Crop shortfall cover
October 1, 2009
by Bernard Belk and Roman Hohl
With high specialization and rapid expansion in production, soybeans have become a significant contributor to Brazil’s agricultural export industry. However, droughts, pests and crop diseases can severely impact production levels and earnings for all stakeholders in the supply chain.
A source of protection against these unfortunate events is customized crop shortfall insurance products, which provide a flexible alternative to cover volume and price risk for key agricultural commodities.
As the world’s largest exporter of sugar, coffee, frozen concentrated orange juice, tobacco, ethanol, beef and poultry, Brazil is a major agricultural powerhouse. According to the Brazilian Centre for Advanced Studies on Applied Economics (CEPEA), the agricultural sector represented 26.5% of the country’s GDP — equivalent to $422.3 billion — in 2008 and contributed around 36% of the country’s total exports in 2007. Out of this figure, 10% came from the soybean complex. In 2008, Brazil ranked second only to the United States (U.S.) in soybean production with an output of approximately 60 million tonnes.
Despite the current global economic turmoil, prospects for the future growth of Brazil’s grain sector remain promising. According to the U.S. Department of Agriculture, the country could become the world’s biggest soybean producer by 2016-17, with an annual output projected at close to 90 million tonnes. High-quality input supplies have boosted Brazilian soybean yields that are already among the highest in the world. Additionally, mainly through the increase of planted area, annual production growth rates of up to 20% in recent years have been achieved in the new agriculture frontier areas in the Centre-West states of Mato Grosso, Bahía, Piauí, Maranhão and Tocantins. However, continued growth is dependent on several factors, including long-term crop price increases driven by Asian demand, increased domestic consumption supported by rising per capita income, and more investments in infrastructure, including transportation as well as storage and processing facilities.
Agribusiness is by nature a capital-intensive business. It is estimated that at least $50,000 per tonne of daily crush capacity is currently needed to build a new hexane soybean crushing plant. The replacement value of the current Brazilian 143,000-tonne-per-day crushing capacity is estimated at $8 billion. Since the profitability of crushing plants depends heavily on stable throughput volumes, increased volatility in outputs under current climate-change impact scenarios could have major financial consequences.
Major players in the agricultural supply chain have longstanding experience in managing risk, ranging from currency and price-risk hedging to insuring against property and liability claims. Despite these efforts, earnings in some segments are still subject to substantial volatility, making it difficult to produce a significant return on equity, create steady cash flows, and/or maintain excess capital for new investments.
In addition, industry experts say that commodity prices, the exchange rate of the Brazilian currency to the U.S. dollar, potential government interventions, lower-than-expected yields resulting from adverse weather conditions, as well as pests and diseases are seen as major sources of earnings volatility in the soybean industry.
Impacts of weather-related production shortfalls can affect the supply chain in several ways. Corporate farmers may default on forward sales contracts if they cannot deliver the pre-agreed amount of agricultural commodities. Thus, they may be unable to pay back their production loans and/or may need to liquidate assets. Bulk handling companies and raw material processors may not be able to use their infrastructure at full capacity. In this instance, they are likely to face a reduction in operational revenues and — in severe cases — may be unable to cover their fixed costs.
Traders may need to make up for producers’ production shortfalls by purchasing additional commodities at high spot market prices. Input suppliers and farm equipment manufacturers may suffer a reduction in sales volume, as producers cannot afford investments in improved technology. Financial institutions and those input suppliers that pre-financed input supplies may face an increased number of growers who default on their credits.
Low production levels in the Brazilian soybean sector are usually caused by periodic severe droughts that impact yields. In 2004, for instance, the effect of drought in southern Brazil, where approximately 40% of the national soybean production is located, coupled with the occurrence of Asian rust disease, reduced yields by 30% compared to the previous year and 12% compared to the 10-year average at that point in time.
Subsequently, a more drastic drought in 2005 reduced yields in Southern Brazil by another 27% compared to 2004 levels, including a 60% decrease in Rio Grande do Sulk. In 2008, Brazilian soybean production was reported to be 7% lower compared to the previous year due to a drought situation in southern Brazil.
CROP SHORTFALL INSURANCE
Stakeholders throughout the agriculture supply chain can now manage earnings and cash flow volatility — resulting from lower production caused by droughts — by purchasing a crop shortfall insurance policy.
Crop shortfall coverage, offered by companies such as Swiss Reinsurance Company, which has offices in more than 20 countries, can help cover fixed costs, compensate against increased costs to procure additional commodities at spot prices, and/or protect gross margins.
Additionally, it can contribute to a lower cost of equity, weighted average cost of capital and improved credit ratings. These metrics increase shareholder value and confidence for both financing institutions and investors focusing on state-of-the-art risk management.
This insurance solution also reduces opportunity costs by making available the accumulation of funds necessary to invest in new operations more predictable.
Bernard Belk is director, senior originator corporate agriculture, and Roman Hohl is director, head of corporate agriculture, for Swiss Reinsurance Company in Zurich, Switzerland. They can be contacted at email@example.com, tel: +41 79 401 8023 or firstname.lastname@example.org, tel: +41 43 285 3160.