How will drought impact your revenue stream?

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The recent headlines have been about how bad the corn and soybean crops are hurting, but those are only a prelude to wide swings in farm revenue as the result of a drought and actions taken to manage agricultural risk.  The assistance of crop insurance, the actions of marketing plans, and others all have an impact on the bottom line—which will be magnified this year as a result of low yields for many farmers.  What are some of the challenges you will face as a result of low yields?

Revenue is a function of production and price—and if both are going the wrong way, some farmers will suffer severe financial consequences.  Others may be protected by the natural hedge in Cornbelt commodity prices.  Others may have a reasonable year, even without the bushels to sell.  And interestingly, those farms could all be contiguous to each other, have the same acreage and suffered from the same lack of rain.

University of Illinois ag economist Gary Schnitkey explores various scenarios in farm income prospects on a theoretical 1,200 acre farm with a variety of ownership, leasing arrangements, and crop insurance against a trio of drought scenarios. 

Schnitkey says a mild drought that cut the 180 bu. average to 160 bu. would push income down to $220,000.  A moderate drought that cut the yield further to 150 bu. would drop income to $190,000.  However a severe drought of 135 bu. that raised prices of commodities and earned insurance indemnity payments would raise income to nearly $300,000.

Schnitkey’s warnings are:
1) Farms that have no crop insurance or crop insurance at low coverage levels would have lower incomes, particularly at very low yield levels.
2) Farms that hedged a large portion of expected production could face income losses. By hedging, farmers would not benefit from assumed price increases.
3) The above scenarios presume that prices increase as a result of lower yields. If price responses do not occur, incomes would be much lower than presented here.  One of his premises is that low stocks as a result of the drought would keep prices high for a longer period of time.

Schnitkey’s second point—regarding hedged commodities—was also addressed by Purdue ag economist Chris Hurt, who said farmers with forward contracts early in the year would be severely penalized by a short crop that was insufficient to meet the delivery requirements.  Chris Hurt says conversations have already been occurring between farmers and elevator managers, but it is difficult to say what the outcome will be because of the uncertainty of prices.  In addition to losing a crop to sell at high prices, he said the failure to meet contractual obligations of delivery is another issue.

Hurt said farmers with forward contract have three options:

  1. If the grain was sold locally, the farmer now may be able to buy back some of the bushels by paying the difference for the lost bushels.  He said, “They would avoid further potential losses if prices move even higher.”
  2. A second option is to buy futures to offset the price impact.  He says, “If prices go higher they could gain on their futures position and those gains could help offset losses on their cash-forward contract.” 
  3. A third venue is to buy a call option that would create the chance to buy bushels for a specific price by a specific date.  He added, “The farmer would have to pay a premium for those rights but would have price protection against rising prices.”
  4. Hurt also said if you have stored grain from the 2011 crop, its value is climbing, and could be used for delivery against the contract.  He said there is a bullish situation if the drought continues, but if it rains, that could change.

Summary:
As the drought continues the reality of fewer bushels converts to farm revenue, which will vary from farm to farm, depending on a wide variety of dynamics.  While moderate and medium droughts will reduce income, a severe drought will create significant revenue problems, unless one has revenue insurance, and then it might be a significant windfall with both indemnity payments and high prices for the few bushels for sale.  Some additional problems could result if there were many bushels forward contracted or hedged early in the year, and could not be fulfilled by a short crop.  Options to resolve that could involve arrangements with elevator managers, buying futures that are expected to climb, or buying a call option to purchase corn at a price that might be under the market as it rises past the strike price.


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