It’s never too late to update your marketing plan for the new growing season. In this post, we will consider some possible marketing strategies for crops, along with some of the risks associated with these strategies.
Potential Risks Associated with Marketing
I want to start by highlighting three potential risks associated with different marketing strategies. The first of these is price risk, or the risk associated with uncertainty about future prices. There is always a chance that the price a producer receives is less than the price they planned to receive.
To mitigate price risk, some producers will enter into a contract to sell what they produce at an agreed upon price. While this strategy may reduce price risk, it exposes the producer to counterparty risk. This is the risk that the other party to the contract will not meet their contractual obligations. Either the buyer does not take delivery of the commodity, or the seller does not deliver the commodity as promised.
Finally, marketing strategies that use futures or options contracts expose producers to basis risk. In commodity markets, the basis is the difference between the local cash price and the nearby futures price. As the local cash price changes relative to the futures price, the basis changes as well. Basis risk is the risk associated with unexpected changes in a commodity’s basis. For producers, this risk leads to losses when the cash price decreases relative to the nearby futures price. That is, when the basis weakens.
In general, different marketing strategies come with trade-offs between different forms of risk. For example, contracting to sell a crop reduces price risk but introduces counterparty risk, and possibly basis risk, to the marketing plan. With these risks and the potential for trade-offs in mind, let’s look at marketing strategies.
Potential Marketing Strategies
Cash Sale at Harvest
The most straightforward approach to marketing a crop is to sell it in a local cash market at the prevailing market price. The trade-off to its simplicity is its riskiness. Producers who choose this strategy are fully exposed to price risk and may not find the prevailing market price acceptable. This risk is made worse because prices for most crops tend to be lowest near harvest. Price risk can be lessened in this strategy if the crop can be stored for sale later when prices are higher. However, storage comes with costs and there is no guarantee that the price will increase enough to cover those costs.
Forward Contracting
Producers who wish to reduce price risk from their marketing plan might consider forward contracting. A forward contract is a legal agreement between a producer and a buyer. The producer agrees to deliver a specific quantity and quality of a commodity on a certain future date. The buyer agrees to take delivery of the commodity and to pay a specific price for it.
The advantage to contracting for the producer is the reduction of price risk; however, there are tradeoffs to consider. While price risk is low, contracts introduce counterparty risk to the marketing plan. There is also the risk that the producer’s crop will not meet the quantity or quality specifications in the contract.
Hedging Using Futures Contracts
A third marketing strategy is to use futures contracts to hedge against price decreases. This strategy is implemented in three stages. First, the producer sells futures contracts for the crop they want to sell early in the growing season. Then, they buy futures contracts later in the season, close to harvest time. Finally, they sell the crop in the local cash market. Normally, price decreases over time lead to profits in the futures market that offset low cash price. The flip side is that price increases lead to losses in the futures market that count against income earned in the cash market.
Hedging using futures contracts reduces price risk by “locking in” a certain price; however, basis risk is an issue. If the basis is weaker than expected, the net price received by the producer will be less than the price they targeted with the hedge. Producers who consider this strategy must also consider the costs required to buy and sell futures contracts. These costs include brokerage fees and margin requirements (a deposit you make to enter the futures market).
Choosing a Strategy
As you develop your marketing plan for the coming year, consider all the options available to you. The purpose of a marketing plan is to help you identify an acceptable price and to reduce the risk of not receiving that price. Which strategy is best for risk management purposes may change from year-to-year as growing conditions and economic conditions change. Your ability to take on risk and your general attitudes concerning different types of risk are important as well. Choose a strategy that you are comfortable with and understand. If you want to learn more about these and other strategies to manage market risk, reach out to the extension economist in your district. We can help you understand how to implement different strategies in your operations and how to evaluate the costs and benefits of doing so.