We are in an era of unprecedented price volatility, and it is going to take a fresh way of looking at our business relationships in order to protect against risk and maximize opportunity.
The banker can be an integral part of a farm’s risk-management strategy, namely through extending a hedge line of credit to secure market positions. You can view this as an opportunity to extend credit where it is very much needed in agriculture today or, you can view it as taking on risk. I view it as both, and so today’s bankers need to be informed and ready to help rural America survive and thrive in these new times.
Feed the Need
High prices in recent years have allowed many (but not all) grain producers to self-fund their operating costs and marketing programs. With increased input costs (especially high land rents), risk is still very real. Hedgers find themselves needing access to an increased amount of cash or credit to cover margin calls and fund marketing programs. On top of that, in a high-price environment, farmers are hedging more and more crops farther out, adding to the margin requirements.
All of this mounting pressure provides opportunities for bankers to talk with their farm clients about their marketing approaches. Encouraging and supporting a disciplined risk-management approach helps build the long-term health and competitiveness of the business. Farm businesses with a consistent, disciplined approach are able to smooth out revenue streams, create a much more consistent bottom line from year-to-year, and create the kind of performance characteristics an underwriter looks for when considering operating or expansion loans. That is not just using risk management to survive; It is using risk and opportunity management to thrive.
Essential Lines of Credit
For livestock and dairy operations, facing high feed costs and tight cash flow, a separate hedge line is essential. When operating funds become limited, emotions take hold and discipline with regard to marketing strategies goes right out the window.
How much should be extended on a hedge line of credit? To answer this question, the lender must be in tune with the marketing approach. Periodic meetings between the banker, the market adviser and the farm operator are good practice.
When you sit down at this meeting, you do not need to be a marketing expert; however, you need to ask questions that will help you understand and monitor the hedge line of credit:
What is the risk tolerance of this operation? This is where the banker has the most input. Providing information about the equity level, liquidity and cash flow will help the market adviser and your client choose strategies that make good financial sense and achieve the long-term goals of the operation. If the business has the staying power of equity, or if it has adequate working capital, the market strategies can involve a little more risk with the eye on greater reward in the end. Without that staying power, you as the banker will likely advocate for less risky positions. Sharing information allows the team to find the “sweet spot” of protection while building the best possible price for the business.
Is the approach consistent and disciplined? Lack of discipline is a primary reason why marketing decisions go awry. Much like amateur stock market investors, undisciplined commodity marketers tend to make decisions based on emotion and not according to the predetermined goals of the operation. Farmers by their own admission tend to get caught up in whether an individual decision was right or wrong, and lose sight of the big picture.
The banker, teaming with the market adviser, lends objectivity to the farmer-client. As an example, our advisers strive to keep farmers focused on the weighted average price, which is the net average price received for all of the commodity sold over a period of time. The farm’s price at any given point in time might be higher or lower than the current market price. However, long-term, the goal is to make strategic and incremental sales that build the best possible weighted average price for all the production long-term. It is a sound, objective measurement, even as markets fluctuate.
Is the hedge line sufficient? If the primary hedging strategy is futures contracts, rising grain prices will result in margin calls that need to be funded. The farm will keep paying those margin calls until enough cash grain is sold to offset those hedging “losses.”
Options strategies can work well in times of volatility because, for a relatively small cost, farmers can protect against price collapse and still participate in market rallies. What options lack, however, is leverage that protects the business long-term. One of the things that determines option cost is time until expiration, and that can make longer-term hedging cost-prohibitive.
The line of credit is usually a percentage of the expected commodity revenue. As a rule of thumb, divide your clients into three buckets: high, medium and low risk tolerance. Those in the low bucket may only need to budget 8 percent of commodity revenue to fund marketing activities. A producer in the high category likely needs to budget 15 percent of commodity revenue.
Using a percentage is a great starting point and then the budget can be fine-tuned in periodic meetings. Remember that a 15 percent budget figure changes at different commodity price points. When there is a big price move, you can go through a line of credit pretty quickly. So, ask the market adviser to establish a likely trading range for the year to help avoid surprises.
The agricultural banker who is ready to ask informed questions and bring objective thinking to a farm operation is extremely valuable. Volatility is here to stay and those farm operations that know how to manage through volatile markets will survive and thrive.
Scott Stewart is CEO of Stewart-Peterson Inc., West Bend, Wis. Contact him at scotts(at)stewart-peterson.com or 800-334-9779.
Copyright (c) January 2013 by BankNews Media