Why not just buy puts?

Why not just buy putsMichael Swanson, Ph.D., Wells Fargo Chief Agricultural Economist

With the 2016 harvest in the bin (or grain pile), many agricultural producers thoughts have turned to preparing for 2017 and committing themselves to land rents and inputs purchases. In a recent publication, the USDA showed that more than 60% of farm ground is rented in the key grain and oilseed regions. Using micro-data from the Center for Farm Financial Management, land rents get paid 28% of total yield on cash rent corn operations. This represents the single biggest expense for agricultural operators, almost doubling machinery expense.

Land rent represents the “make or break” decision point in farming operations. Without the land, farmers can’t farm, but if they pay too much for land rents, they guarantee themselves a loss. This fall and winter, farmers and landlords will have some of the toughest conversations in years. So, what issues will drive those conversations?

First, by definition, farmers need to be hopeful about yields and prices, but a good business plan doesn’t end here. At the moment, the Chicago Mercantile Exchange (CME) futures price for December 2017 corn is $3.75 a bushel. Using negative cash basis of 50 cents per bushel, a farmer could lay off their cash rent risk at $3.25 per bushel when they strike the deal. Put another way, if the farmer agrees to pay the landlord $200 per acre that would be 62 bushels of corn out of the hopper at today’s prices.

Is this too much or too little? It depends on the expected yield. It’s too easy for both the farmer and the landlord to be fooled into thinking that each year’s crop will be a big yield. The five-year average yield for Minnesota is 170 bushels, making the 62 bushels equal to 37% of the expected yield. What if the landlord is tough in negotiation and the farmer is desperate to keep the land? Let’s say they agree to $225 per acre. What’s $25 more to keep a long-term relationship? Now, the farmer has agreed to give the landlord 41% of the yield. Remember that’s 13% more of the yield than normal.

Factor shares for corn

The farmer can easily agree to cash rents that leave them in a losing position if they don’t discipline themselves by looking at the futures market and historical yields when they strike the deal. So, what can they do to make a better deal for everyone involved? First, know their numbers. Every landlord thinks their ground is as good as or better than the ground in rest of the county. The farmer must be able to prove or disprove that point to themselves, and then to their landlord. A farmer will need to be able to show that they made a timely application of above-average inputs, and still had below-average yields. The combination of timely, above-average inputs and below-average yields puts the blame squarely on the quality of the land. If the landlord won’t accept this fact-based argument, farmers must be prepared to walk away from a bad deal. This is where the farmer needs to be ready to deal with the “fixed cost fallacy” of farming.

Too many farmers agree to high cash rents because they have already committed to the equipment and labor of being active farmers. They reason (using the term loosely) that they only need to cover variable costs such as land rent, seed, fertilizer, and crop chemical because everything else is fixed cost. One can certainly use this economic reasoning on a couple of acres out of a thousand, but should not use this reasoning on 50% or even 10% percent of acreage. Why should the landlord’s acreage get a free ride while a farmer’s owned ground carries full cost plus? Over-priced cash rent ground takes time away from reasonably priced ground that could benefit from additional scouting and timely operations to boost its yields even further. Since yield creates efficiency, not acreage, farmers need to look for “addition through subtraction” of subpar acreage.

So, now we get to the single biggest fear of walking away from over-priced cash rent acreage — missing the inevitable rally. Farmers continually worry that if they reduce their acreage and production, this will be the very year that the monster price rally returns. In reality, farmers should look this fear square in the eye. First, even with a rally, they will be producing the highest cost of production bushels on overpriced cash rent ground. This means that corn will contribute the least amount of net profits anyway. The bulk of the profits will come from the lowest cost of production bushels in a very disproportional way. Secondly, direct variable cost per acre can easily run $600 per acre. That’s an incredibly expensive way to buy a call on the market which could languish in sideways price pattern or weaken on any number of factors.

There are much cheaper ways to buy a call based on fears or optimism. A $3.75 per bushel call (at the money) currently trades for 26 cents per bushel. Put another way, if you expect 170 bushels of corn per acre, you could buy the upside price potential for about $44 per acre. That roughly equals the average cost of crop chemical per acre, and one avoids putting in the other $550 of cash expense per acre.

So, why don’t farmers simply buy the calls? They know that “most options” expire worthless, and who wants to waste $44 per acre on worthless calls. At the same time, they will put the $600 per acre into the cash expenses to buy the same potential upside in crop production. This represents an excellent example of cognitive dissonance. Options represent a waste of money because the rally won’t appear, but large cash outlays make sense because there’s potential for a price rally. Perhaps the farmer should resolve the conundrum by embracing the philosophy that the future is unpredictable, but the cost of production can be controlled.