Cycle masters
How producers manage their way through volatile commodity prices.
Two years up, two years down. For hog
producers in North America, the shape
of the production cycle is as familiar as
can be. Typically, prices rise for the first
two years of the four-year pattern, then
fall for the next two years. As prices rise,
producers respond by producing more.
As prices soften, they naturally cut back.
While the hog cycle is well-documented
and at least partly predictable, many
other farm sectors deal with commodity
prices that can be highly variable from
year to year.
According to Bob Richards, even if there’s
not much the individual producer can do
about commodity prices, producers are
creative about managing what they can.
“It starts with knowing your costs and
where you’re at risk,” says Richards,
RBC Royal Bank’s Vice-President of
Agriculture & Agribusiness Banking
based in Abbotsford, B.C. “You then use
this information to maximize profits in
a good year, and sometimes, to minimize
losses in a poor year.”
Covered on all sides
Before moving to Abbotsford late last
year, Richards was RBC Royal Bank’s
Team Leader for Agricultural Risk
Management based in London, Ont.,
for seven years. In that role, he got
a close-up look at the risk management
practices of top RBC Royal Bank farm
clients. These management strategies
allow producers to maximize their
upside while limiting their exposure
to commodity-related losses.
One southwestern Ontario hog-producing
client set up a comprehensive risk
management system. The strategy was
based on the client’s understanding that
they faced risk from at least three distinct
sources. They were at risk of a rise in
feed prices, a fall in cash hog prices and
a rise in the Canadian dollar relative to
the U.S. dollar.
The producer set up a program to manage
price risk on inputs and on hog prices.
Working with RBC Dominion Securities,
they used hedging and options to protect
themselves from foreign exchange and
cash hog price fluctuations.
“These strategies are available
to producers,” says Richards. “You can lock in prices for feed and
supplements using hedging instruments
or through feed suppliers. You can also
forward-price a percentage of production
and manage currency risk, too.”
Draw down, pay down
In Richards’ view, a key consideration
for producers in volatile markets is their
use of credit. First, there’s the operating
line that helps fund short-term cash flow.
Producers will want to ensure, and their
banker will likely want to see, a reduction
in operating loan utilization during
peak earning years. While it’s expected
that operating loan utilization could
remain high during poor earning years,
continued high utilization in good years
could be cause for concern.
A second credit issue relates to term debt
such as equipment loans or mortgages.
In most cases, clients are required to
make scheduled payments regardless
of what commodity prices are doing.
Still, many producers with term debt
are careful to manage their exposure
to interest rate risk, especially near the
bottom of a cycle.
“The last thing you want when cash
flow is tight is to find the term on a
loan or mortgage is up, and you’ll be
renewing at a higher rate,” says Richards.
“Producers can manage interest rate
risk by ‘laddering’ their term debt into
different maturities. This way, you ensure
that all your term debt doesn’t come
up for renewal at the same time.”
When commodity prices and cash flow
are strong, pre-paying term loan and
mortgage principal can put the farm
in a better position when prices head
south. Loans can also be set up as
revolving term facilities in which clients
can pre-pay (when times are good) and
re-borrow up to the previous limit
without the hassle of a loan application.
“This can provide some cash flow relief
that’s very welcome when you’re at the
low end of the cycle,” says Richards.
Bottom-feeding expansion
Expand when times are good. Sit tight
when times are tough. That’s how it
works in many industries, but cyclesavvy
farm producers very often
do the opposite. That, according
to Richards, takes planning,
financial capacity,
patience and guts.
“It’s very counter-intuitive to try to
grow the business when cash flow is
slow,” says Richards, “but it can make
sense if the producer has the equity
base to manage it. In the case of hogs,
if you expand at the top, it could mean
your additional pigs hit the market just
as prices drop. By expanding at or near
the low point of the cycle, the thinking
goes, you start shipping larger volumes
when prices are starting to rise.”
Some farm sectors have pronounced
cycles for production and prices. Others
feature commodity prices that can vary
significantly, and unpredictably, from
one year to the next. No matter the
sector, Bob Richards sees risk-minded
producers taking charge of the factors
they can control or influence.
“The idea is to lock in a margin to cover
your operating costs,” says Richards. “A
risk management plan begins by having
a clear understanding of those costs.”
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