Assessing probabilities can improve marketing plans

Wide swings in crop prices since 2007 are creating challenges for farmers when developing and maintaining a marketing plan. Rapid price swings have occurred for short-term prices, such as variability within a trading session or within a week, as well as long-term changes, which are those across several months or marketing years.

The primary benefit of developing a marketing plan is formalizing a strategy that balances price expectations with managing cash flows, grain inventories, delivery schedules and income tax liabilities. The challenge is keeping the marketing plan current while economic and market conditions are rapidly changing.

One of the most difficult elements to assess when updating a marketing plan due to changing conditions is the probability (odds) that prices will increase versus the probability that prices will decrease. Everyone wants to time sales to hit the high of the year. Unfortunately, no one can predict the future accurately, so consistently selling at the top of the market is nearly impossible. The best that can be done is to understand the forces that are impacting the markets, stay in touch with the changing market conditions and assign subjective (personal) probabilities to future price movements.

The general rule is that if the odds are good that prices will fall and the odds are low that prices will increase, lock in a price now. However, if the odds are good that prices will increase and the odds are low that prices will fall, then price the crop later. Admittedly, this oversimplifies the process, but it does place the focus on assessing the significance of the forces moving the markets and helps remove some of the emotion from the decision-making process during times of high price volatility.

The first step in assessing market conditions and assigning subjective probabilities to price movements is to become familiar with the underlying supply and demand conditions for the crop under analysis. This becomes the base reference point for assessing the impact of changing conditions. One publicly available source of information is the U.S. Department of Agriculture's (USDA) World Agricultural Supply and Demand Estimates (WASDE) report. These supply and demand estimates are updated every month and provide estimates of total production, imports, exports, domestic use and ending stocks. Even though many private analysts often question the accuracy of the USDA estimates, these forecasts are followed very closely by market traders.

The key value to monitor is the estimated stocks/use ratio. This ratio represents the amount of grain that will be available just before next year's harvest relative to the estimated total use of the crop. Average market prices are higher when the stocks/use ratio is small. However, prices are also more volatile when the stocks/use ratio is small because a minor change in projected supplies and/or projected use can make a big difference in ending stocks. This also puts a lot of pressure on the assumptions that are used to prepare the forecasts.

Even though the USDA updates the WASDE every month, many things can change between reports. This is where understanding the forces that influence markets and following the market news becomes important. The difficult part is determining if the issues reported in the market news could impact supply and demand conditions or if they are influencing market psychology and attitudes about the future. Fundamental changes to supply and demand conditions tend to have longer-lasting impacts on price trends, while market psychology tends to create more intense short-term price movements.

What are the odds that prices will increase versus decrease given the new information? This is where planning and decision making becomes very difficult and each individual can have a different assessment of the conditions.

Let's consider two issues that are impacting crop market prices: the projected size of the South American soybean crop and the impacts of the U.S. government debt problems.

Private analysts and USDA forecasters are projecting a record soybean crop for Brazil and Argentina. These expectations are factored into the prices for old and new crop soybeans. What is the probability or odds that both Brazil and Argentina will produce a record crop in the same year? If there is a weather threat or potential production problem in either Brazil or Argentina that reduces planted acres and/or yields, U.S soybean prices could increase significantly.

However, if weather conditions are favorable and/or planted acreage increases, U.S. soybean prices could decrease further because of higher export competition.

Once again, what are the odds and how does this impact your marketing plan? How many bushels of old and new crop soybeans are you willing to leave unpriced, betting on a production problem in South America?

A more complex issue concerns the budget negotiations going on in the U.S.

Congress and the impact these negotiations will have on market psychology, consumer spending, business investment and growth of the U.S. economy. An agreement on future tax policy and federal spending should support commodity prices, while a stalemate could create significant uncertainty about future domestic and export demand, which would lower prices. What are the odds Congress will negotiate an agreement before Jan. 1, 2013? Will this have a major or minor impact on crop prices? Do the answers to these questions impact the timing of crop sales?

Developing and maintaining a current marketing plan takes time and effort.

However, it usually pays big dividends. Placing a greater emphasis on estimating the probabilities of price increases versus price decreases can add focus when making marketing decisions. It also helps reduce the emotional impact that could lead to making a poor decision.

Source: Frayne Olson, Crops Economist/Marketing Specialist

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