Before each planting season, farmers must make crucial decisions about what crops to plant and what seeding rates, fertilizer, and other input levels to use. These decisions are made months before crop yields and prices are known, leaving farmers exposed to unpredictable factors such as weather, pests, and socio-economic issues that impact supply and demand at harvest. In an industry where small commodity price fluctuations can have a big impact on profitability, risk management is extremely important.
The focus of agriculture risk management is to minimize the possibility and impact of unfavorable outcomes. There are three main categories of economic risk that need to be considered when developing a financial risk management plan for the farm: production risk, marketing risk and financial risk.
The last form of risk, financial risk, is associated with borrowing money, and is dependent upon credit availability, interest rates and exchange rates. Farmers must generate sufficient cash flows necessary to service their debt, and must meet any conditions associated with credit availability — including being able to maintain financial covenants.
Production, marketing and financial risks are interdependent. For example, the ability to service debt (a financial risk) depends on the production levels (a production risk) and the prices received for production (a marketing risk). When developing a financial risk management plan, all three economic risk measures must be considered together.
Production risk concerns variations in crop yields and production affected by a range of factors such as weather conditions, pests, and disease. Unlike most manufacturers whose business relies on the assumption that a known quantity of inputs produces a known quantity of outputs, this is not the case with most agricultural production processes. Another source of production risk is the adoption of new technology and the increasing complexity of farming machinery. New machinery and technology increase yearly expenditures, and carry additional risk such as mechanical failure and the costs and downtime associated with repair.
The second form of risk, marketing risk, is associated with the variability of input and output prices. Input price is often less volatile than output price and is incurred upfront. One of the main factors that affect input prices are energy prices. When energy prices rise, the costs are carried through to fuel, fertilizer and pesticides. Output price is more volatile as it is largely determined by the balance of supply and demand. Supply of agricultural commodities is affected by farm production decisions, yield results and government policies. Demand is determined by consumer preferences and incomes. Both supply and demand are influenced by other macroeconomic factors such as exchange rates, export policies, economic strength and the price of competing products.
Presently, these three forms of economic risk are as prevalent as ever and are large contributors to the uncertainty faced by farmers. Commodity prices are experiencing their sharpest increase since the 1970s driven by pandemic induced supply-chain disruptions, a myriad of effects from the war in Ukraine, and the increasing occurrence of extreme weather events. With growing input costs, it is more expensive to expand production and this expense is exacerbated by higher borrowing costs as interest rates increase. Adding to the downward pressure on already slim profit margins are new government policies and rising environmental taxes. With only one growing season per year, farmers are on an accelerated timeline to meet the growing demands for food supply — all while addressing food sustainability, plant and animal welfare, and climate change.
The Olds College Smart Farm is accelerating the development and adoption of technologies and practices by providing the agricultural sector a venue for commercial scale applied research. When it comes to economic risk management, the Smart Farm evaluates new products, and provides data and recommendations that assist farmers and their industry counterparts with making informed economic decisions to help mitigate their risk.
Unlike a conventional farm that must focus primarily on production and profit, the Smart Farm is subject to different economic pressures than a traditional producer. As a part of the Olds College Centre for Innovation (OCCI), the Smart Farm is designed to undertake research and innovation instead of focusing primarily on agricultural output. Therefore, the Smart Farm has historically not had reason to devote its resources towards developing a farm risk management plan that considers marketing and financial risk. Throughout this planting season, OCCI will be collaborating with industry partner Algo-Rythmn Corp. to enhance market and financial risk management innovations with the goal to provide actionable insights and tools to be used by farmers. The addition of price risk solutions to the technological advances coming from Olds College will help the agricultural industry meet its accelerated timeline while increasing financial stability and decision making.
The author of this article, Stephanie Rempe, is a recipient of the Mitacs Accelerate Grant. The Mitacs Accelerate Grant is a year-long paid internship where the recipient works with both an academic institution (Olds College) and an industry partner (Algo-Rythmn Corp.) on a joint research project. Stephanie graduated from Brown University in 2020 with a Bachelor of Science in Mechanical Engineering and is currently working towards her Chartered Financial Analyst (CFA) designation.