These examples serve to illustrate only too graphically how easy it is to lose your livelihood overnight. Add fluctuating commodity prices, interest rates and exchange rates into the mix and the true nature of rural operational risk starts to become apparent.
Wonderful though the thought may be, the elimination of risk in farming enterprises is as likely as the Inland Revenue Department closing down. Plan B, managing the risk, is the next best thing. To this end there are various tools offered by many agribusiness banking arms that farmers can use to hedge against the negative effects of market price, currency and interest rate fluctuations. These can help with more accurate planning and provide more certainty with cashflow and profitability.
With such a volatile currency as New Zealand’s, farmers also need to hedge their currency risks if they’re exporting directly overseas. Swaps, options and dairy futures aren’t commonly used by farmers in New Zealand, but they are available. Banks and the NZX offer these on dairy and other products. This list varies with each financial institution so it pays to know what commodities your bank will trade.
Risk Management Solutions: Please Explain
Dairy futures and options are mainly traded by industry players such as Fonterra. Some larger farms use them to add certainty to their business through hedging. It’s not however a simple equation because the futures and options are on whole and skim milk powders and hydrous milk fat.
Although farmers Colin and Janine are supplying milk to Fonterra they can use futures and options to hedge against commodity price falls.Typically the movement of international prices of milk powders and hydrous milk fat will correlate to the farm gate price for the raw material. More details can be found at: www.nzxfutures.com.
Swaps and options are offered by banks. In a swap, the farmer promises to deliver an amount of produce in the future at a pre-agreed price. Swaps can be used to lock in a fixed price per unit of measurement. They can have multiple settlement dates or a single settlement date known as “˜rate-set’ periods, where a settlement will take place between the farming business and the bank. These rate-set dates may be quarterly, semi-annually or customised to your needs, for example, if you sell through a produce marketing board.
Swaps cannot be extended for an additional term and must be settled by cash at maturity, irrespective of whether the bank owes you a cash payment or vice versa.
- Upside: Swaps give you the security of a fixed future price for your commodity.
- Downside: Swaps are less expensive than options, for a very good reason. Drought, flooding, or storms could mean you can’t provide the produce when it is due ““ yet you still have to settle at that date and pay up at the agreed swap price. Crop insurance, if you have it, may kick in to cover your liabilities, should you be unable to deliver the produce at the due date.
Fred is expecting to harvest 2,000 tonnes of crop in the next three months. He has estimated the crop will return him $350 a tonne, totalling $700,000. He enters into a swap contract with his bank, promising to deliver 2,000 tonnes at $350 a tonne in four months’ time.
Scenario 1: After harvest and at the contracted maturity time, a glut of the crop has pushed the tonnage price down to $250. If Fred sold now on the open market, he would receive only $500,000, a full $200,000 less than he budgeted. However, Fred is rubbing his hands with glee, as he has already contracted to swap the crop with his bank for the pre-agreed price of $350 a tonne. Fred settles and walks away with $700,000, leaving his bank to write off the $200,000 loss.
Scenario 2: When Fred’s swap contract is up for maturity, he discovers extreme weather events have devastated overseas crops. Consequently, prices have doubled and the crop is now is selling at $700 a tonne at this point in time. Fred’s crop could now net him $1,400,000 but alas, he has contracted to sell at $350 a tonne. This time, it is his bank which picks up the $700,000 profit.
In this arrangement, the farmer buys a put option from the bank. This gives the farmer the right in the future to deliver produce at a pre-agreed price, but he or she has the choice not to do so if the price is no longer advantageous. In return for granting the option, the seller (bank) collects a payment (the premium) from the buyer (farmer).
- Upside: The farmer is protected from falling prices and benefits if prices rise.
- Downside: Because options are more flexible than swaps, they are usually more expensive.
Fred buys an option to sell his crop to the bank in four months’ time. The forecast is still the same ““ 2,000 tonnes at $350 a tonne.
Scenario 1: At the time of settlement, the crop price has dropped to $250 a tonne. Rather than make a loss on his crop, Fred elects to take up the option and sell to the bank at the pre-agreed price of $350 a tonne. He gets the money he budgeted for and the bank wears the $200,000 loss.
Scenario 2: With Australian crops failing and Fred’s crop now worth a massive $700 a tonne, Fred declines to take up the option with the bank. Instead, he sells on the open market and makes a tidy $700,000 profit, less the price of the option.
With the basic hedging options listed above, we have simplified our examples and not taken into account the premiums to be paid by either the farmer or the bank, depending on the transaction. Naturally, the premium due will be one of the key factors to take into account in a profit or loss forecast by both the buyer and the seller.
There are many more combination strategies available for hedging risk such as put/call spreads, collars, ratio options and exotic options. These are more sophisticated tools for planning and budgeting necessary to reduce fluctuations in commodity prices and currency movements. Your financial planner, accountant or bank can help with explanations of these and how beneficial they may be to your rural enterprise.