Hedging: A tool to ensure profit

November 2023

CHRISTIAAN VERCUIEL, AGRICULTURAL ECONOMIST, GRAIN SA

With input costs at record high levels and a lot of uncertainty in the market, farmers find themselves in an impossible situation. There is always the possibility that commodity prices may fall back to lower levels. 

With the current international supply and demand outlook it seems that commodity prices will be supported for the near future. Factors supporting prices are:

• Low international carry-over stock from the previous season.
• Declining production estimates in the United States (US) due to unfavourable weather forecasts.
• Weak production estimates in Europe due to heatwaves.
• Uncertainty about exports from Ukraine.
• Weak farmer sales of soybeans in Argentina.
• Lower than expected palm oil production.

The current price levels and the planting season that is rapidly approaching mean it is the perfect time to start doing calculations with the current input and commodity prices to ensure profitability and sustainability.
 
EXAMPLE 1
A farmer calculates with the current prices that his input cost amounts to approximately R15 500/ha to produce maize. The farmer then needs to ensure that he sells his product in the future at a price that will cover this R15 500/ha. If the farmer produces 4 t/ha, he needs to sell his maize at a minimum of R3 875/t to cover his costs. 

• Input cost = R15 500/ha
• Income = 4 t/ha x R3 875/ton = R15 500
• Because profit = income - costs
• Profit = R0 (R15 500 income - R15 500 costs)

If the tons per hectare produced increase or the price per ton increases, a profit will be made.

EXAMPLE 2 
If the tons produced increase to 5 t/ha:

• Input cost = R15 500/ha
• Income = 5 t/ha x R3 875/ton = R19 375/ha
• Profit = R3 875/ha (R19 375 income - R15 500 cost)

EXAMPLE 3 
If the price increases to R4 000/t:

• Input cost = R15 500/ha
• Income = 4 t/ha x R4 000/t = R16 000/t 
• Profit = R500/ha (R16 000 income - R15 500 costs)

Therefore, the two main factors influencing the profit are production and price. A farmer has no control over the production, but he has control over the price that he receives for his crop.

HEDGING
A simple tool to ensure profit is hedging. Hedging is when a farmer sells his product in a forward contract, when he plants at a specific price in the future that is higher than his input costs. The farmer then buys a future contract that shifts the risk to another entity. This ensures that a farmer gets a specific amount per ton for the product he produces. 

The ideal for farmers is to hedge the amount that inputs will cost to ensure that they are able to cover the cost. Depending on market conditions, the farmer can choose to hedge a larger portion of the crop or keep the crop for cash sales when harvesting commences.

In essence, hedging helps farmers to manage the price risk by ensuring that they are able to pay off the input costs. Everything over and above the input costs is profit. Therefore, hedging is an important strategy in sustainable farming.

Prices are affected by production. If surpluses are produced, prices will move to export parity and in times of shortages prices will move to import parity. These parities are affected by international prices, and therefore high volatility and many factors affecting the market exist. This is why hedging must be used to manage risks. 

Publication: November 2023

Section: Pula/Imvula