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.

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.

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).

Figure3. Differenceinannualcostof grainbetweenthehighestandlowestoptionsineachyear.

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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