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Increasing production costs = more capital at risk

Commodity Production and Risk C ory Walters cgwalters@uky.edu 859-421-6354 University of Kentucky Ag Econ/ANR Update October 2012. Increasing production costs = more capital at risk More capital at risk = stronger need for risk management

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Increasing production costs = more capital at risk

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  1. Commodity Production and RiskCory Walterscgwalters@uky.edu859-421-6354University of KentuckyAg Econ/ANR UpdateOctober 2012

  2. Increasing production costs = more capital at risk • More capital at risk = stronger need for risk management • Crop Insurance can help alleviate potential problems • Policy needs to be set up correctly

  3. Crop Insurance • Premium increased from $1 billion in 1994 to over $11 billion in 2011 (7 billion in subsidy) • Insured acres increased from 100 million to 265 million • Continuously changing, new for 2012 • Reduced premium rates in corn belt • Trend adjustment for corn and soybeans in select states/counties in Kentucky. • New for 2013 • Trend Adjustment (TA) for wheat. Currently not available in Kentucky. • High Risk Alternate Coverage Endorsement (HR-ACE) • http://www.rma.usda.gov/help/faq/highrisk.html

  4. Understanding Crop Insurance During a Drought/Heat • Contract decisions are made at the beginning of each year • For an MPCI policy three primary decisions: coverage level, unit type, insurance type. Other decisions include electing TA, HR-ACE • I will walk through each decision providing a motivation

  5. Corn Yield • Historical farm level yield data • Over 32 years across multiple fields, data adjusted for trend • 50% chance of 150 bpa, 10% chance of 100 bpa, 10% chance of 170 bpa • KEY: Grain production is risky 2012

  6. Yield Crop insurance yield guarantee • 75% coverage level • Expect insurance to pay about 12% of the time or 12 of 100 draws. Lots of zero payments • Very important when it does pay- costs are going up • Value of insurance is not guarantee

  7. MPCI Insurance Contract Choices • Coverage level • Unit Type • Insurance Type • Price level • Not discussed • Producer can select percentage of base price to insure • Available contract options depend upon crop and location

  8. Coverage Level • Producer selects between 50 to 85 percent in 5 percent increments • Decision directly impacts guarantee • Higher coverage level implies larger guarantee and higher chance of payments but also more in premiums • Decision based upon probability of payments, amount of desired $ of coverage and budget • Decision impacts subsidy rate

  9. Corn Yield Crop insurance yield guarantee • Changing the coverage level directly shifts the guarantee • Shifting the guarantee changes the probability of payments

  10. Premium Subsidies (for 2012), in Percent

  11. Unit Type • Represents the number of independent insurance units. FSA number = optional units, crop = enterprise. • Producer selects between optional, basic, enterprise or whole farm units • Decision between optional and enterprise depends upon how pooled risks are • Drought can be considered a pooled risk • Centralized hail storm is not • Higher premiums associated with selecting optional units • Subsidy rates change with unit type

  12. Premium Subsidies (for 2012), in Percent

  13. Insurance Type • Producer selects between: Yield, Revenue with harvest price exclusion (HPE) (implied put option), Revenue (implied put and call option) • Decision depends upon price expectations • Don’t care about prices then select yield • Convinced they are going down then select Revenue with HPE • Convinced they are going to drastically change then select Revenue insurance • Subsidy rates are the same across insurance types • Therefore producer gets more subsidy dollars when selecting the most expensive policy, i.e., revenue insurance • over yield insurance

  14. Insurance Type • A = Increase in premium cost. Benefit of downward price protection • B = Increase in premium cost. Benefit of upward price protection

  15. Conclusions • Crop insurance can be a valuable tool in protecting against unforeseen events (yield and price) but it must be set up properly. • Identify important risks • Drought, hail, wind, heat, etc… • Drought/heat is a reminder of how bad it can get • Good for less experienced producers • Risk Managers – DO NOT forget the big risks • Difficult to value low probability events, however cost of protection is low

  16. Historical Yearly Average Corn Price and Standard Deviation, 1992/93 to 2012/13

  17. World Inventory Levels • Coarse grain ending stocks • Overall 12% less than last year • Less in U.S., Canada • Slight gain in Argentina • Soybeans • Overall slight decline from last year • Less in U.S., Argentina • More in Brazil

  18. In times of short supply prices are more sensitive to changes in quantities: p Market demand Different price effects q Same shock

  19. Conclusions • Prices are quite high relative to historical standards • Corn production • This years crop was similar to 2007’s crop size • Difference in planted acre and yield combinations • More acres with less yield in 2012 vs. 2007 • Likely see additional acres in 2013 – needed to replenish U.S. ending stocks • Globally – response to high prices will be to increase production through additional acres • Corn consumption in both U.S. and foreign countries has dropped off a bit • Economic impacts due to high prices (?) • In times of short stocks, prices are more sensitive to changes in quantity – thus could experience a spike • Prices will be very sensitive to production (acreage, weather) events.

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