Purchasing Grain - Benefit and Cost Analysis of Purchasing Options to Manage Risk

Purchasing Grain - Benefit and Cost Analysis of Purchasing Options to Manage Risk

TechnicalBulletin/Dairy

Cost-benefit:grain priceriskmanagementoptions

Keypoints

  • Thecostandriskoffouroptionsforpurchasinggrainwerecomparedusingthreecasestudydairyfarms.Theoptionsexaminedwereto:buygrainonthespotmarket,useforwardcontracts,use futurescontracts,andbuygrainatthebeginningoftheharvestseasonandstoreon-farm.
  • Overaperiodofeightyears,therewasasmalldifferenceintheaverage totalcost of grain andriskbetweenthefouroptions.However,optionswithahighertotalcosttendedtohavelessvariability.
  • Forthethreefarmsstudied,theuseoffuturescontractsincurredtheleastvariabilityintotalcost,butthetotalcostwasgenerallyhigher.Buyinggrainatharvestandstoringithadthelowestcost,butincurredgreatervariability.Afarmmanagerislikelytochooseacombinationofstrategiestomanagetheirexposuretofeedpricerisk.

Background

Purchasedfeedisthesinglelargestcostformostdairybusinesses,representinganaverageof~30%offarmcosts.Arangeofstrategiesareavailabletofarmersformanagingvariationsinpurchasedfeedprice.Thisstudyinvestigatedthebenefit-costofsomeoptionstomanagethevolatilityofgrainpriceovertime.

Theanalysiscomparedfouroptions:1)buyinggrainonthespotmarket,2)forwardcontracts,3)futurescontractsand4)buyinggrainatthebeginningoftheharvestseasonandstoringit.Aforwardcontractisanagreementbetweentwopartiestocarryoutafinancialtransactioninexchangeforaproductorserviceatafuturepointintime.Afuturescontractistradedonacentralexchangeandisstandardisedandregulated.Afuturesmarketiswherecontracts,ratherthantheactualcommodity,arepurchasedandsoldforthefuturedeliveryofacommodity.

TheanalysisofthefourpriceriskmanagementoptionswasbasedonthreeVictoriandairyfarmsoveraneightyearperiod(2007/08to2014/15).ThefarmswereparticipantsintheVictorianDairyFarmMonitorProject.

Grain silos hand holding wheat grains Australian dollar notes harvesting grain in paddock

Approach

Partialbudgetswereusedtoassesseachoption.Thetotalcostofpurchasinggrain(wheat)usingeachoptionwascalculatedforeachyearonthethreefarms.Assumptionsusedintheanalysiswere:

  • Theannualamountsofgrainpurchasedoneachfarmwereusedtocalculatemonthlygrainrequirementsbasedon30%demandforgraininspring,35%insummer,25%inautumnand10%inwinter.
  • AveragemonthlywheatpriceswereobtainedfromtheweeklyhayandgrainreportbyDairyAustraliafortherelevantmonths,yearsandregions.
  • Amonthlyfinancecostof$1.50/twasassumedonallgrainpurchases. This was estimated using aninterest rateof6.5%andanaveragewheatpriceof$280/t,basedonhistoricalpricesfortheanalysisperiod.
  • Anaveragemonthlystoragecostof$0.75/twasassumedforallgrain.Thiswastocoverdepreciationforon-farmstorageand/orifgrainwas heldinofffarmstorage.

Theassumptionsforeachpriceriskmanagementtoolwere:

  • Spotmarket:Monthlygrainrequirementswerepurchasedonthespotmarketonthe10thofeachmonth.Grainpurchaseswerematchedwithactualgrainprice.
  • Forwardcontracts:50%ofgrainrequiredwaspurchasedonthespotmarket.Theremaining50%waspurchasedusingaforwardcontractlockedininJanuarywiththepricebasedonanaveragemarket priceacross themonthsNovember,DecemberandJanuary.Grainpurchasedonthespotmarketandbyforwardcontractwasusedequallyovertheproductionseason.

  • Futurescontract:50%ofgrain required was purchased onthespotmarket.Theremaining50%wasalsopurchasedonthespotmarket,butfuturescontractswereusedtocounteractspotmarketvariability.Threefuturescontractsweretakenout(purchased)onthe10thofJanuaryeachyearforthenextproductionseason.Thecontractswereclosed(sold)onthe10thofAugust,NovemberandJanuary(ofthefollowingyear)andaphysicalgrainpurchasewasmade for16%ofannualgrainrequirementseachtime.FuturespriceswerebasedonhistoricalJanuaryfuturespricecontractsforNSWwheat.Transactionscostsforusingfutureswere2%.
  • Buyandstore:50%ofthegrainrequiredwaspurchasedonthespotmarket.Theremaining50%waspurchasedonthe10thofJanuaryandstoredon-farm.

Results

DetailsofthethreefarmsusedintheanalysisaregiveninTable1.

Thecostofpurchasinggrainforeachyearfrom2007/08to2014/15 usingeachprice risk management tool isshowninFigure1.Thepatterninoverallcostforeachfarminaparticularyearwaslargelyduetothedifferentdemand forgraineachyear.However, foreachyeartherewasvariationbetweenthedifferentoptions.Forexample,insomeyearsfuturescontractsweremorefavourable,butlessfavourableinotheryears.Thiswassimilarforotherpriceriskmanagementtools.

AveragetotalgraincostandstandarddeviationfromtheeightyearsisgiveninFigure2andillustratesriskandreturnforeachoption.Ingeneral,buyingonthespotmarketorbuyingandstoringgrainwerethelowercostoptions,butalsomoreriskyorvariablebasedontheirstandarddeviations.Usingforwardcontractsorfuturescontractswerehighercostoptions,butlessrisky(lowerstandarddeviation).However,overallforthethreefarms,therewaslittledifferencebetweenthefouroptionswhenusedoveraperiodofeightyears.

Table1.Averageofkeyproductionandprofitindicatorsforthethreecasestudyfarmsfrom2007/08 to2014/15.
Parameter (average from2007/08to 2014/15) / Farmlocation
Northern Victoria / Gippsland / SouthWestVictoria
Milkingcowsper usablehectare (cows/ha) / 1.5 / 1.5 / 1.7
Milkproduction percow(kgP+F/cow) / 605 / 494 / 478
Homegrown feed (%ofMEconsumed) / 45 / 64 / 56
Purchasedfeed permilker (tDM/hd) / 3.6 / 2.3 / 3.1
Annualgrain purchased (t) / 2000 / 400 / 2000
Purchasedfeedcosts/Totalfeed costs(%) / 54 / 65 / 68
Concentratefeedcosts/Purchasedfeedcosts(%) / 81 / 95 / 76
Return on assets(%) / 6.2 / 3.3 / 4.8

Figure1. Comparisonoftotalannualgraincost from 2007/08 to2014/15 usingfourprice riskmanagementoptions forthree farms.

A series of three graphs showing the average annual total grain cost and standard deviation for four price risk management options for a northern Victorian farm a farm in Gippsland and one in South West Victoria The standard deviation indicates the risk or variability associated with that option Upward green triangle Futures contract pink square forward contract downward blue triangle spot market purple circle buy and store Y axis is total average grain cost in dollars increments X axis shows standard deviation in dollars In Northern Victoria a futures contract had a standard deviation of 100 000 with a total average cost of grain of 560 000 Forward contracts had a standard deviation of 145 000 with a total average cost of grain of 550 000 Spot market had a standard deviation of around 480 000 with a total average cost of grain of 548 000 Buy and store had a standard deviation of around 150 000 with a total average cost of grain of 542 000 In Gippsland b futures contract had a standard deviation of 280 000 with a total average cost of grain of 125 000 Forward contracts had a standard deviation of around 30 000 with a total average cost of grain of 120 500 Spot market had a standard deviation of 310 000 with a total average cost of grain of just over 124 000 Buy and store had a standard deviation of around 30 000 with a total average cost of grain of around 123 500 In South West Victoria c futures contract had a standard deviation of 100 000 with a total average cost of grain of 568 000 Forward contracts had a standard deviation of 120 000 with a total average cost of grain of 566 000 Spot market had a standard deviation of around 112 000 with a total average cost of grain of around 560 000 Buy and store had a standard deviation of around 121 000 with a total average cost of grain of 558 000

Figure2.Average annual totalgraincostandstandarddeviationforfourprice riskmanagement options.The standard deviation indicates theriskorvariabilityassociatedwiththat option.

Thedifferencesinriskandreturnbetweentheoptionscomparedwererelatively small,sothedifferencebetweenthehighestandlowesttotalgraincostforeachyearwasexamined(Figure3).TheaveragedifferenceovertheeightyearsfortheNorthernVictorianfarmwas$75,000witharangeof$10,000to$130,000.FortheGippslandfarm,theaveragedifferencebetweentheoptionswiththehighestandlowest costwas$16,000witharangeof$2,000to$27,000.TheaveragedifferencefortheSouthWestVictoriafarmwas$74,000(range$9,000to$120,000).

A series of three bar graphs showing the difference in annual cost of grain between the highest and lowest options in each year for a farm in northern Victoria a farm in Gippsland and one in South West Victoria Y axis shows the difference in annual cost of grain in dollars starting at 0 and ascending X axis shows years starting with 2007 2008 to 2014 2015 in annual increments The average difference over the eight years for the Northern Victorian farm was 75 000 with a range of 10 000 to 130 000 For the Gippsland farm the average difference between the options with the highest and lowest cost was 16 000 with a range of 2 000 to 27 000 The average difference for the South West Victoria farm was 74 000 range 9 000 to 120 000

Figure3. Differenceinannualcostof grainbetweenthehighestandlowestoptionsineachyear.

Photo overlooking a dairy farm with cows in feedpads shedding and silage pit and hay bales visible

Summary

  • Thisanalysiscomparedfourpriceriskmanagementoptionsforpurchasinggrainandexaminedthedifferenceinriskandreturn.
  • Basedontheapproachandassumptionsused,therewaslittledifferenceoveraneightyearperiodbetweentheaverageannualcostofgrainforeachoptiononthethreefarmsexamined.However,theoptionsthathadahigheraveragecostgenerallyhadlessvariability.
  • Forthethreedairyfarmsstudied,theuseoffuturesincurredtheleastvariabilityintotalgraincost,butthecostwasgenerallyhigher.Buyinggrainatharvestandstoringon-farmhadthelowestcost,butincurredgreatervariability.Inpractice,afarmerislikelytochooseacombinationofstrategiestohedgetheirexposuretosupplementaryfeedprice.Thisanalysisshowedthateachoptionoffersanapproachtoreducingriskandcost,dependingonattitudetorisk.

Acknowledgements

Funding forthisworkwasprovidedbytheDepartmentofEconomicDevelopment,Jobs,TransportandResourcesandDairyAustralia.

TheauthorswouldliketoacknowledgetheinputintothisstudyfromtheVictoriaDairyFarmMonitorteam.

Wealsothanktheprojectadvisorycommitteefortheirinterestandsupport.

Further information

ChristieHo

AgricultureResearchDivision

DepartmentofEconomicDevelopment,Jobs,TransportandResources

Phone:(03)83412424

Email:

PublishedbytheVictorianGovernmentDepartmentofEconomicDevelopment,Jobs,Transport and Resources,June 2017

© TheStateofVictoriaDepartmentofEconomic Development,Jobs,Transport and ResourcesMelbourne,June 2017

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ISBN:978-1-925629-19-4 (print)

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