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Price Expectations and Risk Profiles Drive Commodity Program Choices

Alejandro Plastina (plastina@iastate.edu) and Chad Hart (chart@iastate.edu)

The optimal commodity program choice depends as much on the specific production system in each farm as on the producer’s expectations about future yields and prices. Furthermore, the risk profile of producers will weigh heavily in the decision. This article illustrates the role of price expectations and risk profiles in commodity program choice using the ISU Farm Bill Analyzer (MS Excel file).

New Safety Net

The 2014 Farm Bill established two new programs: Price Loss Coverage (PLC) and Agricultural Risk Coverage (ARC). The ARC program is offered at the individual farm level (ARC-IC) and at the county level (ARC-CO).

PLC offers price protection ($3.70 and $8.40 per bushel, respectively, for corn and soybeans), while ARC offers shallow-loss revenue protection (based on the most recent five years of marketing year average prices and yields). Payments for PLC and ARC-CO are calculated on 85 percent of base acres of a covered crop in a particular FSA farm number, while payments for ARC-IC are calculated on 65 percent of all base acres enrolled in the program by state.

For each FSA farm number, land owners can choose between enrolling each crop in PLC or ARC-CO and enrolling all program crops on the farm in ARC-IC. For example, a farm can have corn base acres participating in ARC-CO and soybean base acres participating in PLC. However, if ARC-IC is elected for a farm, then all crops in that farm must participate in it, and the farm cannot participate in either of the other two programs. Those crops and/or farms not enrolled in a commodity program by March 31, 2015 will be automatically enrolled in PLC starting in 2015 and will not participate in PLC or ARC in 2014.

Starting in 2015, a producer who insures his or her crop in a particular FSA farm number with a farm-level COMBO plan and whose crop in that farm is not enrolled in ARC, may choose to buy additional crop insurance at a subsidized rate through the Supplemental Coverage Option (SCO). SCO offers shallow-loss revenue protection at a county level by covering a portion of the producer’s crop insurance deductible based on county yields or revenue (depending on the underlying insurance policy held by the producer).

New Choices

In order to participate in the new commodity programs, producers must make three one-time irrevocable choices binding for the life of the Farm Bill: (1) to retain or update payment yields, (2) to maintain or reallocate base acres, and (3) to elect a commodity program for each crop and/or farm. Every year, starting in 2015, producers will have the option to enroll or not to enroll in an elected program.

The set of information available to producers when making the three irrevocable decisions consists of crop production history (planted acres and yields), base acres, crop insurance records, payment yields, and county average yields. The unknowns that affect both the likelihood of receiving payments and their magnitude in 2014 through 2018 are the trajectory of farm and county yields and national crop prices.

The optimal commodity program choice depends on the specific production system in each farm, on the producer’s expectations about future yields and prices, and on his or her risk profile.

The ISU Farm Bill Analyzer (MS Excel file) provides a set of projections of farm and county yields, based on historical and user-provided data, and three different sets of price forecasts to choose from: USDA, FAPRI, and futures-based. Additionally, the user can choose between three levels of expected price volatility (low, average, and high) that impact both the expected net indemnities from crop insurance and from the new SCO program. Expected payments are calculated over 500 draws from a Monte Carlo simulation of prices and yields for each year.

Table 1. Actual Farm Yields per Planted Acre (bushels per acre)
Table 1
Table 2. Projected Marketing Year Average Prices for Corn and Soybeans ($ per bushel)
Table 2

Consider a 125 acre farm in Boone County with 55.2 corn base acres and 44.8 soybean base acres (after reallocation), and updated PLC payment yields of 147.5 bushels per acre for corn and 44.3 bushels per acre for soybeans. Alfalfa is regularly planted on the farm, but it is not a covered commodity. The yield history is reported in Table 1. Every year between 2014 and 2018, the land owner plans to plant 60 acres to corn and 50 acres to soybeans and will consider buying Revenue Protection at the 85 percent coverage level for corn and at the 80 percent coverage level for soybeans.

Price Expectations

Figure 1. Expected payments
and net indemnities under USDA price projections
Figure 1

If the producer’s price expectations align with USDA price projections (Table 2), then the combination of programs that maximizes the net present value of expected payments is PLC and SCO for corn and ARC-CO for soybeans (Figure 1). This combination of programs would result in an expected net present value of $33,535 in program payments and net indemnities from Revenue Protection and SCO.

Figure 2. Expected payments
and net indemnities using futures prices as of Oct. 31, 2014
Figure 2

If the producer’s price expectations are more in line with the futures prices from October 31, 2014 instead, then the combination of programs that maximizes the net present value of expected payments is ARC-CO for both crops and Revenue Protection only for corn (Figure 2).

Risk Profile

If the producer is concerned about his or her safety net in years of very low yields or very low prices, then his or her goal might not be to maximize expected payments over the entire range of possible revenues per year, but to maximize expected payments over the bottom 10 percent of possible revenues. In these cases, the producer is truly looking at the flow of payments during loss years.

Figure 3. Expected payments
and net indemnities during loss years using futures prices as of Oct. 31, 2014
Figure 3

If the producer expects the futures prices from October 31, 2014 to hold, then the combination of programs that maximize the net present value of expected payments in a low crop revenue scenario is PLC, Revenue Protection, and SCO for corn and ARC-CO and Revenue Protection for soybeans (Figure 3).

These last two examples highlight how risk preferences can influence the Farm Bill program choice. Given the same expected prices and yields, producers may reach different choices. The program that offers the highest expected payment may not be the program that minimizes the largest expected loss.