As noted in the previous topic, price contracting is commonly used by farmers and ranchers to help manage risk. Now, let’s take a look at how contracted pricing could work on a hypothetical Midwest farm that chiefly produces corn and soybeans.
As the farm manager, you are responsible for nearly all production and marketing decisions. In your management activities, you work to achieve specific profitability targets designed to ensure the farm’s long-term viability. Your profitability targets are based on expected production yields (bushels per acre) and expected market prices ($ / bushel).
It’s May of the current year, and your production plans are right on track. With continued good weather, you expect that your October harvest will meet or exceed your expected production yield.
On the market side of things, the current year’s corn prices are forecast to be in the $3.25/bushel to $3.75/bushel range; In fact, your profit targets were based on an assumed price of $3.50/bushel, which is the market’s current expected price for October corn. Remember that in agriculture, and most other industries, individual producers have little to no control over market prices. In short, you are a “price taker” at the mercy of the market. For reference, corn prices over the past five years have ranged from $3.00/bushel to bushel to $5.00/bushel – that’s a range of around 50% from your $3.50 assumed price.
While corn is your output, it is also an input to buyers. When corn prices go up during the crop year, you make more money because the value of your crop at harvest will be greater. On the other hand, higher corn prices cause the buyer to lose money, because his costs of production increase as he must pay more for his input.
Of course, the opposite is also true. When corn prices go down between planting and harvest, you lose money compared to what you would have received if prices had remained at previous levels. In this case, the buyer will make more money, as he is able to pay less for his input.
What makes forward contracting work for both parties is the fact that neither you or the buyer know whether the price will rise or fall between the time of the contract and the harvest delivery. Both of you know that you might win or you might lose if you wait until harvest to price the corn. However, a forward contract might make sense if you both know that you can make a reasonable profit at the current price. The uncertainty of price movement between now and harvest carries some amount of both risk and potential reward for you and the buyer.
As you’re surveying your field one day in mid May, you’re approached by one of your neighbors who buys corn for her cattle feeding operation. She asks if you are interested in a forward contract for your corn. The price that you will receive and that she will pay is the current expected October price of corn, $3.50/bushel. Once you sign the contract, your price will be set – no matter what happens to corn prices between now and then.
For the sake an example, assume that you have 100 acres and both expect and actually harvest 150 bushels per acre and have a total of 15,000 bushels of corn to market. At the contracted price of $3.50/bushel you will receive $52,500 in revenue for your corn crop (15,000 bushels x $3.50/bushel). No matter what happens to the market price of corn, you know you will exceed your profit target and have a successful year. However, let’s consider two different scenarios for how things look to you in the fall given possible changes in the market for October corn.
Between the time you sign the forward contract for $3.50/bushel and the time you can sell your corn, the market goes up to $4.00/bushel. In this scenario you have missed out on a positive market move that would have worked in your favor. If you had been able to sell your production at market prices, you would have received an extra 50 cents/bushel, or $7,500 in revenue that would have increased your annual profit. This would have been an “extra-successful” year for you. It would also have been a difficult year for your buyer, who would have been forced to pay the same $7,500 as additional input expense. Instead, because you signed the forward contract you both will have successful years with average profitability.
After you sign the forward contract you get news that the U.S. as a whole experiences a very good corn crop. The corn harvest is plentiful across the country and the market is flooded. Corn prices drop to $3.00/bushel by the time you’re ready to sell your corn. In this scenario you would have been able to generate only $45,000 in revenue ($3.00/bushel x 15,000 bushels) and would not have generated a profit for the year. In fact, you would have lost money. On the other hand, your buyer would have been enjoying the benefits of buying corn more cheaply and saving $7,500 (50 cents/bushel x 15,000 bushels) in input costs. However, both of you will, once again, have successful years with average profitability because you signed the forward contract and sell the corn for $3.50/bushel.
Reflecting on these two possible outcomes can help us understand the value of forward contracting as a risk management tool. As a seller, when the time comes to deliver the corn and get paid at the agreed price after harvest you might regret signing the forward contract in Scenario 1, but you will be very happy that you signed it in Scenario 2. If both scenarios are equally likely at the time you enter into the forward contract you and the buyer are both giving up the possibility of gain to eliminate the risk of loss in the market. With that in mind, neither of you should regret your decision no matter the outcome. You made a decision not to gamble with your profitability and locked in a successful year for your farm.