A Prerequisite to a Profitable Agricultural Enterprise in the 21st Century
Joseph B. Dial
Commodity Futures Trading Commission
Texas Farm Bureau State Convention
December 2, 1996
Being in San Antonio is always a treat for me. I lived here for four years when I attended high school at Texas Military Institute (TMI). Part of my family and many of my friends reside in the Alamo city.
I joined the Texas Farm Bureau in 1962 and always feel at home when I am with other members of this great association. It is thus a signal honor for me to speak to such a special group of fellow Texans. It is also a great privilege to share the podium with Dr. Carl Anderson. Dr. Anderson is an expert on cotton, marketing strategies. A classic example of his good work can be found in an outstanding TAMU educational program called "Risk Management for Crop Production."
The title of my presentation is Business Management, a Prerequisite to a Profitable Agricultural Enterprise in the 21st Century. To understand the basis for this statement, we need first to examine the radical changes that are reshaping global agriculture as we know it today. As a result of these paradigm shifts, farmers in the U.S., and around the world for that matter, are finding themselves in a new era in agriculture. This new environment will require many farmers to change their attitudes and behaviors in order to become business specialists in production agriculture. In the remainder of my remarks, I will present some ideas on change and then close with comments on agricultural risk management.
A New Era for Agriculture
As you all know the FAIR Act has lifted production controls and is gradually phasing out price supports for many agricultural commodities. Supposedly, in the future the government will not intervene in the open market and try to stabilize commodity prices. Nor will USDA be handing out any more deficiency payment checks. Instead, progressively lower transition payments will function as a price support mechanism for six more years. Then you are on your own. Furthermore, Congressional ratification of the GATT and NAFTA trade agreements has set the stage for incremental removal of protectionist tariffs and non-tariff trade barriers. All of this adds up to a major departure from government farm policy of the past 60 years.
As result of this market-oriented new direction in public policy for US agriculture, two things will happen. One, the federal financial safety-net will soon be gone and farmers will have to manage their production and price risks themselves. Two, the protectionist trade wall will come down and the competition between U.S. growers and producers in other parts of the world will intensify.
This change in U.S. farm policy, from government control to a new market-based freedom to farm, is being matched in other countries too. Three years ago I was invited by officials of the United Nations Conference on Trade and Development (UNCTAD) to serve on their Group of Experts. This advisory panel to the Committee on Commodities met in Geneva, Switzerland for three days. We were asked to prepare a road map to the future that governments could use to facilitate farmers' use of private sector tools to manage their risks. Even back in 1993 there was an awareness that deficit reduction was a must, and governments around the world would need to gradually move producers toward relying more and more on the market.
In my opinion, these shifts in government policy will also increase the likelihood of greater volatility in future feed and food grain prices than we have experienced in the past. Granted, prices for farm products that go from mountain top highs to Dead Sea lows are nothing new to agriculture. However, what I'm talking about is not just high-high or low-low prices, but the volatility that occurs in between when we have a demand driven market like the one we had in corn this year.
Another factor that may exacerbate the volatility in grain prices is that taxpayers no longer seem to be willing to pay the enormous cost of large reserve stocks. Likewise, producers, elevators, and processors are reluctant to incur carrying charges on grain storage unless they are convinced prices will go up. As a result of these pocket-book decisions, we may find ourselves in the future with lower levels of year-to-year carry-over stocks. The resulting tighter supply situation may become the launching pad for a short crop, demand driven market, which is usually a harbinger of considerable volatility.
Allow me to make my point one more time. In the new era of agriculture in the 21st century there will be no government price supports, little if any trade protection from foreign competition and unprecedented agricultural commodity price volatility.
For farmers, these realities are what Steven Covey, author of the "Seven Habits of Highly Effective People," would call their "circle of concern" -- situations people worry about but can't change. For some that may be the bad news. On the other hand, the good news about this scenario is what Covey refers to as peoples' "circle of influence" -- things they do have some power to control. And that brings us to the second part of my presentation.
Changing attitudes and behaviors in order to become a business specialist in production agriculture
Will Rogers once said, "Even if you are on the right track you will get run over if you just sit there." For decades producers have considered they were on the right track by concentrating almost exclusively on the production phase of farming. This behavior was in part predicated on the perception that the government was doing most of the marketing and risk management, so why should growers worry about it Besides, farmers would much rather be out in the field, or in the machine shop than sitting at a computer developing a marketing program or keeping the financial records necessary to figure their cost of production per unit -- both of which, by the way, are prerequisites to managing risk.
True enough, operating and repairing farm equipment is where it all begins. But that will only take you so far. In fact, if you just sit there, you are increasing the risk of being run over and flattened financially by bad weather and low prices. When that happens, all your efforts on the production side will be for naught. Some producers will go broke and others at best, will spend years trying to dig their way out of a deep financial hole.
To keep this from happening to you, make the computer a piece of farm equipment that is just as important as the tractor. Many of you are doing just that, others are well on their way -- and some of you are shaking your heads in disbelief.
Why make the computer so important? Because it is the gateway to knowledge and knowledge is power. How do you become computer literate, or if you already are, how do you harness the immense capabilities of this tool? Make continuing education one of your top priorities. Search for an educational program that allows you to control the pace and direction of learning. One that uses terms you understand and then puts you through simulations that let you make mistakes. The more decisions you make through this process the better you will get. Continuing education is within your "circle of influence" -- it is something you have the power to control.
In order to illustrate my point, let me briefly tell you about some farmers that have used education in business, and experience in farming, as tools to build financial success.
The Clark family, Jerry Don, Sr., Jerry Don, Jr. and Tommy, of Jonesboro, Arkansas certainly know how to produce crops - - it's an 80 year old family tradition. But that is not the whole story. The rest of the story is that they have found the right combination of business management skills and modern farming techniques. Jerry Don, Sr. has 40 years of hands-on experience raising crops. Jerry Don, Jr. has a masters degree in agricultural economics and was an Extension farm management specialist for five years. Tommy majored in marketing.
As business specialists in production agriculture, the Clarks do a good job of managing their yield and price risks. They have intentionally limited the number of acres under cultivation in order to pay close personal attention to every detail of planting, growing and harvesting their crops. This management technique, along with combining irrigated and dryland farming, reduces their yield risk. They deal with price risk by knowing the break-even cost of each crop. That way they don't have to chase prices. Instead, when they can lock in a profit by using put options, they do it. What is the payoff for this type of operation? The Clarks have doubled their net worth in just five years and recently won $10,000 worth of DeKalb seed by capturing the grand prize in the 1996 Farm Futures Magazine Best Managed Farms Contest.
For those of you who were thinking, that's great but there are three of them, let me tell you about Kevin and Lori Green of Greenview Farms in DeWitt, Iowa. This husband and wife team own the 20 acres around their house and that's it. Yet they farm 2,750 acres and have achieved as high as a 35 percent return on equity. These business specialists in production agriculture keep meticulous financial records . Lori uses a computer to keep track of every penny of income and expenses. They definitely know their break-even cost.
Kevin graduated from the University of Iowa with a degree in business administration and has continued to improve his business management skills. For the last 15 years the Greens have budgeted $2 an acre for marketing information and education. Using forward contracts and futures Kevin delivers 100 percent of his production out of the field. He has a written marketing plan with specific goals that secure profits. He doesn't speculate. Rather, he uses discipline and pulls the trigger when his plan tells him to.
On the production side, Kevin and Lori use grid soil testing and a combine equipped with a factory installed yield monitor and a global positioning satellite system. By combining modern farming techniques with astute business practices, the Greens have consistently stayed on the profit side of the ledger. And, by the way, they won the 1995 grand prize in the Farm Futures Magazine Best Managed Farms Contest.
Managing Agricultural Production and Price Risks
As we move through the rest of this decade and into the 21st century, you will have more and more opportunities to apply different strategies to manage your production and price risks. Some of them will be prudent and others will be speculative.
As a business specialist in production agriculture, you will have a written marketing program, that includes a prudent risk management plan. That practice, along with some common sense rules I will mention later, should guide you away from speculation.
The first and most important decision in this process is: how much yield and price risk can you afford to self-insure and how much do you need to transfer to others? Put another way, how deep are your pockets? How much of your net worth and sweat equity do you want to put on the line? And how much of your banker's money is he willing to let you put at risk? Over the years, how often has the weather caused you to lose a portion or all of your crop?
You can't even begin to make this crucial decision unless you have detailed production and financial records -- balance sheet, cash flow statement, and a break-even on the crops you produce. Now I know that today there are farmers with these kinds of records and they still don't give a second thought to analyzing their production and price risks.
That strategy didn't work all that well back when we had ad hoc disaster and deficiency payments. It is a wreck looking for a place to happen without those government checks and in the face of highly volatile markets. The reason I say that strategy hasn't worked in the past is because, according to USDA, 78.5 percent of the farmers in this country can't support their families on farm income alone.
After you decide how much to self-insure, you will have to determine which methodology to use to transfer the risks you don't want to take. Among your choices will be revenue insurance, revenue assurance or price protection only. Although many of the contracts that come under these three approaches are in an evolutionary process -- changing to meet farmers' needs -- let me briefly describe the basic categories themselves.
Revenue insurance protects you against poor yields and low prices. Under this arrangement you are guaranteed revenue. There are a number of private crop insurance companies that offer this type of risk management contract under the name, Crop Revenue Coverage (CRC). At the present time I don't think it is available in Texas. It may be available next year. However, you can come close to duplicating CRC by buying MPCI, adding a "replacement cost" rider to it and purchasing a put option on a futures contract.
The Federal Crop Insurance Corporation has a revenue insurance product called the Crop Income Protection Plan (CIPP). It may also be sold in Texas in 1997, but I have been told a final decision hasn't been made at this time.
The second choice is revenue assurance. Producers can use this type of contract to overcome low yields and/or prices and achieve a guaranteed level of revenue. This approach involves an input vendor who will pay part of the producer's premium cost to secure revenue, or in some instances the company will enter into a contractual arrangement with the producer that will guarantee revenue on a per acre basis. Revenue assurance is an evolving risk management tool. Its genesis is found in the need for the private sector to fill the gap left by a reduction in the government financial safety net.
The third approach is price protection only. This is probably the most widely used methodology. However, there is anecdotal evidence that less than 50 percent of U.S. farmers use any risk management strategy at all. Price protection may generate income but it does not guarantee revenue because it doesn't cover crop losses. You can initiate price protection by using futures, options, cash and forward contracts, or in some instances, over-the- counter derivatives. A true hedge position is a prudent way to use a price protection strategy alone. Otherwise there may be a temptation to try to outguess the market and speculate.
Let me close with the common sense guides to managing your production and price risks that I promised earlier. First, past performance is no guarantee of future success. Second, waiting to sell at the top of the market means you won't. Third, if something sounds too good to be true, then it probably is. And fourth, explain the risk management strategy you are considering to your spouse or partner -- and if they can't explain it back to you so that it makes sense, then you better think twice before you do it.
I know that to many of you farming is a way of life. It is in your blood. You are a soul mate of the soil, and being a producer fosters the independent spirit we all hold so dear. I'm not suggesting you give that up. On the contrary, I believe you can still hold on to that way of life.
But just remember, "doing things right" -- being a good farmer -- no longer guarantees success. "Doing the right thing" -- becoming a business specialist in production agriculture -- is a prerequisite to profitability in the new era of agriculture.