Combining Crop Insurance and Forward Contracts to Reduce Revenue Risk for Wheat and Double-Crop Soybeans
Dr. Todd D. Davis— Extension Grain Marketing Specialist
Managers should consider the potential risk protection provided by combining crop insurance with forward contracts to manage revenue risk for wheat and double-crop soybeans. The crop insurance decision was made last September for wheat. However, the insurance deadline for soybeans is March 15, 2019, and farmers will have time to create enterprise budgets, evaluate the farm's financial position to absorb a loss and to assess how crop insurance can fit into their risk management plans.
The analysis uses the budget information from Table 1. The yields are from the Kentucky Farm Business Management (KFBM) program's annual summary for the Pennyroyal area and are the Olympic-Average yield for the last five years. The KFBM data combines yields from different farms over a multi-county area and may understate the yield potential for wheat or double-crop soybeans for a particular farm. The cash price is the cash forward contract (CFC) bids for western Kentucky elevators for June delivery for wheat and November delivery for double-crop soybeans. The cash rent is assumed to be $185/acre; however, this cost varies significantly across the state. The cash rent expense is shared equally by both crops.
The budgeted return over total costs for wheat is -$15/acre while double-crop soybeans have a budgeted return of $93/acre (Table 1). The break-even prices needed to cover total variable costs, variable costs plus rent, and total budgeted expenses are included in Table 1 to help guide pricing decisions. At a yield of 85 bushels/acre, a wheat price of $4.70/bushel is needed to cover total variable costs plus rent, and a price of $5.44/bushel is necessary to cover total costs. Double-crop soybeans need a price of $6.62/bushel and $7.35/bushel to cover total variable costs and total costs, respectively, for a 50-bushel double-crop soybean yield (Table 1).
The July 2019 wheat futures contract closed at $5.27 per bushel on January 31, 2019, with harvest forward contract bid average $5.27 per bushel. Assuming budgeted yields, the market is $0.17/bushel short of covering estimated costs. The January 2020 soybean contract closed at $9.65/bushel on January 31, 2019, with the November 2019 cash forward contract bid average $9.05/bushel. As shown by the break-even prices in Table 1, managers can remove some revenue risk for double-crop soybeans using commodity futures or forward contracts.
Some managers may hesitate in pricing wheat or soybeans before yields are known because of yield risk and the inability to fulfill a contract. Revenue protection (RP) crop insurance exists to provide confidence to managers forward contract or hedging the crop before the crop reaches maturity or is even planted. Figure 1 demonstrates how RP insurance and forward contracting a conservative percentage of average production can be used to mitigate revenue risk.
The projected price for 2019 RP insurance for soybeans will be determined in February; however, the November 2019 soybean futures contract has been trading around the $9.55/bushel level for several weeks. The risk management example assumes the RP price of $9.55/bushel, a crop insurance APH yield of 50 bushels/acre, and insurance coverage at the 75% level. The marketing plan is to forward contract 40% of expected production (20 bushels) at the forward contract price of $9.35/bushel, which requires the bids to increase by $0.30/bushel between now and harvest.
The lines in Figure 1 represent the return over budgeted costs for varying yields for double-crop soybeans. The minimum return for 50-bushel soybeans is $23/acre at the futures price of $6.69. If prices decline further, crop insurance indemnities provide a larger profit. Similarly, more substantial than expected yields improve profitability. If the double-crop soybeans yield 45 bushels/acre, then the minimum return is $7/acre at the futures price of $7.64/bushel.
The risk management plan for wheat presented in Figure 2 assumes RP crop insurance was purchased at the 75% coverage level at the projected price of $5.63/bushel. The marketing plan is to forward contract 40% of planned production (85-bushel planned yield) at the contract price of $5.40/bushel, which will require cash bids to increase by $0.18/bushel between now and harvest.
The graph of the wheat enterprise returns over budgeted costs also includes the revenue from the double-crop soybeans at a yield of 50 bushels/acre. Double-crop soybean revenues are included in the graph to demonstrate how soy contributes to enterprise profitability.
If wheat yields are average (85-bushels), then the wheat/double-crop soybean enterprise has a return of -$14/acre when July 2019 wheat is at $4.50/bushel. A 10% larger yield (93.5-bushels) is profitable until the July 2019 wheat future price is $3.94/acre.
Because of the lower cost structure, locking in a large percentage of expected double-crop soy-bean production at $9.35/bushel in the spot market buoys the wheat enterprise. Managers should monitor both the wheat and soybean market for opportunities to remove price risk in both markets.
The purpose of this article is to demonstrate how risk management tools can be combined to protect revenue. Unfortunately, there is not a silver bullet cure to provide 100 percent risk protection. Managers should calculate how much working capital is available and gauge how much risk can be absorbed by the farm business. The risk that cannot be absorbed by the farm business should be passed to the insurance market and price risk tools.