Risk-Free Farming?

Risk-Return Analysis of Soybean Farming under the 2002 Farm Bill

Bruce A. Babcock Center for Agricultural and Rural

DevelopmentIowa State University

Risk and Return in a Free-Market Economy

• Capitalism works when those with capital are induced to invest by the expectation of a higher return on invested capital than on non-invested capital.

Risk-Return Tradeoff

Expected Return

Risk

Are Farm Programs Counter-Productive?

• One justification for farm programs is that U.S. farmers need support because of their exposure to a great amount of risk.

• But won’t a reduction in risk also reduce expected returns?

• Perhaps, but farm programs also increased expected or average returns.

Structure of Program Paymentsfor Soybeans

Target PriceFixed Payment

Loan Rate

Counter-CyclicalPayment

Loan DeficiencyPayment

NotTiedTo

Prod

ProdReq.

$5.80

$0.44

$5.36

$5.00

RegardlessOf Market

Only If…

2004 Acres Insured in Iowa

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

ActualProduction

History

CropRevenueCoverage

Group RiskIncome

Protection

Group RiskPlan

IncomeProtection

RevenueAssurance

CORNSOYBEANS

Insurance Coverage by Iowa Farmers in 2004

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

50 55 60 65 70 75 80 85 90

CORNSOYBEANS

Distribution of Local Soybean Prices at Harvest 2005Nov 2005 CBOT Price= $5.80, Expected local basis = $0.30)

0

50

100

150

200

250

300

350

400

450

$/bu

Prob

abili

ty

Distribution of Soybean Yields in Webster County(Expected Yield = 45 bu/ac)

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

bu/acre

Prob

abili

ty

Distribution of Harvest-Time Net Market Revenue Variable Costs = $130/acre

0

0.01

0.02

0.03

0.040.05

0.06

0.07

0.08

0.09

0.1

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

Distribution of Harvest-Time Net Market Revenue Plus Direct Payments

0

0.010.02

0.03

0.040.05

0.06

0.07

0.080.09

0.1

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

With direct payments

Distribution of Harvest-Time Net Market Revenue Plus CCPs

0

0.01

0.02

0.03

0.040.05

0.06

0.07

0.08

0.09

0.1

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

With countercyclical payments

Distribution of Harvest-Time Net Market Revenue Plus LDPs

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.1

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

With LDP

Distribution of Harvest-Time Net Market Revenue Plus DP, CCP, and LDP

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

With DP, CCP, LDP

Distribution of Harvest-Time Net Market Revenue Plus RA

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

With Revenue Assurance at 75% Coverage

Distribution of Harvest-Time Net Market Revenue Plus DP, CCP, LDP, and RA

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

-50 10 70 130 190 250 310 370

$/acre

Prob

abili

ty

Effects of Government Programs

• With no government programs, probability of negative net revenue is about 5% (1 in 20 years).

• With government programs probability of net revenue less than $60/acre is less than 1%; probability of net revenue less than $70/acre is less than 5%.

• Average net revenue increases from $114/ac to $145/ac.

Effect of Programs on Wheat

0%

4%

8%

12%

16%

20%

24%

28%

-60 -30 0 30 60 90 120 150 180 210 240 270 300 330

Market Receipts Less Variable Costs ($/ac)

Pro

babi

lity

With All GovernmentSupport

Effects of Government Payments on Cotton

0%

4%

8%

12%

16%

20%

24%

28%

-400 -300 -200 -100 0 100 200 300 400 500 600 700 800 900

Market Receipts Less Variable Costs ($/ac)

Pro

babi

lity

With All GovernmentSupport

Effects of Government Programs on Iowa Cash Renters

• Cash rents will increase due to the increase in expected returns.

• Cash rent is also a variable cost of production.

• How much will cash rents increase?– Depends on returns to corn land.

Effect of Government Programs on Corn

0.00

0.02

0.04

0.06

0.08

0.10

0.12

-150 -70 10 90 170 250 330 410

$/acre

Prob

abili

ty

Effects of Government Programs on Iowa Cash Renters

• Expected returns to corn production increase by about $75 per acre.

• So assume that programs increase cash rents by $50 and that cash rents for Iowa land without the programs equal $100.

Effect of Government Programs on Net Returns from Iowa Soybean Producer Who Cash Rents Land

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

-150 -75 0 75 150 225

$/acre

Prob

abili

ty

A Comparison of Risk and Returns for Cash Renter

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

-150 -75 0 75 150 225

$/acre

Prob

abili

ty

No programs except revenue assurance

Current situation

Final Words

• Government programs and crop insurance greatly reduce the risk of farming for operators who farm their own land.

• It could be argued that land renters would be better off with RA and no other programs.

Implications

• Risk reduction/return increase only occurs with government programs:– Incentives increase to plant only program

crops– Incentives increase to focus on maximum

yield rather than maximum qualityGreater returns to managing commodity

production rather than managing possibly new ventures