February 13, 2015

A new approach to risk management

A new approach to risk management looks at the range of variables rather than average values. Cam Nicholson, a farm consultant with Nicon Rural Services, explains how this approach can help shape a more effective risk management strategy.

It’s common practice for farmers to use average prices when they’re calculating their potential income. But Cam Nicholson, a farm consultant with Geelong’s Nicon Rural Services, believes that average prices can be misleading. “For example, when farmers were using an average wheat price of $287 a tonne in their calculations the price they were most likely to get was just $255 a tonne,” he says.

This discrepancy explains why farmers who’ve been careful in assessing their risk can still find themselves earning well below what they were expecting – and it happens across all commodities.

“Whatever you’re selling, when there’s a glut or oversupply, there’s always a floor – the amount investors are prepared to pay to store the produce until prices rise,” says Nicholson. “But, when something is in really short supply, people typically spend more and more money in a bid to outcompete each other. This drives prices to very high levels which drags the average price up considerably – often by as much as 10 or 15 percent.”

Averages can be equally misleading when it comes to yield. “Four tonnes might be the average wheat crop but what you really need to know is how often you’re likely to get a two tonne crop or even a wipe out,” Nicholson says.

Risk lies in the extremes

Nicholson isn’t impressed by sensitivity analyses that take the average price and then adjust this by 10, 20 or 30 percent each way. “The problem with this is that a price which is 30 percent higher than average might only occur one in every three years, while a price that’s 30 percent lower might occur one in every 10, so they’re not comparing the same things,” he says. “They also don’t take account of the fact the risk lies in the extremes, not the average.”

He sees more value in using historical data to establish probabilities and then stress testing different scenarios.

“If you need to make, say, $150 a hectare to cover your loans and other outgoings, you might find there’s a one in eight-year chance you won’t generate that much,” Nicholson continues. “You can then either factor this in to your calculations or look at ways of improving the odds – by changing your ratio of grains to livestock, for example. You can also consider a worst-case scenario, such as the poorest year happening three times in a row, and work out what you need to do to ensure you’d survive that.”

A history of volatility

As well as his consulting role at Nicon Rural Services, Nicholson manages the Grains Research and Development Corporation’s (GRDC) Grain and Graze program in southern Australia and, as part of that, is conducting workshops and working on individual analyses with farmers. By March, a new Grain and Graze website will provide commodity prices from the past 10 years.

“Farmers have survived volatility for 200 years and they’re very aware that risk is the only road to reward,” he says. “Risk is also a very personal thing, and the amount of risk you’re prepared to take will change over the course of your working life. We’re aiming to help farmers collect and process the information they need to make risk management decisions that are right for their age and their circumstances.”

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