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Reduce pricing risk

Dale Hadden's 2011 growing season was marred by 21 inches of rain in June, followed by drought.

The Jacksonville, Illinois, farmer had followed the fundamentals of selling between March and July, aiming to hit the high 80% of the time.

“Farmers selling corn off the combine were nicely rewarded with $8.30 a bushel,” he says. “I left $1.50 on the table.”

Hadden vowed to adjust his marketing plan in 2012. “Flexible will be the word,” he concluded.

How did it work out?

“Staying more flexible helped a little,” he says. But drought shriveled his corn.

“Yields were worse than expected,” he says. “We chopped three times more for our cattle than the norm.” His beans were saved by a 5-inch Labor Day rain.

“I wasn't as aggressive in my marketing,” he says. “I was haunted by last year. But this year's lower production limited how much I had to sell. I began by pricing what I thought would be 35% of the corn. It turned out to be 80%.”

Hadden says his greater use of options increased flexibility. “If there was a price rally, I picked up a portion of it,” he says.

But he's not alone in his frustration with his marketing strategies over the past two years.

“Early marketing is still sound,” says Moe Russell, Russell Consulting Group, Panora, Iowa. “You need to know your costs and where you have positive margins, and then take them when there's a profit. Most years, early marketing pays big dividends. When it doesn't work, everyone is critical of that concept.”

Easier said than done

Prices for the 2013 crop are being buoyed by record-high 2012 prices. The potential for continued drought will linger like the proverbial elephant in the room from now until next spring.

Farmers identify price risk as a top risk-management priority. “One of the major challenges of marketing is extreme variability in prices – not only across years, but also within years,” says Darrel Good, University of Illinois ag economist.

He says that challenge is exacerbated by another big one. “Future prices can't be anticipated with a high degree of accuracy,” he says. “Producers have a long time frame to price production.” Livestock futures contracts are available 18 months into the future, and crop contracts are available four years out.

But factors that determine prices often can't be forecast with any certainty that far into the future.

“Price-determining factors can and often do change dramatically, making the decision about when and how much to price extremely difficult,” Good says.

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Good and his colleague, Scott Irwin, developed an integrated model of pricing that's intended to coax producers to go beyond the time-honored aim of “beating the market.”

“In general, producers remain very frustrated by the traditional decision-making process, and they believe they often do a poor job of pricing,” Good says.

Beating the market typically combines fundamental and technical analysis to forecast market price behavior and then set the time frame for specific pricing decisions based on those forecasts.

Good and Irwin suggest a pricing matrix based on a four-step approach:

1. Select the appropriate time window for pricing crops by using the pricing matrix shown above.

The price window extends from the point of initial production plans to the end of the crop storage season. For corn, soybeans, and winter wheat in the Midwest, the pricing window extends 20 to 24 months.

2. Consider the entire spectrum of available pricing strategies.

“The traditional approach is developing a plan for the timing of pricing decisions and pairing it with the selection of a pricing tool,” Good says.

Instead, he says a more sound strategy is to define a pricing approach that includes a portfolio of self-directed and externally managed pricing strategies.

  • Self-directed strategies may include mechanical strategies that routinely price a percentage of production at predetermined intervals or active strategies that time sales based on a producer's own price analysis and evaluation.
  • Externally managed strategies are pricing decisions made by someone else. This may include mechanical strategies with pricing predetermined by price-averaging contracts and active strategies where timing decisions are based on recommendations of professional market advisers. 

3. Determine what portion of the crop will be marketed via each one of these pricing strategies.

“This is the heart of the new approach to pricing,” Good says.

Producers would create their matrix, selecting the percentages for each marketing approach based on the following five factors (using pricing matrix cells):

  • View of market efficiency
  • Risk preference
  • Financial position
  • Pricing skills
  • Decision-making discipline

“If a producer believes cash, futures, and options markets are efficient [fully reflecting available information], that producer generally should adopt mechanical pricing strategies that assume it's not possible to beat markets,” Good says.

“Producers who believe markets are efficient should follow active pricing strategies only if they possess information not available to the market, or have superior analytical skills,” he says.

“But if a producer believes that cash, futures, and options markets are inefficient, then active strategies that attempt to beat the market will be preferred,” he says.

Good says risk-averse producers with high debt will prefer mechanical strategies that are likely less risky than active strategies, and vice versa.

“Producers with poor pricing skills will prefer mechanical strategies; producers with good pricing skills will prefer active strategies,” he says. “If a producer believes he or she has poor pricing skills [regardless of the view on market efficiency], the focus should be on mechanical pricing strategies.”

4. Follow through with a feedback loop to evaluate how well your marketing percentages worked.

“At the end of the marketing year, consider the outcome of your strategies and decide how you'll tweak these strategies going forward,” Good says.

He says much of the frustration experienced by farmers the past two years shouldn't be blamed on market advisers.

“The reason advice hasn't been successful is more a reflection of the changing nature of the markets than the source of the advice,” he says. “Many factors are influencing market prices.

“But,” Good concludes, “many producers rely too heavily on self-directed, active strategies. They're substantially underdiversified in terms of pricing approaches. Diversifying across the four cells of the pricing matrix would likely improve marketing outcomes and reduce the risk and frustration of pricing decisions.”

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