5 Key Steps to Manage Market Risk
By Kent Bang, Compeer Financial
Price risk has become more volatile in recent years and continues to be a critical management function in the pig business. Managing both revenue and feed cost risks are vital to the success of the business. In the end, it all comes down to developing a strong risk management plan.
Over the last decade, I’ve talked to producer groups about risk management and the need to lay off some risk in the market based on the farm’s balance sheet. My theory is that the stronger a company is financially, the more risk they can take in the marketplace. The inverse is the more leveraged a company is relative to peers, the more they need to reduce price risk in both revenue and input costs. I have discovered the reverse might be the case, as the financially strongest farms I work with generally have more coverage.
Recent volatility in the market has spurred me to make this point: The pork industry has been on a very volatile roller coaster in 2020, and I don’t think we are off yet. Recent strength in the grain markets is adding to production costs and will limit profit opportunities to some degree. Many producers lost money in 2020 and will likely seek to take some price risk off the table in the next few years. Hopefully, the following will assist you in developing a company risk management plan.
An effective risk management policy for any farm should incorporate the following in its plan:
1. Objective
It sounds too simple, but it is often overlooked. The objective is generally to lay off or limit price risks or to take advantage of profit opportunities when they meet a stated goal. The objective should incorporate a company’s financial position, cost of production, live hog market price discovery and owner’s risk tolerance. It will also incorporate price trend bias, which is generally the most difficult to manage.
2. Strategy
There are a few different strategies used to manage risk. One common strategy is to look at historical profitability and crushing profits. For example, look at when the market indicates a profit of 70%, 80% or 90% of historical profits in that period. This method works because it reduces or exposes our personal bias in what we think prices should do.
3. Tools
One of the most important relationships you should have is with your risk management advisor. They can help you with tools to manage your portfolio and risk profile. These tools are critical to understand your positions, refine strategies, and communicate internally and externally. There are several tools available to you, including the revised USDA program (Livestock Revenue Protection) and the new Pork Cutout contract at CME.
4. Execution
Establishing an execution plan is important. It should include who will be involved in the decisions and when and where will they meet to make those decisions.
5. Evaluation
Have a discussion at least annually to determine how you did relative to your goals. The outcome of that discussion should be to adjust or improve the objective, strategy, tools and execution.
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