Risk Management on The Farm: The Hedge Fund Manager vs The Gambler

(Part 2 of 3: A Simple Example)

Leveraging my time in both the financial markets and the agricultural markets, I’ve identified many differences — and similarities — to approaches to risk management. The following is a simple example of how a risk manager understands their positions, looks at the upside potential versus downside risks, and when/where to lock in profits and decrease their exposure to the market.

In Part 1 (read it here!), I assessed the similarities between a farmer and a hedge fund manager. In this post, I’ll use a simple example to show how farmers are like hedge fund managers — but tend to manage risk differently.

The below scenario is very basic. There are a lot of mechanisms and insurance instruments (i.e. options) that can be used to manage price risk, but the fact remains that the vast majority of farmers (an estimated 90%) do not use futures and options and only care about is one thing: the cash price.

“What is the size of the payment I’m getting for the grain I’m hauling?”

Being a former professional hockey player, I’ll break the scenario down as to how a hockey game would go.

The Tale of The Tape — Understanding the game in front of us

The Hedge Fund Manager

XYZ Co. is a blue-chip type stock that has been trading sideways for the past year. It is relatively liquid (easy to sell shares, lots of volume).

• Decides to purchase 100,000 shares at $9.00 / share.
• Total risk in the market: $900,000

The Farmer

Canola is a crop often in my rotation. While the price is well below where it was a few years ago, I can still make a profit on it. I’m pretty good at growing it and it’s a crop I can usually sell pretty easily. There’s more than few buyers around me.

• I will plant 2,500 acres at a cost of $360/acre, to produce an expected yield of 40 bushel / acre, or 100,000 bushels.
• Total risk in the market: $900,000

Pre-Game Warm-Up: Early in the trade / early in the growing season

The Hedge Fund Manager

XYZ Co. price sees a bump to $11 / share thanks to some government regulation change that opens up new markets for the company.

• Sells 20% of shares (20,000) for $220,000 or 22% ROI
• Remaining risk in the market: $780,000 or 80,000 shares unsold

The Farmer

Canola sees some weather premium (growing season pains) and the price jumps to $11.00/bushel

A Risk Manager: Sells 20% (20,000 bushels) for $220,000 or 22% ROI

• Remaining risk in the market: $780,000 or 80,000 bushels unsold

A Gambler: “I don’t sell anything that’s not in the bin”

• Remaining risk in the market: $900,000 or 100,000 bushels unsold

1st Period: Operational / Harvest Pressures

The Hedge Fund Manager

XYZ Co. price pulls back to $10.10 / share on rumours a big partner is about to pull out of big deal

• Holds position, no sales
• Remaining risk in the market: $780,000 or 80,000 shares remain unsold

The Farmer

Harvest pressures push canola price down to $10.10 / bushel

Risk Manager: Fills 20,000 bu forward contract & hold position

• Remaining risk in the market: $780,000 or 80,000 bushels unsold

A Gambler: “I need cash and bin space!”. Sells 20,000 bu at $10.10/bu for $202,000 or 12.2% ROI

• Remaining risk in the market: $798,000 or 80,000 bushels unsold

2nd Period: Rebound From Uncertainty / Winter Markets

The Hedge Fund Manager

XYZ Co. price climbs up to $10.75/share above pre-rumour levels on deal getting done w/ big partner

• Sells another 30% (30,000 shares) for $322,500 or 19.4% ROI
• Remaining risk in the market: $457,500 or 50,000 shares unsold

The Farmer

Canola limbs to $10.75/bushel on currency & demand factors.

Risk Manager: Sells 30% (30,000 bushels) for $322,500 or 19.4% ROI

• Remaining risk in the market: $457,500 or 50,000 bushels unsold

Gambler: “It’s going to $11! Just you watch!”. No sales.

• Remaining risk in the market: $798,000 or 80,000 bushels unsold

3rd Period: Competition Everywhere / Seasonal Challenges

The Hedge Fund Manager

XYZ Co. price pulls back to $10.30 on a new competitor entering the market.

Sells another 30% (30,000 shares) for $309,000 or 14.4% ROI

• Remaining risk in the market: $148,500 or 20,000 shares unsold

The Farmer

Canola pulls back to $10.30 on overseas competition& bearish new crop acreage forecasts.

Risk Manager: Sell another 30% (30,000 bushels) for $309,000 or 14.4% ROI

• Remaining risk in the market: $148,500 or 20,000 bushels unsold

Gambler: “These acreage estimates are usually BS anyways but I need cash for inputs”. Sells 30,000 bu for $309,000 or 14.4% ROI

• Remaining risk in the market: $489,000 or 50,000 bushels unsold

Overtime: Clearing the field for new opportunities / Clearing the bins

The Hedge Fund Manager

XYZ Co. price pulls back to $9.80 on a continued market competition

Sells final 20% (20,000 shares) for $196,000 or 8.9% ROI

• Remaining risk in the market: Zero risk.
• Total sales of $1,047,500 or 16.4% ROI and a $147,000 profit.

The Farmer

Canola pulls further back to $9.80 on back on growing conditions, veggie oil competition

Risk Manager: Sells final 20% (20,000 bushels) for $196,000 or 8.9% ROI

• Remaining risk in the market. Zero risk:
• Total sales of $1,047,500 or 16.4% ROI and a $147,000 profit.

Gambler: “I gotta move something because the market doesn’t look good and it doesn’t look like I’ll have any bin space for the crop coming off in a few weeks”. Sells 50,000 bu at $9.80/bu for $490,000 or 8.9% ROI

• Remaining risk in the market: Zero risk.
• Sales of $1,001,000 or 11.2% ROI and a $101,000 profit

Those farmers who are more disciplined and who are proactively managing their price risk exposure are better off.

Throughout the grain marketing season (which is really more like 1.5 years — not 12 months), those farmers who are more disciplined and who are proactively managing their price risk exposure are better off. A 5% difference between the risk manager and the gambler may not be a lot, but it’s a difference of nearly $50,000 / year for this crop. Spread this out over a couple of different crops. Then spread that out over a couple of growing seasons. Thinking more long-term, each subsequent 5% difference adds a whole lot more to the bottom line and when margins aren’t great (like they aren’t great right now and don’t look to be improving any time soon), taking those slightly better profits is totally worth it.

Join me next week in Part 3 of this series where we’re review some of the main lessons to be learnt in the differences between a risk management type and a gambler, as well as a challenge as to how you’ll approach the 2017/18 crop year.

To growth,