A Margin Risk Approach to Risk Analysis and Risk Management in Ag

8/12/2019 A Margin Risk Approach to Risk Analysis and Risk Management in Ag

1/39

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


2/39

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


3/39

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


4/39

The Case


5/39

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


6/39

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


7/39

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


8/39

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)


9/39

0.94

0.33

-0.

1

0.

0

0.

1

0.

2

0.

3

0.

4

0.

5

0.

6

0.

7

0.

8

0.

9

1.

0

+Yield / Stochastic (Empirical Distribution)

+Price / Stochastic (Empirical Distribution)

Coefficient Value

Total Revenue, 50% Leverage, $12.50 ContractRegression Coefficients


10/39

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


11/39

The @Risk Simulation


12/39

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)


13/39

cash Marlcet Pr ..

u 0111\-Prlo l ( l l l t1111\)Mnmm $7. 13116S:I2S1'JI1.0.


14/39

Yi

0.0035

0.0030

0.0025 I 725 4 1.m lf:I,'Hlln 862 51SIIIDov 71 00500


15/39

Harvest cg L - - - - - ~ ~ - - - - - - ~ 9[).

87

.Ss -On.m t,,3USS-.m 0.71.'1.714 Noon t4,t67.njd D194.87- 5113210 i'"' ' ' '


16/39

$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

1

00

1

09

1

18

1

27

1

36

1

45

1

54

1

63

1

72

1

81

1

90

1

99

2

08

2

17

2

26

2

35

2

44

2

53

2

62

2

71

2

80

2

89

2

98

3

07

3

16

3

25

3

34

3

43

3

52

3

61

3

70

3

79

3

88

3

97

4

06

4

15

4

24

4

33

4

42

4

51

4

60

4

69

4

78

4

87

4

96

SimR

esults

100% Hedge, 50% Leverage, $12.50 Contract

Total Revenue

Total Cost

Revenue= $894 Cost= $492


17/39

$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

1

00

1

09

1

18

1

27

1

36

1

45

1

54

1

63

1

72

1

81

1

90

1

99

2

08

2

17

2

26

2

35

2

44

2

53

2

62

2

71

2

80

2

89

2

98

3

07

3

16

3

25

3

34

3

43

3

52

3

61

3

70

3

79

3

88

3

97

4

06

4

15

4

24

4

33

4

42

4

51

4

60

4

69

4

78

4

87

4

96

SimR

esults

No Hedge, 50% Leverage

Total Revenue

Total Cost

Revenue= $1464 Cost= $498


18/39

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


19/39


20/39

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


21/39


22/39

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



No Hedge


23/39

The Hedge

Oh merde!


24/39

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


25/39


26/39

$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

109

118

127

136

145

154

163

172

181

190

199

208

217

226

235

244

253

262

271

280

289

298

307

316

325

334

343

352

361

370

379

388

397

406

415

424

433

442

451

460

469

478

487

496

SimResults

100% Hedge, 50% Leverage, $11.25 Contract

Total Revenue

Total Costs


27/39


28/39

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


29/39

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


30/39

The Forecast


31/39

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


32/39

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


33/39

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 ~


34/39

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


35/39

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


36/39

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


37/39

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


38/39

Data Sources

University of California Cooperative Extension(2009)

USDA Agricultural Marketing Service MarketNews

Monterey County (CA), Office of the AgriculturalCommissioner

Proprietary Sources


39/39

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]

[email protected]

Documents

A Margin Risk Approach to Risk Analysis and Risk Management in Ag