Trading in, or selling, agricultural commodities is a risky business for both producers and buyers. Rapid price swings can occur because of weather, politics or demand changes around the world. Multi-year cycles of boom and bust also can occur as the market adjusts to changing conditions over time.
There are, however, strategies that can be employed to mitigate some of the risk. For producers that might include federally subsidized crop insurance. For both producers and buyers, the futures market provides avenues for hedging your risk.
The futures market involves selling or buying futures contracts, or options on such contracts, to offset activity in the cash market. For a farmer:
This speaks to the heart of risk management strategy. How much of a crop should be hedged on the futures market, and how much should be aimed at the cash market? This is a complex calculation that changes over the course of a season as prices rise and fall, production estimations change, geopolitical shifts occur, demand rises and falls and so on. This is further complicated by very nature of agricultural production and prices, which tend to move in multi-year cycles.
For these reasons, it is important to develop a long-term, written plan that accounts for protecting revenue in a given year, while recognizing and building toward long-term, cyclical opportunities. A somewhat contrarian plan that protects business margins in a down year can give a farm or a business a leg up on competitors that have allowed poor margins to define their level of success.
This is especially true for businesses that can seize opportunities to expand during down cycles in a commodity. Risk mitigation that can help generate profitability in down years provides the resources to out-compete, or even buy, companies that are less effective at protecting price and revenues. This is true for, and documented for, both farmers and agribusinesses. Both have seen a great deal of consolidation in recent years as price cycles have bottomed out. Successful companies with good risk management, are buying up the weaker ones.
Risk mitigation is a complex job. It is best executed by a team with adequate education and training in the concepts, knowledge and experience in agriculture and agriculture markets and in consultation with lenders or partners. For the long-term health of the company, part of the strategy should include continuing education and succession plans for each member of the team.
Above all, it is important that a risk management team understand that the goal is not to make money trading in commodities. It is to even out the price received in a way that protects total revenues. Trading to maximize trading returns is nothing more than speculation. Hedging and risk mitigation are tools to reduce the risk of the marketplace while locking in acceptable profit margins.