There’s an excellent article on risk and underestimating risk in the online version of the New York Times Magazine that I think every farmer could benefit from. It’s not about farming. It’s about the BP oil spill in the Gulf of Mexico. But its central point is directly relevant crop and livestock hedging:
“. . . there also appears to have been another factor, one more universally human, at work. The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely – and may even have been unlikely – but that would bring enormous costs. Perhaps the easiest way to see this is to consider what BP executives must be thinking today. Surely given the expense of clean-up and the hit to BP’s reputation, the executives wish they could go back and spend the extra money to make Deepwater Horizon safer. That they did not suggests that they figured the rig would be fine as it was. For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does . . . We make two basic – and opposite – types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them.”
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Go see the article at http://www.nytimes.com/2010/06/06/magazine/06fob-wwln-t.html?ref=magazine
The reason I am thinking about this in relation to crop and livestock prices is that I’ve seen a number of periods in the past couple of decades when prices have crashed and farmers have been wiped out. Each time everyone has been bewildered by the size of the crash. In 1998 I remember the widespread devastation when hog prices almost completely collapsed, falling far, far beneath what any farmer or analyst could have predicted. The same applied to the hog price slump that we have just crawled out of: no one was predicting a third year of low prices a little over a year ago. The hog cycle tends to have a year or two at the most of loss-making prices before recovering. When the market suddenly turned down a year ago – due in part to H1N1’s appearance – it was like a bolt of lightning out of a clear blue sky, electrocuting producers’ reasonable assumptions of recovery.
So on the one hand, in both of these price slumps, it seems reasonable to have been unprepared for the totally unexpected. But that’s the point of the passage from the NYT article above, and the main point of the work of Nassim Nicholas Taleb, who wrote the influential book The Black Swan: you need to be unprepared for the totally unexpected or you’re running a huge risk. As former U.S. defence secretary Donald Rumsfeld once famously said, there are known knowns, known unknowns, and unknown unknowns. I think Taleb’s point is that it is reckless to ignore the unknown unknown just because you don’t know what it is.
Where this comes into crop and livestock price hedging is in highlighting the need for hedging regardless of the outlook. Some sort of downside price protection is essential even when everything looks ducky. Manitoba Pork Marketing Coop people pointed out to me last year that profitable or break-even prices were available a number of times in the past three years through their various programs, yet most producers didn’t like the idea of locking in or paying for the right to take “low” prices when the outlook was for higher prices. But when prices went lower instead, many of the unhedged hog producers went out of business. (I’m not talking about weanling producers hurt by Country of Origin Labelling. That’s a unique situation.)
It was the same situation in 1998. I remember horrifying a hog producer who was complaining about near-zero prices for his market hogs whether he’d used futures contracts or other methods of hedging against situations like the one he was in. “I don’t speculate,” he said, defiantly.
That’s like the BP executives not “speculating” on a well blow-out by not preparing for it, which is what they appear to have done, and which is now likely to cost them billions of dollars. If speculating on risk means thinking about downside risks and establishing more protection from unexpected calamities, then we all need to do a bit more speculating.
