Will pricing crops now reduce risk?

By Debra Levey Larson

The bottom line is that 2011 is likely to be a profitable year for farmers. Determining just how profitable involves a complicated equation that includes number of bushels per acre, price per bushel, level of revenue protection and hedging.

Assistance

An issue of University of Illinois Farm Economics Facts and Opinions looked at some of the possible scenarios to help farmers juggle the numbers and the risk.

“Most people are buying revenue protection insurance products,” said University of Illinois agricultural economist and farm management specialist Gary Schnitkey. “We wanted to know if you had to hedge grain now, what its impacts would be at several levels of RP and at no insurance just to get a feel for how much risk is mitigated by different amounts hedged.”

Schnitkey compared the RP at 85 percent coverage level, 75 percent coverage level and 65 percent coverage level and no insurance for a central Illinois farm with a 184-bushel average yield.

Visitors to the U of I farmdoc website (www.farmdoc.illinois.edu/manage/newsletters/fefo11_09/fefo11_09.html) can view the entire Farm Economics Facts and Opinions issue.

“At low coverage level of insurance or with no insurance, hedging at least 50 percent of expected production is needed to reduce downside risks to their minimum,” Schnitkey said. “At 75 percent and higher coverage levels, only modest amounts of hedging are needed to reduce risks.

“Using last year’s purchases as a guide, most farmers purchased at 80 and 85 percent coverage levels,” he said.
“At these coverage levels, most of the gains of reducing downside risks are obtained when around 10 percent of expected production is hedged.”

Higher levels

Schnitkey added that much higher levels of hedging do not affect downside risks. Farmers with high-coverage level insurance policies have large latitude in hedging grain without impacting risk.

“What are the chances of having revenue below that, giving hedging? Obviously lower yields could happen if we have a poor growing season and prices are currently at what they are now — about $6 for corn. But in this scenario, gross revenue from an acre will be about $1,000,” Schnitkey said.

For farmers who purchased RP at high coverage levels, hedging modest amounts of expected production now reduces downside risk, but most of the risk protection has already been obtained through the crop insurance policy.

“If we hedged somewhere between 50 and 60 percent with no insurance, we can reduce the probability of having revenue below $850 from over 30 percent to just below 10 percent,” Schnitkey said. “If we throw crop insurance into the mix — at the 85 percent coverage level, which is what most people have, we can minimize that risk by hedging 10 percent of production. We can reduce most of our risk by hedging — a really modest amount, 10 percent of the production.”

Factor

Another important factor is that with the crop insurance policy you can minimize the risk by about 10 percent production, but if you go up to about 70 percent, you’re not also increasing your risk, he said. According to Schnitkey, farmers will have a very wide range of very low risk with crop insurance and marketing.

“The higher the coverage level, the wider the range,” he said. “For example, at 65 percent coverage, 30 to 40 percent expected production is needed to minimize that $850 benchmark revenue.”

Similar patterns exist for a 65 percent RP policy.

“The chances of revenue reach their minimums at lower amounts hedged,” Schnitkey said. “The minimum chance with an 85 percent RP policy and is reached at 61 percent hedged compared to 71 percent for no insurance. At the $750 benchmark revenue, the minimum chance is obtained at a 2 percent hedged amount compared to 21 percent for no insurance.

“At $650 benchmark revenue, the minimum chance is obtained at a 1 percent hedged amount compared to 13 percent hedged for no insurance. Reaching the minimums will continue to go down as higher coverage crop insurance is examined.”

No chance

He added that there is no chance of being below $650 and $750 per acre over a wide range of percentage hedged when crop insurance is purchased at high coverage levels.

“This suggests that a great deal of latitude exists when marketing grain with higher levels of crop insurance because marketing will have lower impacts on downside risk than at lower coverage levels.”

Schnitkey also noted that the results from this recent projection will change as the growing year continues.