A Margin Risk Approach to Risk Analysis and Risk Management in Ag
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A Margin Risk Approach to Risk
Analysis and Risk Management in
Agriculture
Dr. Jay Noel, Chair, Agribusiness Department
Steven Slezak, Lecturer, Agribusiness Department
College of Agriculture, Food, and Environmental Sciences
Cal Poly, San Luis Obispo, California
Palisade Risk ConferenceLas Vegas, Nevada
Thursday, 8 November 2012
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Two (Related) Types of Ag Risk
Operations and Financing
price, cost, and yield
debt (including interest expense)
Debt Financing Links Them operational debt for cultural costs
debt incurred to cover thin or negative margins
Address Margin Risk Perspective
revenue is volatile; function of price and yield
costs are less volatile
margin risk results
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Managing Margin Risk
Operational and Financial Risks Intersect in Margins low prices, high costs, low yieldmargins indicative of risks in other areasmanage margins and address broader risk issues
Important Strategic Functionsuccess or failure can depend on margin management
strategy
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The Case
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The Case
Iceberg Lettuce Grower and Shipper leases 1500 acres in Salinas Valley two harvests a year 850 cases per acre average borrows 50% of cultural costs rule of thumb: hedge 80% of production
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The Problem
Farm Credit Wants Operator to Manage Margins default risk too high operational (not credit) issue condition of credit manages risk to revenue using forwards
no management of risk to costs hedge ratio insufficient
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For Purposes of This Simulation
Margin revenues less all costs
costs include debt service (P & I) similar to debt service coverage margin is whats left over
Margin Risk chance that annual debt service (P&I) will not be
covered, triggering a default event
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Revenues Driven by Spot and Yield
Year Average Spot Price Yield(40 lbs per carton)2004 $ 8.10 8502005 $ 7.93 8042006 $ 10.75 7252007 $ 12.38 8302008 $ 11.93 8242009 $ 9.08 9282010 $ 12.88 983Mean $ 10.44 849
Correlation Matrix
Yield Average Price
Yield (40 lbs per carton) 1 0.2082Average Spot Price 0.2082 1
Forward Contract Prices Vary with Spot Price Between
$11.50 and $12.50 on Sliding Scale ($0.25 Increments)
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0.94
0.33
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+Yield / Stochastic (Empirical Distribution)
+Price / Stochastic (Empirical Distribution)
Coefficient Value
Total Revenue, 50% Leverage, $12.50 ContractRegression Coefficients
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Seed $144.00 Total Production Costs $7,457.06Fertilizer $359.00
Weed Control/Thinning Labor $146.00 Cash Overhead per acre $130.00
Pest Management (includes PCA costs) $582.00 Land Rent per Acre $1,100.00
Water $280.00Interest on Operating Capital (based on 6.275% peryear on half of cultural cost) $38.98
Irrigation Labor $241.70 Total Overhead Cash Cost $1,268.98
Tractor Labor $148.35
Fuel $172.93 Depreciation and Interest on Investments $50.00
Tractor and Machinery Cost $255.58
Supervision and General Labor $105.00 Total per Acre Cost $8,776.04Compost $50.00
Total Cultural Costs $2,484.56
Total Cost less Harvest Cost $3,803.54
Fresh Market Harvest Cost ($/Carton)Cut/Pack/Haul $5.85
Average Yeld/Acre (Cartons) 850Total Harvest Cost (cooling, palletize, and sell) peracre $4,972.50
Production Costs (per Acre, Single Harvest)
Harvest Costs Variable (Driven by Yield);
Cultural Costs Fixed
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The @Risk Simulation
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Technical Specifications
@Risk Functions RiskNormal
yield driving harvest costs RiskGeneral
spot price and contract price yield driving revenues
500 simulations
@Risk for Excel 6.0.0 (Industrial Edition)
MS Excel 2010, Windows 7 Oracle VM VirtualBox Manager 4.1.23 iMac (3.1 GHz Intel Core i5)
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cash Marlcet Pr ..
u 0111\-Prlo l ( l l l t1111\)Mnmm $7. 13116S:I2S1'JI1.0.
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Yi
0.0035
0.0030
0.0025 I 725 4 1.m lf:I,'Hlln 862 51SIIIDov 71 00500
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Harvest cg L - - - - - ~ ~ - - - - - - ~ 9[).
87
.Ss -On.m t,,3USS-.m 0.71.'1.714 Noon t4,t67.njd D194.87- 5113210 i'"' ' ' '
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$6,000
$7,000
$8,000
$9,000
$10,000
$11,000
$12,000
$13,000
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19
28
37
46
55
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SimR
esults
100% Hedge, 50% Leverage, $12.50 Contract
Total Revenue
Total Cost
Revenue= $894 Cost= $492
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$6,000
$7,000
$8,000
$9,000
$10,000
$11,000
$12,000
$13,000
1
10
19
28
37
46
55
64
73
82
91
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1
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1
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1
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1
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SimR
esults
No Hedge, 50% Leverage
Total Revenue
Total Cost
Revenue= $1464 Cost= $498
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87
cis-14J 3210l :'
No Hedge: Net Income, Total costs Total Reven ...
0
7,111.07.10 517.258.771.25
Tobol fleolau:
$4M.(7500
$6,(1(11.18.U 490.996,997.711 500
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-$5,000 -$3,000 -$1,000 $1,000 $3,000 $5,000
CumP
robability
Net Income
Net Income with 50% Leverage
All Hedge, $12.50 Contract
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-$5,000 -$4,000 -$3,000 -$2,000 -$1,000 $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000
CumP
robability
Net Income
Net Income with 50% Leverage
All Hedge, $12.50 Contract
All Hedge, $10.50 Contract
No Hedge
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The Hedge
Oh merde!
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The Hedge
Analysis Says 100% Hedge is Sensible In Practice, 80% Hedge Ratio
acting as though contract price is $11.25 locking in a reduction in net income
Why Take the Risk? retail market and supply chain dynamics strategy not focussed on minimizing margin risk trading upside for chance at extra $150 per acre self-insured; moral hazard; What the hell? attitude
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$6,000
$7,000
$8,000
$9,000
$10,000
$11,000
$12,000
$13,000
1
10
19
28
37
46
55
64
73
82
91
100
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145
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SimResults
100% Hedge, 50% Leverage, $11.25 Contract
Total Revenue
Total Costs
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-$5,000 -$3,000 -$1,000 $1,000 $3,000 $5,000
CumP
roba
bility
Net Income
P&L For Result ing Hedge
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80%
82%
84%
86%
88%
90%
92%
94%
96%
98%
100%
-$1,000 -$900 -$800 -$700 -$600 -$500 -$400 -$300 -$200 -$100 $0 $100
CumP
robability
Change in Net Income
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The Forecast
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The Forecast
@Risk Functions RiskNormal (as before) RiskGeneral (as before) RiskTriang (0,0.0074721,0.0074721)
cultural costs grow at maximum annual rate of 1.5% 500 simulations
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0%
20%
40%
60%
80%
100%
-$
5000
-$
4000
-$
3000
-$
2000
-$
1000
$
0
$
1000
$
2000
$
3000
$
4000
$
5000
CumP
robab
ility
Forecast Net Income: 2012a to 2017b
All Hedge 2012a
No Hedge 2012a
All Hedge 2017b
No Hedge 2017b
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Net Income Fol"' C.1:: Harvests 20 2.e tD 20 ...
$1,000 ...:1
... ... .:' ..... ... ... "'- - ... - 0 ~ 0 ~ 0 ~ 0 ~"' "'..... .....i .. i .. i .. I .. Ia a 6c c c- - - -1z J 11z J 11z J 11z 11z.. ..... ... ... ....... ... ... .......
...II"'- ...0"' ....... I-
...-"',6c-
- MI I I'I I 1 std Dev.
5 ~ 9 5 ~
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Reconsider Understanding of Risk
Look Beyond Revenue Side prices, yields, revenue require management What About Costs?
land, fertilizer, energy, water, seed, weather, pests,disease, regulations, technology, food safety, foreigncurrency
major sources of risk all require management
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Reconsider Our Treatment of Risk
Mistake to Focus Mainly on Prices ignores effect of financing and capital costs
Must Focus on Revenues and Costs -- Margins Margin Risk Management is Key StrategicCompetence
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Hope is Not an Option
Risk Management is a Strategic Function part of competitive advantage
or lack thereof
major component of management responsibility
just like operations, harvest, distribution, sales operations and finance intersect in margins integral part of strategic activities
needs daily attention, high level of expertise, andgood information
contributes to success or failure of company
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Strategic Implications for Industry
More Broadly: prepare to adapt and change in other words, research, develop, innovate
There Will be Failure; Risk Taking Required small scale failure (no catastrophes) fail quickly, learn, move on risk management more important than ever
Innovation Creates Value share benefits with customers share risks with customers, too
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Data Sources
University of California Cooperative Extension(2009)
USDA Agricultural Marketing Service MarketNews
Monterey County (CA), Office of the AgriculturalCommissioner
Proprietary Sources
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Contact Information
For additional information on the Agribusinessprogram at Cal Poly, please contact:
Dr. Jay Noel, ChairSteven Slezak, Lecturer
Agribusiness DepartmentCollege of Agriculture, Food and Environmental Sciences
Cal Poly UniversitySan Luis Obispo, California 93407Phone: 805-756-5008E-mail: [email protected]