Analyzing ’04 Combined Crop Insurance, Grain Marketing Strategies

By David W. Bullock
david.bullock@state.mn.us

The sales closing date for crop insurance purchases (March 15) has passed and hopefully, most producers have locked in their insurance coverage for the 2004 crop year.  Now comes the hard part – developing and implementing a preharvest marketing plan.

A good preharvest marketing plan includes the following components:

1) farm operator’s financial and personal ability to bear risk,

2) outlook for harvest time prices and yields,

3) list of marketing tools to consider (futures, options, forward contracts,
etc.),

4) list of deadlines for marketing decisions, and

5) a list of target or trigger prices to implement marketing decisions.

In this article, we will analyze three basic marketing strategies for a case study Red River Valley hard red spring wheat enterprise. This case study is based upon a FINBIN (farm financial database, http://www.finbin.umn.edu/) enterprise analysis summary for Polk County, Minn. spring wheat production. 

From this information, our typical operation has 300 acres planted with an average historical yield of 42.5 bushels per acre and a yield standard deviation or variability of 12 bushels per acre. Figure 1 on page 33 illustrates yield probabilities based on the average. So, for example, the graph tells us that there is a 42% chance (42 out of 100) of seeing a yield of 45 bushels or greater.

Next, we need to derive a forecasted MGEX spring wheat futures price.  We anticipate harvesting in mid-August; therefore, let’s use the September 2004 delivery month (first delivery month after harvest) as our contract.  The current (2/24/04 as of this writing) futures price is $4.15 per bushel.  This will be our baseline price forecast for harvest. 

Next, to evaluate futures hedges and to determine our forecasted cash price at harvest, we need a forecast of the basis – which is just the spread between the local cash price and the futures price.  The best method to forecast the basis is to look at the historical average and standard deviation for your location. For our basis forecast, we will use the USDA-NASS September Minnesota wheat price as our cash market price and adjust it based upon values observed for the past four years in Alvarado, Minn.  This results in an average basis forecast of -$0.20 per bushel.

Now that we have price and yield forecast numbers to work from, we move on to define the strategy toolbox, decision dates, and target prices. Let’s look at three strategies:

1) a scale-up futures hedge strategy covered by purchased puts on the unhedged portion.

2) up-front purchase of put options on 100% of anticipated production, and

3) up-front placement of an option fence strategy on 100% of anticipated production.

There are four parts to a scale-up futures hedge strategy: 1) a series of price targets, 2) a target implementation date for each price, 3) the percentage of anticipated production to hedge at each price, and 4) a backup strategy if the target is not implemented by target date.  In addition, it is helpful to have some idea of the odds that each target price will actually be hit by the target date.

The following table shows our pricing objectives, percentages, and odds of implementation (based on a market volatility model). Our target date is August 15 for all price targets and we will implement a stop-loss strategy for determining when to purchase put options on the remaining production. 

Price Percent Odds of Target Hedged Implementation $4.15 25% 100% $4.34 25% 70% $4.54 25% 50% $4.65 15% 50% $4.80 10% 30%

Our stop-loss strategy is implemented by purchasing at-the-money puts at the next lowest price target, if the target is implemented and price falls back below the next lowest price target.  So, for example, if the $4.34 target is implemented and then price falls below $4.15, we will buy $4.10 puts on the remaining 50% of unhedged production.

For the up-front put hedge strategy, we will buy $4.10 puts on 100% of the expected production. The premium on the $4.10 put is 26.75 cents per bushel.

For the fence strategy, we will buy $4.10 puts and sell $4.50 calls on 100% of expected production.  The premium for the $4.50 call was 18.75 cents per bushel.

Each marketing strategy will be evaluated with three different crop/revenue insurance coverage assumptions:

1) catastrophic coverage (50% yield, 55% price) only;

2) actual production history (APH) with 75% yield, 100% price election; and

3) revenue assurance (RA) with the harvest price option at the 75% coverage level. 

For CAT and APH, the maximum price election is $3.35 per bushel. As of this writing, the final RA base price has not been determined; however, it looks to be in the range of $3.96 (source: Art Barnaby, KSU).  The table below shows the insurance premiums and administration fees for Polk County, MN assuming an APH yield of 43 bushels per acre.

Finally, no preharvest marketing plan is complete without taking account of the free put option offered by the USDA through the loan deficiency payment (LDP), triggered when the market price falls below the loan rate.  For our example, we will use the Polk County loan rate of $2.93 per acre and a payment limitation (LDP only) of $75,000 on the operation (single operator).

To evaluate our marketing strategies, we will incorporate all of our information into a farm revenue risk management simulation program that I developed called RevRisk. We will evaluate each strategy with regards to mean return per acre over variable costs (assumed to be $130 per acre) and the minimum loss that can be expected 10% of the time (relative to variable costs).

Insurance Product	Coverage Level	Premium	Admin Fee
CAT	50/55	None	$100 per crop insured
APH	75/100	$5.94 per acre	$30 per  crop insured
RA w/ harvest	75% of		$30 per crop insured
option	Base Revenue	$8.86 per acre	insured

Figures 2, 3, and 4 show evaluation results for each crop insurance coverage.  Clearly, the scaled hedge strategy dominates from both an expected return and risk perspective for all three insurance coverages.  Also, the use of Revenue Assurance results in the lowest level of risk for each marketing strategy.

Figure 1: Polk County, Minnesota HRS Wheat Case Study
Farm Yield Forecast Distribution

Figure 2: Return/Risk Profile Catastrophic Crop Insurance

Figure 3: Return/Risk Profile Actual Production History (APH) Crop Insurance, 75% Yield, 100% Price Election

Figure 4: Return/Risk Profile Revenue Assurance with Harvest Option, 75% Coverage Level

Results of this analysis show the relative risk and return advantages of using a scaled-up futures hedge strategy combined with residual put option coverage versus just purchasing put options (or option fences) up front. The key to an effective scaled-hedge strategy is to have realistic price targets and backup plans if those targets are not reached.

Obviously, this is just one way of analyzing different grain marketing strategies under various crop insurance scenarios, for just one crop.  Put the pencil to various grain selling strategies that may work under the crop insurance coverage on your farm and for the different crops that you produce.  

Bullock is risk management specialist with the Minnesota Department of Agriculture. His web site with more risk man-agement resources: www.mda. state.mn.us/riskmgmt.