0 | 42 | 33 | 26 |
| The cost of the option premium is too great to Justify the purchase of these types of contracts | 13 | 81 | 5 | 42 | 25 | 33 |
| I approve of the options market | 90 | 3 | 6 | 45 | 18 | 37 |
| My local basis is too unstable to effectively use the options market | 3 | 86 | 11 | 23 | 36 | 41 |
| The use of options in my marketing plan would result in higher farm income | 57 | 16 | 27 | 20 | 26 | 55 |
| The use of options in my marketing plan would reduce risk in my farming operation | 83 | 10 | 8 | 38 | 20 | 42 |
| Options (and futures) are too restrictive Because they only allow me to contract Increments of 5000 (and 1000) bu. | 14 | 79 | 6 | 32 | 33 | 35 |
*Non-hedgers are those farmers who do not use futures.
Almost all the survey respondents participated in government programs during the past three years. Given the expected similarity of risk management objectives of farmers using forward pricing contracts and/or government programs, the surveyed farmers were asked to indicate if past government support had reduced their need to use forward pricing contracts. About 47% of the farmers indicated that the programs replaced their need for futures and options hedging strategies.
Many farmers indicated that they expect government support to diminish in the future and that additional use of forward pricing will be needed to substitute for the risk-reducing role of government programs. About 72% indicate that forward pricing alternatives will be necessary in the future when government support diminishes.
The survey also evaluated the expressed demand for marketing consulting services. These types of services may provide advice about appropriate marketing strategies and brokerage services, as well as advice on the timing of market transactions. While only 16% of the responding farmers currently hire this type of service, many of the farmers not currently using marketing consulting services expressed an interest in using them in the future. In response to the question, “Would you consider using a marketing consulting service for your farming operation?” 32% of the farmers answered “yes.” Based on these responses, we estimated the average amount this group of farmers would willingly pay for these services is about $2.79 per acre.
The response to this marketing survey provided useful data for examining the methods farmers use to market grain, the set of factors that are thought to influence their marketing decisions, and the opinions farmers have about the use of marketing tools to hedge commodity price risk. The results indicate that a large percentage of farmers forward price grain production with forward contracts, futures, and options. Forward contracting is clearly the dominant method, but there are significant differences in how those forward contracts are being priced.
Our analysis of the characteristics of the farmers and their farming operations suggests that several factors may influence the choice of a particular forward pricing strategy and the type of forward pricing contract that is used. Farmers who are most likely to use futures and options contracts operate larger farms, carry higher relative debt positions, have higher levels of formal education, and are younger. These results are generally consistent with previous survey findings in other regions of the United States.
Surveyed farmers anticipate that direct government support payments will diminish in the future and other methods will be needed to manage grain market price risk and stabilize farm incomes. Many farmers even suggest that the use of grain marketing consultants could be a feasible alternative to single-handedly developing their own grain marketing strategies.
Darin K. Hanson is a former Research Assistant and Glenn Pederson is a Professor in the Department of Applied Economics.
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