“We’ve seen a halving in the number of UK dairy farms in the past ten years. This is a real problem.”
That’s Richard Counsell, entrepreneur and managing director of Stable, a business that aims to help farmers manage the impact of volatile commodity prices. In this conversation Richard shares how his background in software and farming provided the knowledge and insight to help farmers manage their risk.
Richard explains why giving traditional commodity futures markets are not equipped to really help ‘normal’ family farms in Europe and APAC manage risk effectively, but that having some form of risk management is crucial in giving farmer’s confidence to invest in new plant and machinery is so important. He shares how agricultural commodity prices are typically uncorrelated within a year and how providing this risk management is better delivered as insurance. Finally he explains why farming is potentially a great career opportunity of the future.
Stable is due to launch in early 2018. You can follow Richard on Twitter @richcounsell and Stable @stableprice. Also check out the resources on the bottom of this post that related to our conversation.
Richard Counsell (RC) “The first thing to say is that I am a farmer and so that is a massive advantage in terms of understanding what farmers are willing and able to take on board in this area. And as a kind of weird combination I previously built a software company in Chicago, and had this dual life of having a Somerset farming background. It was really the combination of this experience that came together really and the urgent need to do something to help family farms manage commodity price volatility.
But the agricultural sector in the US is very different from the UK isn’t it?
(RC) “When I sat down to have a beer with trader friends in Chicago and they explained futures and options it took me so long to get my head around it. How the hell would you ever transpose this into a European agricultural context where the farms are smaller and they don’t have this historical background in Futures and Options? I just kept thinking this is the wrong product for the wrong audience. Farmers aren’t traders, 90% of their time is spent worrying about yield and production. The opportunity cost of sitting down and wrapping your heads around derivatives is far too high for the vast majority of family-sized farmers.”
Agriculture in the UK and elsewhere in Europe is typically on a much smaller scale than in the US.
(RC) “Only 2.7% of farms are over 100 hectares in Europe. And then you go and talk to the risk management brokers and they say well unless you’ve got 400 hectares we won’t even pick up the phone. I totally get it from their perspective as it takes 2-3 months to get a farmer through the regulation side of things because of course farmers are regulated as retail clients and it’s not really worth their time and effort to get them through the process and even then it’s only really based around arable and there’s nothing there for the dairy or livestock farmers.”
Although futures markets have their historical routes in the US, as exchanges developed to help farmers manage risk, things have changed. Many farmers in the US complain that futures prices bear no resemblance to the underlying fundamentals, making it increasingly difficult to use futures markets for the purpose that they were originally intended.
(RC) “What I found fascinating when I was in America researching who uses futures, over 50% of the volume is short term speculation and so the basis risk is all over the place. If you are just trying to offset a bit of risk for your farm, it’s getting pretty complex with the levels of volatility that are going on. In 2015/16 the European press and politicians were saying futures exchanges are the answer but when you were over there and talked to normal sized farmers, they were telling me ‘don’t get your hopes up as it’s not a panacea.’ There’s some real problems here, because it’s changed from a simple risk transfer process into much more about short term speculation. To my mind it felt like it was shifting away from its historical roots and the real problem is was set up to solve.
So the challenge was to think how on earth could we offer an alternative and what would that look like? Because of my US software background, I was lucky enough to be able to call on some academic contacts from Harvard and University of Wellington in New Zealand and together we built a very simple options exchange, thinking it was perhaps the user experience that was the problem. But six months of development later and we started showing it to farmers and getting their feedback on what was effectively an agri-focused prediction market. It worked simply by asking a farmer, ‘Will the price of wheat be over £140 per tonne in September 2018?’ The farmer could just answer yes or no and then buy yes shares or no shares. I liked it because it had a very simple user experience, but in reality you are still asking the farmer to calculate the probability of a rise or fall…That was already too much.
At this point in the R&D I was doing talk at farming events all over the country and one speech that I did up in the Cotswolds was a real turning point for the initiative. I thought I was talking in pretty simple terms , but still using the language and terms of derivatives (i.e. puts, strikes) and it was honestly one of the most painful speeches I’ve ever given. Towards the end, one farmer stood up and said, ‘can I just ask one question…are you actually talking about me insuring my milk price?’ It was at that moment that I was like yes, yes it’s just insurance for your milk instead of your tractor. Then they all went, we totally get it, why didn’t you just explain it was insurance?” A lesson learned!
Sometimes it’s about breaking it down into a language that the audience is familiar with.
(RC) “It’s true, every word really really matters especially when you are in education mode and actually I would be a very old man before I educated British farmers about derivatives. Not because it’s too complex; farmers are some of the smartest people I know, just because the opportunity cost for busy farmers to learn about it is just too high. Crucially as well, we wanted to work with organisations that already had an existing financial relationship with farmers. The banks for example, have as much to gain from price insurance as the farmers as we make the farmers more creditworthy. The other benefit of selling insurance, is that 3rd parties can’t easily recommend a derivative product to a ‘retail’ farmer, as it’s got car crash written all over it. But with insurance you are suddenly back in the game of normal day to day business instead of having to get involved in all of the financial regulations and far more professionals can recommend a farmer comes to talk to us.
At this stage the Stable initiative was in an awkward position. The farmers were telling us that it had to be ‘real’ insurance and Insurance companies were rightly saying ‘commodities are systemic, you can’t insure systemic risk’. To overcome this I started researching new areas of insurance that might throw us a lifeline…areas such as Cat Bonds and Insurance Linked Securities for example. To help steer through this complex area, I turned once again to academia to help me make sense of it all.
I was introduced to Professor Hirbod Assa at Liverpool University. He works at the world renowned Institute of Financial and Actuarial Mathematics and they were like Rich you are onto something and it could potentially have huge impact. After over a year of collaborating with many of their academics, we figured out a ground breaking way to deal with the issue of systemic risk. The eventual solution was inspired by the A.G. Street adage, ‘Up corn, down horn’. Traditionally all farms were mixed and so farmers knew that if one crop tanked another would do well and so they were protected from large fluctuations in income. But as farms have increasingly specialised to seek economies of scale, that diversification benefit has largely been lost.
I challenged Liverpool to see if that phrase ‘Up corn, down horn’ is true, using the latest data science available i.e machine learning. To build an efficient platform, we needed to use an index, which meant we didn’t need to have an expensive claims process that would make the end product too expensive. As a farmer I pay a levy to the AHDB to collect pricing data on all the commodities that British farmers produce. And that valuable data just sits there and hardly anyone uses it. So then Liverpool University and our growing team of Quants and developers got stuck into the data and we ended up building a very sophisticated model and data driven platform that both forecasts prices for the individual commodities using a suite of sophisticated algorithms and then dynamically allocates capital across all the commodities in real time. In the UK alone we do 10^60 simulations and we’re rolling out to another 12 countries so you can start to see the size of the data science aspect of what we’ve built.
Instead of having to monitor a Bloomberg screen, we’ve essentially replaced that with three simple questions for a farmer to answer: ‘How much do you want to insure?’ i.e. 10 tonnes. ’How long do you want protection?’ i.e 1 year and finally ‘What price do you want protection from?’
The system generates a premium for the farmer and they can either accept or reject it, just like insuring your car (or perhaps tractor)!
But grain and other agricultural markets have been especially calm over recent years. Is there a risk that the premiums may not accurately cover the risk of an escalation in volatility?
(RC) “It’s not like trading on the markets with prices that change every day. We take the monthly calendar average from the AHDB prices, and it’s much less volatile than futures markets. As a farmer I’m much happier to use a monthly average so I don’t need to keep checking the position instead of doing my real job on the farm.
To reduce our risk the system also dynamically allocates capital. Say we had too many wheat farmers using the system; we would manage the availability of wheat insurance until sheep farmers, sugar or palm oil farmers joined. It’s an enormous correlation exercise. Put in the context of ‘Up corn down horn’ we’re acting like the world’s largest mixed farmer to hedge our own risk! There is almost no correlation between the price of Portuguese strawberries and Welsh lamb for example. The other challenge is from a regulation point of view we have to work very hard to ensure that only real farmers can participate and they can’t insure more than their farm could possibly produce for example.”
Having lots of uncorrelated markets to insure against is a potential goldmine for insurers, right?
(RC) Stable can offer risk that is very uncorrelated with cars, property etc., but what’s unique is that we also have our own real time portfolio management going on within Stable too. That’s what’s so attractive to underwriters and why many of them have offered to invest in us as well as support us with risk capital.”
People naturally tend to think about topping up their insurance only after the earthquake hits, or after the house burns down. Does the agricultural sector need a shock to the system before farmers want to buy?
(RC) That’s a clever question. While we’re educating farmers, there is a risk that some only think about ‘hedging’ when prices may have already fallen. And of course you’re right, demand will change throughout the cycle. Let’s say that demand in the UK is currently dominated by wheat and dairy. We can manage that, because we are working with lots of other products in lots of other countries.
Farmers don’t just face price risk, they also face income risk as well that ultimately hits their bottom line.
(RC)” Absolutely, and covering both price and cost risk is something I’ve always wanted to do. Next year we will also help the farmer insure against an unexpected increase in fertiliser prices or feed for example.
We’re also getting lots of approaches from food manufacturers [looking to hedge their input costs]. And many of them were like we don’t understand it [derivatives] either. We built Stable focused on making it simple for farmers, but along the way I realised that there are a lot more people in the supply chain that are confused about derivatives, than get it.”
Agricultural productivity is woeful. Many of the Baby Boomers that still own and operate farms both in the US and in Europe are reluctant to invest in new technology that would help them increase their yields and return on investment.
(RC) I believe this is totally solvable if inventors and developers rigorously focus on the economic case for their new invention or application. Building software is easy- solving a real problem is hard. If you can make it practical and show that it will clearly increase profits within a reasonable time period, then farmers will respond. “I meet many really smart developers who are developing clever tech that stacks up in the lab, but not in a field. The best thing they could do is close the laptop and pull on a pair of wellies! If the farmer doesn’t know where his revenue will be in 12 months-time, that’s a big barrier to investing in new technology to increase productivity.”
So what is the future for the agricultural sector? My son is 7 years old; would you recommend a career in farming for him in 10-15 years-time?
(RC) “I genuinely think it’s a very exciting sector to be a part of. All of this new technology is coming through and farming will be transformed in the next 5-10 years. It’s a really exciting place to be in right now. What’s really noticeable is that the sector is attracting some really bright people that see the potential to make a real impact in surely the most important industry in the world.”
Risk management schemes in EU agriculture: Dealing with risk and volatility https://ec.europa.eu/agriculture/sites/agriculture/files/markets-and-prices/market-briefs/pdf/12_en.pdf