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Managing Market Risk in Citrus1 John J. VanSickle2 1. This is EDIS document FE 196, one of nine papers in the 1999 Citrus Risk Management Series, a publication of the Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL. Published October 2000. Please visit the EDIS website at http://edis.ifas.ufl.edu. 2. John J. VanSickle, professor, Department of Food and Resource Economics, University of Florida, Gainesville, FL. The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service/Institute of Food and Agricultural Sciences/University of Florida/Christine Taylor Waddill, Dean. Introduction The Florida citrus industry has several tools that can be used to manage risk in marketing its products. Decisions that must be made that influence the risk a producer assumes include product form, the marketing method used, and the price-risk management tools used. The decisions related to product form involve choosing whether to produce for the fresh or processed markets. Returns will generally be higher in the fresh market, but costs of production and the amount of production risk assumed also are generally higher in the fresh market. Choosing how to sell your production is one of the decisions related to the marketing method. There are many tools that can be used for selling in the cash market when the product is ready to be sold. Growers can choose to place their production into a participation plan that then sells all products from growers placed in that plan. Growers can also choose to contract with a fresh fruit packer or processor to prepare their product for market and then market their own products. In addition, growers can use reference-pricing mechanisms where they price their products off of a publicly reported price. The price-risk management tools available to growers can help them manage price risk. Farmers can contract with packers or processors to deliver a fixed quantity at an agreed upon price or they can use futures and options to remove price risk in the marketing of citrus. Citrus growers have many of the same tools that farmers in the grain and livestock industries have for managing market risk. Crop and livestock producers have choices available to them on product form and what marketing method to use. They also have futures and options contracts they can use for managing price risk. The decisions that relate to price-risk management are described in the following sections and the advantages and disadvantages of using various price-risk management tools are presented. Risk management begins with developing an understanding of the tools available for managing risk and then knowing when to use those tools to meet the objectives of the organization. Product Form Product form is important in determining the outcome of returns in a citrus operation. The key decisions that must be made relating to product form are choosing fruit variety and whether you will produce for the fresh or processed market. These
Managing Market Risk in Citrus 2 decisions should be the result of a careful analysis of comparative market returns and the risk management alternatives available for producing each of the products. Tables 1, 2, and 3 show the comparative returns for oranges, grapefruit, and tangerine crops in Florida and the utilization of those crops in fresh and processed form. Oranges in Florida are grown mostly for the processed market (94.2%). The average on-tree price received for all oranges in Florida in the 1998/99 season was $5.13 per box with fresh oranges providing a return of $8.77 per box and processed oranges providing a return of $4.91 per box. Clearly, fresh oranges provide a higher return, but production costs are higher and production risk is generally higher since appearance affects the return on fresh product. Early and midseason oranges, excluding navels, (also known as early-mids) account for 57 percent of the total orange crop and are primarily harvested for processing (97.7%). On-tree returns for all early-mids averaged $4.67 per box in the 1998/99 season with fresh market early-mids averaging $6.60 and processing early-mids averaging $4.57 per box. Navel oranges are a small crop in Florida (2.7% of the total orange crop) and are harvested mostly for the fresh market (72.6%) with on-tree returns averaging $9.40 for fresh market and $2.39 for processed market. The orange crop in Florida is primarily harvested for the processing market. Navel oranges are the exception with more of the production of navels being sold in fresh form. Growers must make a decision on whether they will grow navels for fresh or processed market. Grapefruit growers produce more of their crop for the fresh market with 42.4 percent of the grapefruit crop sold in fresh markets and 57.6 percent being sold in processed markets. Seedless varieties receive higher returns in the fresh market ($6.80 per box for white seedless and $4.52 per box for colored seedless). Seeded grapefruit are sold almost exclusively in processed form, averaging $1.02 per box in the 1998/99 season. Even more of the tangerines are sold in fresh form with 72.1 percent of the 1998/99 crop sold in fresh form. The higher returns for fresh tangerines ($12.30 per box compared to $3.65 per box for processed tangerines) commands that most of the tangerines are produced for fresh market with the processed product representing culls that can not be marketed in fresh form. Decisions related to product form begin with choosing the type of product planted. Alternatives related to fresh and processed form are narrowed once a decision is made on the trees planted in the grove. These decisions should be determined by comparative returns, costs of production, and production risk. Citrus Marketing Alternatives There are several methods that can be used to market fruit out of the grove. Growers can choose to sell their fruit in a market that provides a price when the fruit is delivered (priced fruit). This can be accomplished by selling in the spot market at delivery or through a cash forward contract. Hedging with futures and options can also be used to price fruit in advance of selling in the cash market. Deferred pricing alternatives include pooling your product with other growers in a cooperative, placing your fruit in a pool operated by a private company, or by consigning the fruit to a marketing representative in the packing house or processor. Toll and contract processing and reference pricing systems are other deferred pricing alternatives available at some fresh fruit packers and processors. Each of these alternatives are discussed below with advantages and disadvantages of each alternative described. Priced Fruit Marketing Spot Market Selling fruit in the spot market involves delivering the fruit to a buyer and selling the fruit for cash at the time of delivery. The price that is paid in the spot market is determined by the fruit supply at the point of delivery and the buyers' needs for meeting their demand. It should be expected that prices in the spot market will change daily or more often. The advantage of selling in the spot market is that full payment is generally received at the time of delivery. It also gives growers the opportunity to take advantage of price increases when supply is short. It
Managing Market Risk in Citrus 3 offers the greatest degree of flexibility since no obligations are made until growers harvest the fruit. A disadvantage of the spot market is that the timing of delivery can impact the price growers receive. Because capacity utilization is so important to processors and fresh fruit packers, they attempt to schedule as much of their capacity as possible to run the plant at optimal efficiency. As such, spot market sellers become residual suppliers and may not have the opportunity to deliver when they choose. In times of surplus, residual suppliers may compete for limited capacity with price dictated more on packing capacity than on market value. Cash Forward Contracts Selling fruit using cash forward contracts involves growers agreeing in advance of harvest to deliver fruit to a buyer at an agreed upon price. Quantity and quality are also likely to be specified in the contract. A major advantage of cash forward contracting is that more negotiating should be available to growers. Because packers and processors are trying to schedule as much of their capacity as possible in advance of the harvest, there may be some bargaining room on specifications within the contract. Minimally, growers will have time to sit down with the contract offers and consider how the contract specifications fit with the objectives in their operations. A major disadvantage of cash forward contracts is that growers lose flexibility in marketing after the decision is made to sign the contract. It is difficult to offset the obligations of a cash forward contract without penalty for not fulfilling the terms of the contract. A second disadvantage is that growers may be increasing the amount of production risk they assume in their operation. Because cash forward contracts often specify fruit quality that must be met to deliver on the contract, production risk associated with fruit quality increases because of added cost that may be incurred if fruit quality is not met with the delivered fruit. Hedging The citrus industry is offered opportunities to manage price risk by using futures and options to eliminate some of the price risk inherent in citrus markets. The New York Board of Trade (NYBOT) offers futures contracts and option contracts on frozen concentrated orange juice (FCOJ). NYBOT offers FCOJ-1 and FCOJ-Diff futures and options for managing price risk. Selling FCOJ-1 contracts, buying FCOJ-1 put options, or some combination of futures and options can eliminate some of the price risk inherent in the juice market. Selling FCOJ-Diff contracts allows growers to manage the premium risk associated with Florida citrus. Florida citrus is generally perceived by the trade as being higher in quality. The premium associated with that quality varies and the FCOJ-Diff contract was created to allow growers to manage that premium. The futures market can be used to set a price target for fruit by selling FCOJ-1 contracts in advance of the time that you expect to sell the actual fruit in the cash market. Futures contract prices for the delivery month generally track the cash market with the difference between the two referred to as basis (cash price minus futures price). Basis is generally driven by location, crop size, market demand, and processing capacity, and is generally predictable within a certain range by studying previous basis patterns. Futures contracts can be used to set a target price equal to the futures price in the FCOJ-1 contract sold when the hedge is implemented plus the expected basis for when the fruit will be sold in the cash market. This tool eliminates general price risk and leaves growers only with the risk of being wrong in the expected basis, a risk that is generally lower than general price risk. Put options can be used to set a price floor by purchasing a put option with a strike price that provides a price floor that covers the risk associated with a price decline. The price floor set by purchasing a put option is the strike price in the put option plus the expected basis when the fruit is sold less the premium you pay to buy the put option. As such, the put option becomes an insurance policy that is executed only if the market fails to exceed the strike price in the option. It eliminates the downside price risk in the market.
Managing Market Risk in Citrus 4 There are several advantages of using futures and options. First, futures and options allow growers to decouple price risk from production risk. Second, it decouples the pricing decision from the selling decision. Growers are able to retain flexibility in choosing a market outlet, allowing them to influence the actual basis when the fruit is sold in the cash market. The major disadvantage of using futures and options is that it requires knowledge about the relationship between cash market prices and futures market prices so that you can determine a target price or floor price. Transactions in the cash market for FCOJ are not generally publicly reported and it can be difficult to develop an expected basis. Another disadvantage is that it may add cash flow responsibilities in meeting margin requirements. The integrity of the futures market is guaranteed by making traders post a margin deposit to insure that they will perform their obligations in the contract. When the market moves against the traders' position in the futures market, they may be required to post additional margin monies to guarantee performance in their contracts. Those monies will be earned back when the fruit is sold in the cash market because cash market prices increase to cover the additional margin requirements. A related disadvantage to futures markets is that using futures and options efficiently requires a matching cash transaction. A hedge is performed by selling a futures contract when the target price meets the objectives of the firm. The futures market obligation is offset by buying back the same type of contract when the product you grow is sold in the cash market. Much of the citrus that is marketed in Florida is taken through pooling or participation plans (deferred pricing market practices). In these alternatives, growers turn over their fruit to a marketing agent who sells his fruit along with fruit belonging to other growers who are members of the pool or participation plan. Growers then receive the average price of all fruit sold in the plan. Because an average price is received, growers have no matching transactions to use with futures and options in hedging. Deferred Fruit Pricing Pooling and Participation Programs Pooling and participation plans are marketing arrangements where growers pool their fruit with other growers and allow a professional marketing agent to market the products in the plan. Each grower receives an average price of all fruit that is sold as part of the pool or participation plan in which they place their fruit. Fruit is delivered to the processor or packer and final payment is usually not made until all fruit has been sold. The main advantage of using pooling and participation plans is that the growers' fruit is placed into the hands of a capable marketer. Another advantage of selling fruit through these plans is that the timing of delivery to the packing house or processor is not as important in determining returns. Finally, the stress of marketing fruit is placed into the hands of someone who deals with these markets on a daily basis. The main disadvantage of using pooling and participation plans is that growers bear all of the market price risk with no opportunity for managing that risk. The marketing is done by the packer or processor and the grower has few opportunities available for taking advantage of opportunities that surface in the market that meets his objectives. Because sales are spread out over the season with no single transaction tied to a producers fruit, there are no opportunities to use traditional hedging strategies with futures and options. Finally, growers are also placed at a disadvantage in payment for their products. Final payments for pooled fruit are usually not made until the pool has been closed out, which will affect the cash flow of the firm. Toll or Contract Processing or Packing Another opportunity with some packers or processors is to contract with them to prepare your fruit for sale in fresh or processed form for a fee and to sell your own products. Toll or contract processing or packing requires a contract which specifies the services to be provided and the cost of those services.
Managing Market Risk in Citrus 5 The advantages of using toll or contract processing or packing is that the grower retains more control over scheduling the harvest and sale of fruit. This marketing alternative also gives the grower more flexibility in using futures and options for pricing his product, which helps in managing price risk. The main disadvantage of this marketing alternative is that it requires additional expertise in marketing. This alternative requires developing marketing strategies for selling fruit to wholesale and retail outlets, or directly to consumers. Reference Pricing Reference pricing alternatives are developed to allow growers the opportunity to price their product based upon the value of a product in another market. Alternative reference prices may include the canners' average cash fruit price, weekly market quotes published by Florida Citrus Mutual, or futures prices negotiated at the NYBOT. These systems use the reference price with premiums and discounts for fruit quality and services provided. The advantage to reference pricing systems is that it gives the grower flexibility in pricing fruit through the timing of sales. It is also easy to use futures and options with reference pricing systems, especially those based off the NYBOT futures quotes. The basis will be known in a reference pricing system using NYBOT futures quotes, and target prices become actual price received when the fruit is priced by the grower. The disadvantage of reference pricing systems is that there are likely to be large discounts associated with being able to time your own sales. Processors and packers like to be able to offer a steady supply of fruit in the market throughout the season. Reference pricing systems can impact that supply flow unless the reference is based upon NYBOT prices. Using NYBOT prices for the reference allows the packer/processor to sell the actual fruit and go long in the futures market until the grower prices his fruit. Conclusion Price-risk management requires a careful study of the marketing system by the growers. The marketing alternative that is chosen by a grower will influence the risk-management alternatives available for managing production and price risk. It is important to understand that risk management begins with an assessment of a grower's ability to assume risk. It is also important to understand that growers assume risk the minute they make a decision to own a resource. Growers assume price risk as soon as they own a resource and hold that price risk until the product is sold. Managing risk is a necessary part of successfully managing a grove.
Managing Market Risk in Citrus 6 Table 1. Orange Crop Utilization and 1998/99 On-Tree Prices. Orange Crop Crop Size (1,000 Boxes) Average On-Tree Price ($/Box) Percentage Fresh $/Box Fresh Percentage Processed $/Box Processed All 185,700$5.13 5.8%$8.7794.2%$4.91 Early and Mid107,000$4.67 2.3%$6.6097.7%$4.57 Late 73,700 $5.71 6.3%$9.4093.7%$5.46 Navels 5,000 $7.48 72.6% $9.40 37.4% $2.39 Source: Florida Agricultural Statistics Service. "Citrus Summary 1998/99." Florida Agricultural Statistical Service. Orlando, Florida, January 2000. Table 2. Grapefruit Crop Utilization and 1998/99 On-Tree Prices. Grapefruit Crop Crop Size (1,000 Boxes) Average On-Tree Price ($/Box) Percentage Fresh $/Box Fresh Percentage Processed $/Box Processed All 47,050$2.2642.4%$5.0457.6%$0.21 Seedy 550 $1.02 0%N/A100%$1.02 White Seedless 17,800$2.0125.5%$6.8074.5%$0.36 Colored Seedless 28,700 $2.43 53.6% $4.52 46.4% $0.02 Source: Florida Agricultural Statistics Services. "Citrus Summary 1998/99." Florida Agricultural Statistics Services. Orlando, Florida, January 2000. Table 3. Tangerine Crop Utilization and 1998/99 On-Tree Prices. Tangerine Crop Crop Size (1,000 Boxes) Average On-Tree Price ($/Box) Percentage Fresh $/Box Fresh Percentage Processed $/Box Processed All 4,950 $12.3072.1%$15.6527.9%$3.65 Early 3,050 $10.1871.2%$13.0528.8%$3.08 Honey 1,900 $15.69 73.5% $19.65 26.5% $9.65 Source: Florida Agricultural Statistics Service. "Citrus Summary 1998/99." Florida Agricultural Statistics Service. Orlando, Florida, January 2000.