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Ideas for effectively managing price risk

BBC Royal Bank Published on 20 November 2012

For Canada’s agricultural producers, a profitable year of farming depends on successfully managing multiple, and often simultaneous, sources of risk such as weather, market prices and disease. Of all the risks faced by producers, the major one is price risk.

“Having a business strategy that includes managing price risk is essential,” says Gwen Paddock, RBC Royal Bank’s national manager, agriculture and agribusiness.

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“This task is taking on a new dimension on the Prairies with changes to the Canadian Wheat Board’s mandate. Producers now will have to take a more direct role in marketing certain crops.”

Kent Peters sees this risk from two distinct perspectives. As director of group risk management for RBC Royal Bank, his job is to ensure strong credit underwriting practices.

As co-owner of a family farming operation in Killarney, Manitoba, he also knows the importance of risk management on the farm.

In Peters’ view, today’s volatile commodity markets make price risk management a pressing concern for producers. Effective management of price risk starts with having a precise reading on cost of production.

“If you have an opportunity to sell some crop,” Peters says, “you can only make that decision if you know what it costs you to grow that crop. If you want to hedge, you need to know where your breakeven point is.”

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Producers seek less volatile returns
Many Canadian farmers prefer to accept the going cash price for what they produce and may do well with this approach.

Other producers are active users of production contracts and financial instruments to ensure their costs are covered and an acceptable profit is locked in.

As Peters explains, these instruments can be complex and highly technical. As such, the newcomer to price risk management might be best to start small and build from a solid foundation.

“One of the simplest ideas is to sell some of the crop you’re growing through a fixed price contract,” Peters explains. “For example, if you can lock in a sale of 2,500 bushels of canola at $12, and you know your breakeven is $9, you’re locking in a $3 profit for that portion of your crop.”

Moving up the risk management ladder, Peters’ next idea is to consider the use of put and call options. In the case of canola, a producer could purchase a put option that gives them the option, but not the obligation, to sell a set volume of canola at, for example, $12 per bushel.

“You are limiting your downside, but leaving your upside open,” says Peters. “If the cash price goes to $14 by harvest, you’ll let the option expire and sell at the cash price. If it goes to $10, you still have the right to sell at $12, so you’ll make money on the put.”

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Individual advice is essential
Beyond fixed price contracts and put and call options, there are many other ways producers can manage the risk associated with changes in commodity prices.

However, these financial instruments carry their own risk profile and should not be undertaken without individual advice from a qualified professional. Kevin Simpson, vice-president and investment adviser with RBC Dominion Securities in Waterloo, Ontario, is one of RBC Royal Bank’s long-time experts on the subject.

“No two farming operations are the same and no two people have the same tolerance for investment risk,” says Simpson. “Our job is to educate people, share our information and knowledge to help our clients make marketing decisions that they are comfortable with.”

“It’s about control,” says Simpson. “People come to us because they want to have greater control and predictability of prices. They want to take advantage of market opportunities while protecting themselves from market risk. That process begins by getting the right advice.”  PD

—From RBC Royal Bank

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