The predominant academic belief is that all sectors of the agricultural industry will efficiently allocate supply and demand for the long term. The theory suggests that, once all information is known, the price will reach equilibrium. Essentially, no profit or loss will exist at this point.
As producers, we know that operating at break-even in a competitive economy will eventually lead to the poorhouse. Break-even exists in the pure economic model, but it seems that in the real world the odds are much higher that producers will spend more time below break-even than above. That is why I believe agriculture cannot make exceptional profits for any length of time before supply increases and demand is rationed.
The problem with the efficient market theory is that it cannot explain price bubbles that last for an extended time period (for example, 2008 to 2011). Sometimes, the theories of Adam Smith (generally known as the father of economics), which suggest that a rational decision maker will always put his money where it can make the most return, do break down.
The storm clouds will come. This gives rise to new lines of economic thought that suggest there are periods when those acting in their own (economic) self-interest eventually make irrational decisions, leading to a disequilibrium in the markets. Examples include the housing bubble, where banks had money (from China) to loan and the government was pressuring home ownership. As a result, home values increased. At its peak, everyone thought home values could not go down and that anyone not buying into the housing boom was a fool. As we all know, it was hard to see the storm clouds developing during the bubble; but after the bubble burst, it was pretty obvious.
Corn, soybean and wheat values, and now cattle and hogs, have been in an exceptional profit bubble since 2008. Except for 2009, we have seen three of the highest profit years in history for corn and soybean producers. This is now leading to an increase in land costs, cash rents, equipment costs and just about every item associated with the producing crops.
What are the dangers ahead? I believe debt or leverage is one of the basic building blocks of a bubble. When too many people with too much money are chasing the bull, the market tends to overreach. After the crest, it is a big scramble to see who can reach the exit first. We could possibly see a repeat of the 1968 to 1980 price range. Lest we forget, a period of excess profit eventually leads to the 1980s, when costs were too high to the revenue side and producers came under tremendous financial pressure.
China isn’t the answer. The bulls will argue that today everything is different and it can never happen again. We have ethanol and China on the demand side for corn and soybeans, and supply simply cannot keep up. Granted, the demand growth during the past 10 years has no historical comparison. I will also agree that China, while it wants to increase its hog production to feed its people, does not want to become dependent on U.S. corn like we are addicted to Mideast oil for our energy.
As end users, the Chinese got a strong dose of what high priced corn, soybeans and wheat taste like, and they didn’t like it. Already they are making strong steps to diversify their feed source. I see two efforts. Chinese government officials are desperately trying to keep domestic prices high in order to encourage domestic producers to implement better production methods to increase yields. Since their corn and soybean output is way behind that of the U.S., they know they have room for much improvement. They are also increasing their involvement to help improve wheat production in the Black Sea region and parts of the old Russian Empire near their border. This is simply good economics; it gives them feed diversification and it puts hard currency in the pockets of their neighbors so they can consume more of the products the Chinese manufacture.
Yes, because of China and other countries demand will remain strong, but the exceptionally strong growth rate of the past 10 years will be difficult to match. Any slowdown in the global economic system could result in a negative imbalance in the global supply and demand situation.
I believe that, with two exceptionally profitable years behind us, producers are in good shape to increase corn and soybean acres this year. While stocks should be exceptionally tight into summer, the complete opposite pattern could be seen in the last half of the year, having a dramatic impact on carrying charges, spreads and storage decisions.
Numbers can lie. Because of a strong belief that the corn and soybean markets operate in an efficient manner, the pursuit of fundamental analysis has prevailed for most analysts and producers. That’s why so many farmers try to predict planted acres, yields and weather. This is why big companies and end users spend millions on data collection to get that edge before the public.
Producers trading strictly fundamentally often act on a perceived outcome. Essentially, they believe that by participating in the market they can influence future predictability and random events.
Then there are those who study past chart patterns under specific situations for a living. The problem with technical analysis is that it’s not an absolute science. Two people can look at the same chart and one sees the glass half full while the other sees it half empty. It all comes down to each individual’s viewpoint of the market. In other words, it is not reality that is important; it is the perception of reality.
Sell and defend. This leads me directly to why I attempt to get producers to accept the strategy of selling and defending rather than trading and guessing. If they figure their basic production cost and come up with a target selling price, they know what they want/need from the market.
Once the market exceeds profit levels, they can start implementing a selling program depending on their ability to handle cash flow, time commitment and fundamental and technical biases. Once the selling decision is made, it’s best to have a back door if the market starts to exhibit irrational behavior. This is why I believe a put strategy of limited risk is more sound than the all-or-nothing approach of being net short cash or futures that many attempt to implement and fail to carry out when things get tough.
- February 2012