Don't Look Back

July 26, 2011 09:09 PM
Don't Look Back

A 1970s crash isn’t likely, but volatility is the new norm.

Farmers welcome tight stocks and sky-high crop prices, but the situation raises a troubling question: When will it all come crashing down? Those who lived through the farm crisis of the late 1970s and early 1980s, or know someone who did, can’t help but wonder if the good times will be followed by a financial blow.

Good News. Most analysts predict the walls won’t come tumbling down, at least on average, and
that the likelihood of the industry experiencing a repeat of the farm crisis of 30 years ago is slim.

Robert Thompson, professor emeritus of ag economics at the University of Illinois, believes
present-day agriculture has very little in common with the 1970s. Today there’s a population boom as well as an incredible growth in demand in the developing world that wasn’t there in the 1970s—in particular, a rising middle class that desires more meat, milk and eggs. There’s also ethanol, which today consumes 39% of U.S. corn production.

In recent years, Thompson adds, production has increased and the price hasn’t collapsed; in fact, it’s gone the other way. Look for crop and livestock profits to remain strong for the next decade, he says.

Thompson and a number of other analysts are turning bullish based on three key factors: rapid upticks in global food demand, growth prospects for the world economy and the fact that more grain is being used for fuel.

It’s mind-boggling, but by 2025, just 14 years from now, the world will have the equivalent of another China in population.

farm level prices"This is a bright opportunity for the U.S.," Thompson says. "We have the best soils in the world. The only two other areas with comparably good soils are the Ukraine and Argentina. The Ukraine is still acting a lot like it did under Communist rule, at least in terms of agriculture, and Argentina taxes ag exports 25% or more and at times bans them outright."

Sub-Saharan Africa has potential, but many governments there are unstable and have underinvested in rural roads and ag research, Thompson adds.

Price Points. All told, demand is likely to increase faster than supply, which means strong prices.
"It used to be the baseline for corn was $2.50 per bushel. We’re not going back there," says Bruce Scherr, chairman of the board and CEO of Informa Economics Inc., in Memphis, Tenn. While he does not see long-term corn prices averaging $8 per bushel, he believes $4.50 per bushel corn for the next decade is realistic.

While current prices cannot likely be maintained long-term, Iowa State University economist Chad Hart thinks corn prices will be very strong in the next two years, then settle out in the $4 range and be above $10 for soybeans. By 2014/15, he sees corn prices in the upper $4, low $5 range, and $10 to $11 per bushel soybeans.

Some are even more optimistic on the numbers. The Food and Agricul-tural Policy Research Institute (FAPRI) at the University of Missouri predicts an average corn price of $4.80 per bushel during the next decade, with a low of $4.66 in the 2013/14 marketing year and highs above $5 in 2011/12. FAPRI forecasts an average soybean price of $11.68 until 2020 and $5.59 for wheat. Cotton prices should remain relatively stable at 76¢ per pound farm price.

USDA is slightly more conservative, though still bullish, in its long-range outlook. In its forecast
to 2020, the department calls for an average corn price of $4.36, soybeans $11.43, wheat $5.64 and cotton 73¢.

The view that strong world commodity prices are here to stay is not shared by all economists. "There is a tendency to think that price spikes are the new world order, but history is very pessimistic of that," says Will Martin, chief economist for the World Bank.

High prices could bring a lot of capacity not only in the U.S. but around the world, says Purdue University economist Brent Gloy. "Supply and demand still rule, and while higher prices are possible, though not likely, so is $2.50 corn."

Because of that, he thinks it makes the most sense during the gift right now of higher prices for producers to get production costs as low as possible.

"I don’t know what will happen on prices and so many things could affect them, but I do know that producers who get their costs under control will be OK. Corn at $4, $3, or even $2 is not impossible," he says. Things can happen, such as a downturn in demand, a slowdown in economic growth or a reduction in biofuels, he adds.

Price Stimulus. It’s important to remember that "black swan" events, such as Japan’s earthquake and meltdown situation, always have the opportunity to reduce U.S. exports and change the price outlook. Short-term events, such as a spike in oil prices, floods and droughts, impact near-term outlooks, but USDA’s long-term forecast appears solid, says David Stallings, senior economist at USDA’s World Agricultural Outlook Board.

Besides the growth of the global middle class, one reason Stallings is bullish on demand for U.S. grains and oilseeds is that he sees modest appreciation of the U.S. dollar against other currencies in the decade ahead. This will make U.S. goods attractive to other nations. Another factor contributing to export growth is successful free-trade negotiations that were not in play 20 years ago, Stallings says.

He disagrees, however, with those who see high levels of volatility to be a perennial problem moving forward. Stallings sees a real possibility of volatile prices during the next two or three years because grain stock levels are so low, but as higher prices stimulate more crop production, he thinks, price volatility will possibly narrow thereafter, even as prices continue strong.

Ohio State University economist Carl Zulauf notes that part of the recent runup in commodity prices was due to global grain production problems. "Many of these problems have been relatively small, but cumulatively they have meant that the worldwide supply has not increased as much as one might expect," he says. "The one recent exception to small problems is the large reduction of 2010 wheat and barley production due to drought in the former Soviet Union countries."

In the intermediate period, Zulauf says, the question becomes whether yield growth can be fast enough to meet the increase from both food and nonfood sources, and whether demand growth is curtailed for some reason. "History suggests not to underestimate the long-term impact of yield growth on the supply-demand balance, and thus not to underestimate the potential for lower prices over time," he says.

A New Normal. FAPRI director Patrick Westhoff doesn’t think $3 corn is very likely. However, he notes that FAPRI’s econometric model forecasts a 10% chance of corn below $3.50 and a 10% chance of corn above $6. What this says to him, as well as to others, is that the odds are good for a high level of volatility in the years ahead, which puts a premium on the ability of farmers to manage risk.

"As we’ve seen in the past 12 months, there has been $4 corn and $8 corn. If we have a production problem this year, we will find out how high ‘high’ is," Westhoff says.

Iowa State’s Hart sees major waves every 30 years in which prices settle higher. Prior to 1972, it was $1.25 for corn; from 1972 to 2006, it was $2.50. "Today, moving forward," he says, we’re looking at $4."

Hart does not see much impact on prices even if agricultural policy changes because federal payments have a much smaller per-acre impact than they used to have.

"The one big wild card would be the development of cellulosic ethanol based on crop residue or some other feedstock that would reduce the demand for corn-based ethanol," Hart says. With ethanol such a huge demand pull on corn, that would alter his outlook. He is not predicting that, but says it’s by no means impossible. Though unlikely, another possible major impact would be a change in ethanol policy that would reduce corn used.

In the long run, producers need to keep in mind that population growth is slowing down and is expected to max out at around 9.5 billion after 2050, professor emeritus Thompson says. Yet poverty has been declining and the middle class is growing in developing nations at unprecedented rates—even through the recent global financial crisis. This will cause demand of feedgrains and oilseeds to keep growing, adding to crop price pressure. Risk management will be more important, not less.

Farm Financial Picture Now Versus Then

Several factors separate today from the go-go years of the late 1970s and early 1980s, says Steve Iversen, executive vice president of FCS Financial in Jefferson City, Mo. First, farmers today are far less leveraged, despite the runup in land values, due to wanting more equity versus debt in their businesses, as well as tougher lending standards.

net farm incomeIn addition, farmers, particularly grain farmers, are coming off several strong years of profits and that puts them in a position of having real staying power.

Another factor that separates today from the 1970s is the high number of producers who have switched to fixed-rate financing, which protects from a rise in interest rates.

Producers also are protecting themselves more today by using risk mitigation tools. "Twenty years ago, probably just one-third of crop producers used federal crop insurance, leaving them vulnerable. Today, 85% use it," Iversen says.

Key on the banking side is the fact that in the early 1980s, interest rates peaked at 22%, with inflation of 16%, says Bruce Scherr, chairman of the board and CEO of Informa Economics Inc. That soaked up a lot of cash flow. Today, of course, short-term interest rates and inflation are both very low, and neither give an indication of rising substantially anytime soon. —Ed Clark

Livestock Outlook

The profitability for livestock producers until 2020 is remarkably robust, particularly in light of the expectation of strong grain prices. Reasonable income growth and a U.S. dollar that doesn’t appreciate are key reasons, says Scott Brown, economist with the Food and Agricultural Policy Research Institute (FAPRI) at the University of Missouri.

Aiding pork in particular, beef and dairy producers will be strong exporters due to the weak dollar and rising incomes in developing economies. Also, on the supply side of meats, the U.S. is in much better shape to handle high feed costs, Brown says. Dairy, how-ever, still has some supply adjustments to work through, he adds. This will occur as supplies are cut by producers in regions distant from feed sources.

"Overall, the livestock outlook is pretty optimistic," Brown says. Volatility will continue to be the norm; thus it’s important for producers to put risk mitigation strategies in place. For some, that will be using futures and options; for others, margin insurance, he says.

Brown sees pork demand (both domestic and foreign) increasing by 1% to 2% per year for the next decade; beef demand by 0.5%; and slight increases for dairy.

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