– James Mitchell, Livestock Marketing Specialist, University of Arkansas
We make important decisions about our cattle operations and don’t always immediately know the result of those decisions. The time it takes to observe the result of our decision is referred to as a time lag, and it is driven by the biology involved in raising livestock and growing forages. For example, consider how long it takes to market a new calf crop. Your operation is subject to favorable and unfavorable market swings in the months following the calving season. A more extreme example is the time between retaining a group of heifers and those heifers’ first calf crop. In this case, your operation is subject to short-run and long-run market dynamics that might not go your way. These long lags subject our operations to a lot of risk.
Risk is defined as the probability of an event occurring multiplied by the consequence of that event. The types of risk that we face include production (e.g., yields, weaning weights), market (e.g., prices, trade), institutional (e.g., property rights, farm policy), personal (e.g., work injury, property theft), and financial (interest rates, operating loans). Two common strategies to manage these risks include risk transfer and risk mitigation. Most of us already implement these strategies but might not think about them in these terms.
Risk transfer means paying someone else to take on your risk. There is a risk that you won’t produce enough hay because of drought. You could transfer this risk to an insurance company by paying a premium to purchase a Pasture, Rangeland, and Forage (PRF) insurance policy. The insurance company has taken on the risk of a lack of precipitation on your hay acreage and the policy would pay indemnities following drought. Futures, options, forward contracts, and LRP insurance are other risk transfer tools.
Risk mitigation means using best management practices to minimize the damages and likelihood of risk. We use these strategies all the time without thinking about them from a risk management perspective. Before PRF Insurance was available, the only way to manage hay production risk was through best management practices. Maintain hay reserves to reduce drought impacts. Store hay in barns to reduce hay waste. Use multiple hay storage locations to lower the impacts of a fire. These are all best management practices used to minimize the damages of reduced or lost hay production.
In many cases, these two strategies are complementary. For example, payouts from a PRF policy won’t make you whole after a bad drought. With a PRF insurance policy, managing the impacts of drought on forage production is still in your best interest. If a PRF policy covered 100 percent of the losses from drought, there would be no incentive to manage it. Together, a PRF policy coupled with rotational grazing, soil and hay testing, forage diversification, and proper hay storage will go a long way toward managing drought impacts.
Some of the best advice I can give when developing a risk management strategy is to set goals before making production and marketing decisions. This forces you to commit to managing risk regardless of the degree to which that risk is realized. It’s hardest to manage risk when you find yourself in the middle of it. I compare that scenario to going to the store to buy a fire extinguisher when your kitchen is already on fire. Hopefully, this article provides context that can lead to more strategic thinking about risk management.