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Corn+Soybean Digest

Hedging On Uncle Sam

Government programs are risks that should be managed Government programs are one of three guaranteed risks in farming. The other two - the weather (production) and markets (prices) - can be offset through insurance or some sort of hedging strategy. But the government's impact on your operation is harder to control.

Yet simply realizing there can be risk associated with government programs may be enough to help you find ways to take some control over this increasingly important source of farm income.

The 2000 harvest was under way in McLean County, IL, yet the basis was actually tightening, causing the loan deficiency payment (LDP) rate to sink. Brad Glenn knew he had to take action to offset the risk that the LDP would fall further. So Glenn took an unusually aggressive step - he rented an additional combine.

"We weren't willing to risk that it (the LDP) would shrink further, and we knew that if we captured a higher LDP it would more than account for the rental of the combine," he states. "As a result, we finished up two weeks earlier than we could have otherwise."

For Glenn, renting the combine to help harvest his 1,500 acres was a way to manage risk - the risk that an important revenue source could be cut drastically. For his peace of mind alone, the action to manage the risk was worth the extra cost and effort.

Glenn is no stranger to risk management. In addition to farming, he works for a crop insurance company, and his rental of the combine certainly could be compared to buying an insurance policy, albeit for a slightly unusual purpose. Unusual or not, government payments have become a part of income that needs to be managed as an increasingly important source of revenue. In fact, in the most recent fiscal year, over half of farm income, or $28 billion, came from USDA program payments.

Many components of government program payments can't be planned. Production flexibility contracts (PFC), conservation reserve program (CRP) payments and emergency aid are all determined by something other than market forces. The LDP, however, does fluctuate based on the price of the crop, and analysts say it only makes sense to account for the LDP when planning a marketing strategy.

LDPs accounted for $8 billion of the $28 billion in government assistance last year, and Mike Kvistad, vice president of Benson Quinn Commodities, Minneapolis, argues that the LDP is "a revenue stream that should be planned for when prices are depressed and captured at the most appropriate moment."

In Glenn's case, and historically, the most appropriate moment has been at harvest (see chart). Typically, both the local basis and Chicago Board of Trade futures prices for soybeans and corn are weakest at or near harvest, which results in the highest LDP (if there is one). Most farmers realize this fact, and the majority of farmers (10:1 in Illinois as of late October) take the LDP in lieu of a loan once the crop is harvested.

However, as the 2000 harvest got under way, reported yields weren't living up to expectations, and USDA had reduced its crop estimates in each of the previous two reports. The result was nervousness in the market and prices were holding steady and even showing strength rather than continuing a downward trend that started in June (see above chart). For Glenn, that was the trigger he needed to take the action of renting a second combine.

In part, however, Glenn was able to take this action because his marketing plan made it possible. Part of his marketing strategy was to take some form of price protection on the bulk of his crop earlier in the year, which, in his words, made the LDP "gravy."

Kvistad endorses that strategy and points out, "Even if a farmer had waited until June, he could have taken money (nearly $1/bu decline in futures) out of a strategy that was simply intended to protect the price."

Glenn agrees and says he determines how to price ahead by simply looking at the basis. If basis is strong, he'll cash forward a higher percentage of his expected production. If the basis is weak, he'll use put options or sell futures on the bulk of his expected crop. Both methods protect against a decline in futures, while providing an opportunity to benefit should the basis improve.

Strategies involving the LDP don't end when the crop is harvested. In fact, in many cases, they've just begun.

"If you take the LDP and do nothing, you must realize that you immediately become long soybeans," Kvistad notes. "It's the same as having an open futures position because you are exposed to downward risk."

Some farmers, like Eldon Gould of Maple Park, IL, are comfortable taking the risk of storing crops or even being long the board as a replacement for the crop. But Gould says he also looks at each year independently. "The LDP is another marketing tool, and I look to maximize the LDP and still capture a carry in the market." Some years, that may mean cash forward contracting after taking the LDP, Gould offers, while in other years it means taking the risk of a long cash position.

For Gould, the relatively low prices of recent years were enough to convince him that the downward risk was less than the potential for reward on the upside.

In 1999, he thought the lows were put in near harvest, and he thought the same thing for the 2000 crop. Gould does admit, however, that he has a higher level of risk tolerance than many farmers. In addition, he has a hog operation and the long grain position can simply equate to a hedged feed position.

Gould's position in 1999 did pay off for him, as he captured an early year rally. But for others who didn't pull the trigger in time, the declining prices amounted to double whammies if they hadn't hedged their long cash positions when they took their LDPs.

Not only did they receive less for the beans when they went to sell, but they also could have received higher LDPs had they each not taken the LDP at harvest.

To prevent this scenario, Kvistad says that farmers should consider taking action to protect their position once an LDP is taken.

It's not too early to start planning for the 2001 crop. Establishing a marketing plan early gives you more options. By keeping on top of program changes and establishing strategies for marketing your crop now, the odds are you'll come out ahead in the long run.

Kvistad says marketing a crop can be an 18-month process if all scenarios are utilized. Whether it's analyzing option premiums, basis trends or combine rental rates, it's better to prepare now to manage risk than wait and let the opportunities pass you by.

Rather than deal with the intricacies of government programs, Joan Centlivre decided to cash rent her land. Most farmers wouldn't go quite to this extreme, but certainly many other farm owners feel Centlivre's pain.

For instance, in 2000 alone the Farm Service Agency (FSA) introduced 39 new programs. As a result, The Chicago Farmers, the organization that Centlivre chairs, recently invited Illinois FSA Director Stephen Scates to one of its meetings to make things a little clearer. The result? Members with as many as 12,000 acres traveled three hours or more to hear what he had to say.

Soybean Digest recently called upon Scates and Iowa County, IA, FSA Executive Director Kathy White to discuss some common mistakes made by farmers when dealing with farm programs.

They listed these six tips. Tip #1: Don't lose beneficial interest. Both White and Scates cited this as the No. 1 mistake made with LDPs. "Even after three years, it's apparent that LDPs are still not widely understood," says White.

Beneficial interest means a farmer must have control of the commodity, be at a risk of loss and retain title to the commodity. Once beneficial interest is lost, the commodity becomes ineligible for a loan or an LDP.

Tip #2: Make use of faxed-in signatures. It's a new, more convenient way to claim an LDP, but you need to have a form on file that says you intend to fax in a form. Similar to a bank signature card, Form 237 gets your name on file and gives you the option of faxing in Form 666 to claim the LDP.

Tip #3: Protect your base. In parts of Illinois and elsewhere, farmers have planted fruits and vegetables on corn base. This is a no-no, says Scates, and can result in significant penalties.

Because the 1996 law has been labeled "Freedom to Farm," Scates says many farmers believe they can plant whatever they want. However, at the time the act was written, language was included that prohibited the planting of fruits and vegetables on contract acreage. So much for flexibility!

Tip #4: Check with your FSA office. In the past, FSA personnel may have had time to get more information out to farmers.

But after staff cutbacks (for example, 30% staff reduction in Illinois) and a flood of LDPs to process, FSA staff doesn't have the time to communicate with farmers the way it used to. As a result, onus is on the farmer to take the time to call in and make sure the plan of action he'll take will comply with FSA regulations.

Tip #5: Check for local quirks. For example, all counties in Iowa have "quiet hours." No, they aren't running day care operations in their offices.

Quiet hours are a set time frame when the FSA office asks farmers not to call or stop in so the staff can focus on processing payments. In many Iowa offices, those hours are before 10 a.m.

Tip #6: Know what you're signing. This goes hand in hand with Tip #4. Know exactly what the forms mean before you sign them and you'll avoid problems down the road.

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