Prices determined by supply and demand, can be managed to minimize risk
Powell – “The first step in developing a market plan is to know what price we need to market our product at,” stated Brett Crosby, president of Custom Ag Solutions.
Crosby stated that when price increases, supply decreases and vice versa. For the consumption of a product to increase, the price has to decrease.
When it comes to markets in agriculture, prices are mainly supply driven.
Supply and demand
“Where price and supply meet on a supply and demand graph is the equilibrium point, and this is where the price actually ends up,” said Crosby. “Supply changes do not create inflation.”
Rather, inflation results when government increases the availability of money.
“Inflation is a result of printing money and having more money than we used to, which results in increased willingness to pay more for the same amount of goods and services,” added Crosby.
Shift demand curve
To change the price of a commodity, either the supply decreases or increases. A shift in the demand curve can also occur, which will change the demand of the commodity.
“The market is always going to be seeking equilibrium, based on the constant movement up and down of supply and demand expectations,” explained Crosby. “Market equilibrium is based on expectations of the market moving and on people guessing how much supply there is going to be.”
A shifting supply curve will change market equilibrium and, thus, will change the price.
“Price can change abruptly and drastically,” described Crosby. “That’s why we need to take the same precautions and spend the same amount of effort dealing with price grids as we do with dealing with reduction risks.”
When a market reacts to new information by estimating a new equilibrium, economists are forecasting what the market may do and what supply and demand will be. This phenomenon is called price allocation, and it occurs when the price of a commodity moves to allocate for scarce resources and to keep shortages of supply from occurring.
An example of price allocation occurring in the market was the oil embargo on the U.S. during the 1970s.
“There is a constant entry and exit of producers in the production chain, based on their own profitability in producing a commodity,” said Crosby. “Over the long run, the price of a commodity reflects the cost of production.”
Crosby mentioned that it is no big secret that production costs vary by operation, and every producer has different costs of production.
“During any one year, there are going to be producers who are making money from their operation, and there will be producers who are losing money,” stated Crosby. “Eventually the people who are consistently losing money over time will fall out of the business.”
Market risk is the uncertainty of prices producers will receive for their commodities or must pay for their inputs.
“It’s not just about the price a producer receives, but about the prices producers pay for fewer inputs,” explained Crosby. “The nature of price risk varies significantly from commodity to commodity.”
“We can measure risk by the amount of variance in the production of a commodity,” said Crosby. “Variance is the measure of change in price and supply of a commodity.”
Risk management tools are used to develop risk management strategies that help producers deal with a commodity’s variance.
“Risk management tools are like chess pieces, and risk management strategies are the moves made with the different chess pieces,” described Crosby.
“Some of the risk management tools that are used in agriculture are forward contracts, futures contracts, options and crop insurance,” he added.
When entering a forward contract, a price of the commodity has already been established, and a call is placed to a buyer to see if they are interested in buying the commodity at the set price.
If the buyer agrees, a forward contract has been placed, and the price for the commodity has been set.
If the market price goes below or above the previous established agreed price, the producer will still receive the agreed price for their commodity.
“The risk of selling the commodity is gone for the producer, and the buyer now resumes the risk,” said Crosby.
A form of a price risk management is price averaging. This is the process of selling a portion of a commodity on several different dates.
“Price averaging serves to eliminate the possibility and risk of an adverse price movement in one particular week,” added Crosby.
“An effective risk management strategy allows us to capitalize on the profitable situations but also allows producers to pay as little as possible for it,” explained Crosby. “They also protect the producer from decreases of the market’s prices.”
“Hedging is what we call an offsetting investment position intended to offset losses or gains incurred in the core business,” described Crosby.
Futures markets, Livestock Risk Protection insurance (LRP), options and diversifications are examples of hedges.
“When we enter into that investment position, we don’t affect the price that is going to be received for the cattle. We affect the profitability by entering into the market and offsetting it.”
Crosby spoke at Northwest College in Powell for a five-part series for producers explaining how to create a Comprehensive Marketing Plan. The series began on Jan. 30 and ended on Feb. 27.
Brett Crosby from Custom Ag Solutions stated that the most effective tool to manage prices and market risk is information, whether it’s in the form of market reports, publication from Extension offices, private analyst groups such as CattleFax or BeefBasis.
Most importantly, however, he said information from a producer’s own accurate records is vital in risk management.
“We care about where we are in our production and our records because we want to know if we are a high-cost or low-cost producer,” commented Crosby. “We need to keep records to help us know where we are in our production and, if we are a high-cost producer, what we need to change.”
Items producers need to keep track of are production data, price data, total income, total expense, overhead costs and any indirect costs that will change their breakeven price.
“When projecting what our income and expenses are going to be, our actual production history is the most effective and accurate way to project next year’s income and expenses,” said Crosby.
“Because income flows from a number of different sources on an operation, it is difficult to track the breakeven prices for each commodity. It can be done with accurate records,” explained Crosby.
Crosby mentioned using programs like Quickbooks helps to keep input prices of each commodity of an operation separate, as well as to calculate breakeven prices and profitability.