Applied risk management in agriculture

Applied Risk Management in Agriculture Tai Lieu Chat Luong Applied Risk Management in Agriculture Dana L Hoag Boca Raton London New York CRC Press is an imprint of the Taylor & Francis Group, an informa business CRC Press Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2010 by Taylor & Francis Group, LLC CRC Press is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S Government works Version Date: 20110715 International Standard Book Number-13: 978-1-4398-8246-7 (eBook - PDF) This book contains information obtained from authentic and highly regarded sources Reasonable efforts have been made to publish reliable data and information, but the author and publisher cannot assume responsibility for the validity of all materials or the consequences of their use The authors and publishers have attempted to trace the copyright holders of all material reproduced in this publication and apologize to copyright holders if permission to publish in this form has not been obtained If any copyright material has not been acknowledged please write and let us know so we may rectify in any future reprint Except as permitted under U.S Copyright Law, no part of this book may be reprinted, reproduced, transmitted, or utilized in any form by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying, microfilming, and recording, or in any information storage or retrieval system, without written permission from the publishers For permission to photocopy or use material electronically from this work, please access www.copyright com (http://www.copyright.com/) or contact the Copyright Clearance Center, Inc (CCC), 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400 CCC is a not-for-profit organization that provides licenses and registration for a variety of users For organizations that have been granted a photocopy license by the CCC, a separate system of payment has been arranged Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the CRC Press Web site at http://www.crcpress.com Contents Preface .ix Acknowledgments xi Editor xiii Contributors xv Section I Introduction Chapter Introduction Dana Hoag Chapter Managing Risks and Risky Decisions Dana Hoag Chapter A Case Study of EWS Farms 19 Aaron Sprague and Catherine Keske Chapter The Strategic Risk Management Process© 39 Dana Hoag and John P Hewlett Section II The Strategic Risk Management Process Chapter Step 1: Get a Financial Health Checkup 51 Duane Griffith Chapter Step 2: Determine Risk Preferences 91 Dana Hoag and Catherine Keske Chapter Step 3: Establish Risk Goals 109 John P Hewlett v vi Contents Chapter Step 4: Prioritize Risks 149 Dana Hoag Chapter Step 5: Identify Risk Management Alternatives 169 Jay Parsons and Dana Hoag Chapter 10 Step 6: Determining the Likelihood of Outcomes 191 Catherine Keske, Dana Hoag, and Eihab Fathelrahman Chapter 11 Step 7: Choose the “Best” Risk Management Alternative 219 Dana Hoag, Eihab Fathelrahman, and Jim Ascough Chapter 12 Steps through 10: Manage Operational Risks 243 John P Hewlett Section III Advanced and Customized Risk Management Programming Chapter 13 Marketing and Price Risk 271 James Prichett Chapter 14 Production Risk 299 Jay Parsons Chapter 15 Understanding Your Financial Statements and Ratios for Risk Management 323 Duane Griffith Chapter 16 Human and Institutional Risk 343 John P Hewlett and Dana Hoag Chapter 17 Ag Survivor 357 Dana Hoag and Jay Parsons vii Contents Chapter 18 Building Customized Risk Management Plans 369 Dana Hoag and Duane Griffith Index 385 Preface Over the last few years I have witnessed a great deal of interest in risk management education However, based on my participation in more than fifty Ag Survivor educational and extension programs, I could not understand why more agricultural producers were not using risk management tools when so many were readily available My suspicion was that the topic required the integration of many disparate and difficult parts, which is time consuming and overwhelming for producers who are already giving it their all to maintain a viable business So, I set out to write a book about risk management and the fundamentals of building a risk management plan I was encouraged when I conceived (or stumbled on) the idea of using strategic management to organize the process of risk management Strategic management has been around for a long time and has been widely accepted inside and outside the business community This approach provided an almost ideal platform for organizing risk, since risk management is a business decision As I developed the idea, the program grew into ten steps that fell neatly into the three traditional stages of strategic risk management Fortunately, these steps could still accommodate a breadth of information in a practical, formulaic framework Over time, other colleagues joined me in order to bolster the quality of information I could offer Their skills proved complementary and they expanded the risk management resources we could make available to readers We also added Aaron Sprague, who was working on his master’s degree with me, as a case study Aaron and his family were gracious enough to allow us to use their actual farm, EWS Farms, and family information to test and demonstrate the SRM process Although using a single case study about a single corn-wheat farm makes it hard for people to relate to if they don’t grow the same crops, using one case study adds consistency and clarity to make the process flow from one step to the next That is, we can connect the Sprague’s financial health from Step to their choices on risk management in Step 7, rather than using a corn example in Step and tomato example in Step The concepts are the same, whether we are talking about farming corn or catfish As you read on, think catfish, or whatever enterprise you are into, when you see the word corn, and concentrate on the bigger strategic risk management process It is our experience that producers have a lot in common, even when they don’t grow the same crop As we commenced writing, we measured EWS Farms from every angle so as to make our example meaningful In so doing, we estimated that the mean corn price would be about $2.00 per bushel based on ten years of real and local data Despite our diligence, the very next year prices skyrocketed, earning corn producers over $6 per bushel In this case, the past did not very well on predicting the future We considered updating the book with new prices, but the high prices did not last After two years, prices returned to the $2 to $3 range This lesson confirms that a process such as the one demonstrated in this book can be useful, but the process needs to ix x Preface provide flexibility and to look at risk and risk management from multiple viewpoints, which we have tried to here On behalf of all the authors, I hope you find the book to be a well-organized, complete source of information about risk management We have made the book accessible and meaningful for agricultural producers, college students, and people outside of agriculture who can adapt what they find here to their own conditions Section of the book provides a complete description of all ten steps in the SRM process, an example of how it was applied to EWS Farms, and a user’s guide for the free tools available at www.RiskNavigatorSRM.com Go to this Web site, or our companion Web sites, www.RightRisk.org and www.AgSurvivor.com, for a comprehensive collection of risk management information related to agriculture Section provides a discussion of a more traditional view of risk management and has two chapters that will start you on your way to customizing your own risk management programs With this information, a reader can learn about risk and build risk management plans with Risk Navigator SRM, supplement this framework with traditional tools, and then move on to customizing complicated problems with advanced tools when ready Dana L Hoag Professor, Colorado State University 376 Applied Risk Management in Agriculture H I J K 65 Table S4 Rank scenarios based on the Mean Variance (MV) 66 67 68 69 Scenario A B 70 71 C D 78 79 80 81 82 83 A B C D E Variance 8.422 Mean 19.90 L MV Rank 59.893 29.73 14.973 0.298 14.86 9.97 72 23.396 34.83 E 73 74 75 76 Table S5 Rank scenarios based on the MINIMUM & MAXIMUM Scenario Minimum Min Rank 77 Maximum 14.32714 14.87238 7.436189 9.076193 25.54524 27.70283 50.54087 25.27044 10.98937 47.83805 84 85 86 Table S6 Rank scenarios based on the Absolute COEFFICIENT OF VARIATION (CV) 87 88 89 90 91 92 93 Scenario A B C D E Minimum 19.90 29.73 14.86 9.97 34.83 M Std Dev 2.902144 7.739049 3.869525 CV 14.58553 26.03423 26.03424 CV Rank 0.545843 4.836907 5.473157 13.88758 Max Rank FIGURE 18.3B  Risk information computed by Simetar© in Best Demo (altered for presentation purposes) with leased land For EWS Farms to lease extra land, they must also invest in more machinery and equipment Irrigated corn and wheat are grown on the leased acres Simulation indicates that the standard deviation of net farm income (risk) increased from $14,397 to $42,479, something that should be avoided However, the mean net farm income increased from $35,372 to $194,698, shifting the distribution of net farm income to the right substantially If the leased ground is added, there is only a 2.3% chance of getting a net farm income of less than $110,000 Without the leased ground, there is zero percent chance of getting a net farm income above $110,000 This appears to be an attractive strategy to change the profitability of the operation through on-farm activities to provide for additional family members Off-farm activities may also be considered as a way to relieve the expected financial stress on the operation Surveys indicate that on average, only 12.2% of surveyed 377 Building Customized Risk Management Plans 2.500 Statements!O27 (Sim#1): Mean = 35372.53 Statements!O27 (Sim#2): Mean = 194698.8 Values in 10^–5 2.000 1.500 1.000 0.500 0.000 –50 50 100 150 200 Values in Thousands 90% 5% 14.6749 59.8489 250 300 350 5% FIGURE 18.4  Simulation showing net business income from the Income Statement, with and without expansion of leased acres producers indicated off-farm investments were effective, while 14.7% indicated offfarm employment was effective (Coble, Knight, Patrick, and Baquet, 1999) An off-farm strategy to reduce or eliminate financial stress focuses on the cash flow problems of the combined business and family This strategy is fundamentally different than trying to change the productive capacity of the operation and increase net farm income For a variety of reasons, this strategy may be a preferred, or the only alternative, for some producers Financial information in Figure 5.5, tells us exactly what type of off-farm job to look for Figure  5.5 indicates an Owner Withdrawal of $85,000 Increasing this by $15,000 (adjusting for the affects of long-term inflation) and using an Owner Withdrawal of $100,000, the Operating Loan Carryover increases to $47,409 Therefore, one or more of the children and or their spouses must get a job off-farm that will pay $47,409 = (32,409 + 15,000) Figure 18.5 is a simulation showing, as you would expect, that net farm income does not change comparing before- and after-simulation results for the addition of inflows from off-farm sources—the distributions overlap perfectly Off-farm inflows are not included on the Income Statement Another simulation, not shown, indicates that annual net cash flow for the combined family and business will always be zero without added off-farm cash inflows of $40,000 and will have a mean value of $5,995 with $40,000 of added cash inflow from off-farm sources The off-farm inflow is entered on the inflow side of the Cash Flow Statement under the heading of Other Nonfarm Inflows and reduces the $47,409 Operating Loan Carryover to $7,409 The Cash Flow Statement, statement of owner equity (SOE), and the ending Balance Sheet are all affected by this change Annual Net Cash Flow and the ending Cash on Hand is $0 The SOE now shows Non-Business 378 Applied Risk Management in Agriculture 3.500 Statements!O27 (Sim#1): Mean = 35372.53 3.000 Statements!O27 (Sim#2): Mean = 35372.53 Values in 10^–5 2.500 2.000 1.500 1.000 0.500 0.000 –10 5% 10 20 30 40 50 Values in Thousands 14.6749 90% 60 59.8489 70 80 5% FIGURE 18.5  Simulation of net income with and without off-farm inflows and no expansion Cash Inflows and calculated and reported ending net worth are identical, maintaining a zero discrepancy Net Farm Income does not change While off-farm wages and salaries are income to the wage earner, they are not income to the farm business, they are simply inflows The negative change in net worth reported on the Balance Sheet, −$30,849, is calculated as ($29,151 + $40,000 − $100,000) Another off-farm job of $7,409 or greater will eliminate the remaining operating loan carryover and provide a positive cash flow for the combined business and family financial statements 18.5  RISK NAVIGATOR SRM LITE© SRM Lite© was developed for fast, easy, and intuitive risk comparisons It involves filling out two worksheets: the risk payoff worksheet and the graphical payoff worksheet You have to use a bit of ingenuity to organize your information, but this Risk Navigator tool makes it easy to compare risks 18.5.1  Using Ag Survivor You can use Ag Survivor scenarios to test, apply, and evaluate different risk management rules because the program allows users to compare the results of changes quickly and easily Several Fact Sheets to learn about decision analysis tools like those discussed in Chapter 11 are available at the RightRisk Web site, such as a safety first guide by Bastian and Hewlett (2004) One of those Fact Sheets shows how to use the scenarios in SRM Lite© (Hoag and Parsons, 2009) Let’s see how it works The distribution for making no decisions in the Mountain View Farms barley scenario is presented in Figure 18.6 Note that the mean is about $243,000, with a 379 Building Customized Risk Management Plans minimum of (–$37,685) and a maximum of $392,173 Suppose I wanted to know whether to purchase crop insurance for malt barley There are two opportunities to purchase insurance, as shown in the box titled “Decisions” in Figure 18.6 Mountain View Farms considers two types of insurance, multiperil crop insurance (MPCI) and revenue assurance (RA) In each case the optional malt barley supplement, plan B, is also purchased Consult the scenario guide for details about this scenario or Hoag and Parsons for details As with many of the Ag Survivor scenarios, users can click Compare Second Option to recompute and redisplay the histogram with the new insurance options The results of having MPCI are shown in Figure  18.7 and the results for RA are shown in Figure 18.8 There is a lot of information to be gained just by looking at how the histograms changed But let’s be a little more organized by putting the information into SRM Lite© Record the information from each of the three screens (Figures 18.5, 18.7, and 18.8) into the top portion of the risk payoff worksheet, as shown in Table 18.3 Next, Decisions Year 1: Jan – Mar 31 Buy Barley Insurance Buy Wheat Insurance None None Year 1: Apr – Jun 30 Distribution Results 25% Buy Barley Insurance Buy Wheat Insurance 5% 2% 3% 5% 1% Profit Category ($1,000’s) Maximum $392,173.84 Median Mean $243,045.26 Standard Deviation Minimum –$37,685.32 10th Percentile Close Print None None Forward Price Wheat Forward Price Feed Barley Forward Price Calves 0 Year 2: Jul – Sep 30