Production Risk and Margin Management

Of the many risks producers face in their operation, production risk is certainly a big one that merits attention given what has occurred recently.  Hog producers are facing this issue head on right now with the spread of porcine epidemic diarrhea virus or PEDv, and crop producers felt this acutely during the drought of 2012.  When crafting a marketing plan, production risk is something that must be taken into consideration given the impact it can have on marketable supplies and ultimately the bottom line profitability of the operation.  A crop producer may not feel comfortable for example marketing too much of their crop ahead of pollination or even harvest due to the uncertainty surrounding their yields and final production levels.  A hog producer likewise may not want to think about pricing their pigs until they have been weaned and thus past the highest mortality risk period for PEDv.

Given what both industries have gone through over the past few years, this is certainly understandable and may very well be prudent risk management depending on the type of marketing a producer is doing.  If for example a crop producer normally establishes forward contracts or hedge-to-arrive agreements with the elevator ahead of harvest, production losses associated with drought can create the risk that the producer will need to buy out of their contractual obligation with the elevator.  The loss of doing so against bushels that ultimately are not produced then must be spread across the remaining bushels that are available to market, reducing the overall return on the crop.  This can have a detrimental financial impact on the operation depending on market conditions.  In a similar way, a hog producer that has contracted deliveries with their packer may find that they do not have the pig supplies available to meet these contractual commitments, and have to buy them on the open market to make up the difference.  This also can have a negative impact on the hog producer’s returns.

While the risk associated with production loss is very real and must be carefully considered in any marketing plan, it remains the case that very strong profit margin opportunities may present themselves well ahead of when a producer can be sure of their production outlook.  Given this knowledge, what should a producer do?  A conservative choice might be to wait for greater production certainty before any margin management plan is implemented, but what if the profit margin outlook deteriorates before that marketing supply is known?  If the strategy is to do nothing until I have greater visibility in my forward production, I may very well miss opportunities to protect favorable margins being projected by the market.  What if there was a way to address both the forward production uncertainty and profit margin opportunity together in a thoughtful plan?

Perhaps it is possible to define a production risk scenario and build that into my margin management plan.  As an example, a corn producer might look back at their actual production history to determine both an average historical yield as well as a variance around that yield.  They might determine based on that history that in a bad drought year, such as in 2012 for instance, it is possible to lose 30% of their yield potential from the trendline average.  Knowing this fact, they might want to incorporate that into their marketing plan to protect a forward profit margin opportunity.  In determining the various types of contracting alternatives they could consider, the plan might stipulate that no more than 70% should be contracted in a manner that would require physical delivery of those bushels or place a fixed sale commitment against them.  This doesn’t necessarily mean however that the operation has to assume risk on the other 30% of their production.  Another contracting alternative would be to set a floor for example on this portion of the expected production so that a profit margin opportunity could be preserved should the bushels be available to market.

A hog producer likewise may discover a forward profit margin opportunity in a deferred period that is historically attractive against pigs that have not even been born yet.  Faced with the uncertainty that one or more of their sow units could break with PEDv, the operation is faced with production risk over the eventual supply of hogs that will be available to market.  The producer might consider that given current information on the disease, it is possible to lose 10% of their expected production due to the fact that systems that have reported outbreaks are discovering losses of around 2.7 pigs per sow per year.  Not knowing if their farm may get hit with PEDv or how much potential loss they might suffer if it does, the producer could incorporate this into their margin management plan also.  They might stipulate for example that no more than 80%-90% of their expected hog production should be contracted in such a manner that would either require physical delivery of the pigs in the cash market or set a firm sale price on the animals.  This still leaves the operation open to set a floor or range of protection against lower prices to help secure or protect the profit margin opportunity should that production eventually be realized.

The main point is that production risk should not be a factor limiting whether or not protection is taken to protect a forward profit margin opportunity; rather, it should help direct how that opportunity should be protected.  Fortunately, there are various contracting alternatives using option strategies that allow for greater flexibility to protect a price level.  These can be incorporated into a thoughtful margin management plan that helps protect the operation from the dual risk of production loss and profit loss in forward time periods.