Wild Ride in Rural Texas
Oil and gas are woven as deeply into Texas legend as farming and ranching. Yet these industries have been anything but stable foundations for rural economies. The worldwide markets in which oil, gas and agricultural commodities are traded can make any local economy that depends on them move up and down like a roller-coaster—a roller-coaster that many rural Texas communities can’t get off.
Oil prices have bounced all over the board over the last three decades, with average monthly wellhead prices moving from $6 per barrel in 1974 to more than $34 in 1981, down to almost $9 in 1986, back up to nearly $31 in 1990, back down to $8 by the end of 1998, and up to over $30 in 2000. (See Exhibit 31.) Most of the oil market’s ups and downs are spurred by external events beyond any producer’s control—conflicts in the Middle-East, bickering among oil-producing nations, overproduction, and world political unrest. What’s a lease operator to do if Saudi Arabia doubles its oil output? Not much, unfortunately. The value of his or her product could be cut in half in a matter of days.
Natural gas also is subject to volatile prices. (See Exhibit 32.) Outside events or changes in other fuel markets such as coal or fuel oil can affect gas prices directly. Weather also is a major factor; warmer- or colder-than-average winter temperatures can send prices plummeting or skyrocketing, depending on the amount of gas in storage for the heating season, as witnessed in late 2000. Excessively high summer temperatures, particularly in the South, can boost gas prices due to high utility demand for cooling. U.S. natural gas producers compete with Canadian counterparts, so a major storm in our northern neighbor’s backyard can affect a gas lease in South Texas.
Daily oil and gas prices can vary significantly even over the short term. Oil prices on the daily spot market moved from $10.72 per barrel in December 1998 to a high of nearly $27 by December 1999. By September 2000, oil prices had climbed to more than $38, levels not seen since the Gulf War. (See Exhibit 33.)
Similarly, natural gas cost about $1 per thousand cubic feet (Mcf) in December 1998, due to a relatively warm winter, but tripled to more than $3 in August 1999, due both to a demand for cooling energy and the buildup of gas stores for the winter. By late November 1999, natural gas prices were down to $1.99, a one-third drop. Then, in just a year, gas prices skyrocketed to an unbelievable $10.50 per Mcf in December 2000—a more than 500 percent increase!
The same patterns hold true for farmers—any type of farmer. (See Exhibit 34.) Agricultural prices are subject to unpredictable and uncontrollable events—the development of more cropland in other countries, drought, flood, insect plagues and hurricanes. In a world market, events on the other side of the globe can affect farmers in Texas. If Australian farmers produce a bumper crop of wheat, U.S. wheat prices will suffer in response. Even if a farmer’s crop survives weather and pests during the growing production season, its value—and the farmer’s income—can easily be slashed by a price drop. By the same token, widespread crop losses can contribute to lower world supplies and raise prices for farmers elsewhere.
The volatile nature of the oil and gas industry and agricultural commodities that underlies so much of Texas’ rural economy can spell disaster for counties that rely on these industries, especially Texas’ 65 farming-dependent and 30 mining-dependent counties—half of all rural counties. And it’s not just the farmers or the oil workers who feel the economic pinch when prices fall. The whole community suffers, as less money is spent for food, clothes and everything else. Devastation can come to some rural economies when both oil and gas and agriculture hit a trough at the same time.
Risk Management: Options for Agriculture
Both producers and purchasers of oil have used futures market trading for two decades to help manage price volatility. As the agricultural industry has evolved into a riskier global market, many farmers have looked to new ways to level out the agricultural price swings.
Many farmers use a variety of risk management tools such as supplemental off-farm employment, crop insurance, production and marketing contracts, diversification, as well as the futures and options contracts that have helped offset volatility in energy markets for more than two decades. No single approach suits all farmers. The size and type of their operations, their location and the consistency of their crop yields all play important roles in determining which forms of risk management farmers use to protect their incomes.
Bryce Myrick, director of Agricultural Marketing Education for the Texas Farm Bureau (TFB), regularly tours the state making presentations to Farm Bureau members on agricultural marketing strategies. He notes that age plays a role in farmers’ receptiveness to new risk management methods. According to Myrick, farmers between the ages of 35 and 50 are receptive to learning about and implementing new marketing strategies, while older farmers tend to resist change (the average Texas farmer is 56 years old, according to the 1997 Census of Agriculture).
With the passage of the 1996 federal farm bill, which was designed to reduce the government’s role in supporting agriculture, farmers increasingly are obligated to understand the markets in which they operate and the available risk management strategies.
Of the strategies mentioned above, off-farm employment, crop insurance and diversification are the most obvious and well-understood methods. According to the USDA, most farms, both large and small, report that they supplement their farm incomes with off-farm employment.
Crop insurance can protect against falling income and/or yields, preferably in combination with some type of price-risk protection, such as futures contracts. And farmers who diversify the commodities they produce stand a greater chance of offsetting losses in one area with profits in another.
Production and marketing contracts and futures and options contracts guarantee a future price for harvested commodities, but all include potential downsides. Production contracts allow farmers to shift the risk involved in running their operation, but limit their control of the production process. For instance, a farmer might agree to give another party the right to a significant say in how he produces his crops and actual ownership of the contracted commodity in exchange for help with production costs and an agreed-upon payment after harvest.
Marketing contracts also provide a set price for harvested commodities, but allow farmers more control in producing them. That is, the farmer manages the production of his crop, but sells it at an agreed-upon price before delivery time. In this situation, the farmer assumes more risk, because if his crops fail, he will be forced to make up the difference by obtaining the commodity on the open market.
Futures and options contracts can be traded on commodity prices, interest rates, foreign exchange rates, price indexes, crop yields, and even the weather. According to the USDA-ERS, “a futures contract is an agreement priced and entered on an exchange to trade at a specified future time a commodity or other asset with specified attributes.” The trades take place at commodity exchanges throughout the country, such as the Chicago Board of Trade and the Chicago Mercantile Exchange.
Futures can be purchased by anyone interested in buying them, whether they own a commodity or not. The market is made up of hedgers, or those who are selling a commodity at a future price, and speculators, those who agree to purchase commodities at a future price. Futures can benefit farmers by allowing them to offset potential losses in the open market with gains from the contract, and in essence “lock in” a floor price for their commodity. Usually, no actual transfer of individual commodities takes place between the buyers and sellers of futures and options contracts.
Two types of options can be purchased in the marketplace. One type is called a “put,” which give the purchaser the right but not the obligation to sell a commodity at a certain price. A good way to look at “puts” is as a premium on an insurance policy—farmers are in essence insuring themselves against low commodity prices.
The other type of option is called the “call,” which gives the purchaser the right but not the obligation to buy a commodity at a certain price. These can be viewed in the same light as earnest money on the future purchase of a home or car you would like the owner to hold for you until a certain point in time.
Purchasers of futures must pay commissions and put up significant amounts of equity when buying individual contracts. Before purchasing futures, farmers must determine if the risk reduction is worth the transaction cost.