"Examining the Current Policy Environment and It's Impact on Agri-Market Strategies"
Commissioner Joseph B. Dial
Commodity Futures Trading Commission
AGRICULTURAL RISK MANAGEMENT CONFERENCE
Sponsored by ICM MARKETING
January 28, 1997
I am delighted to be with you this morning. Call it nostalgia if you like, but I brought with me the printed transcript of the " Forum on Futures and Options Education Programs for American Farmers and Ranchers," held here in Chicago on January 24, 1992. I convened that forum with the assistance of the American Farm Bureau Federation and Bill Tierney of Kansas State, who served as moderator. Nearly 50 participants, representing a broad cross-section of U.S. agriculture, participated in that day-long conference.
On that January day five years ago, the many speakers at the forum described various programs they were involved with to educate farmers about risk management. Notwithstanding all their efforts to teach producers how to transfer production and price risks, the speakers found that most growers simply were not interested. At the time, it was estimated that only about ten percent of the two million producers in the U.S. were doing anything at all to manage their risks.
At the end of the day-long event, I thanked Bill for the excellent job he had done. He responded that the day's activities had been informative, but that he'd participated in similar exercises before and not much, if anything, ever came out of them.
As I flew back to Washington that evening, I made up my mind that something substantive would come out of the meeting we had just concluded. Although it has taken five years, and a major change in farm legislation, an increasing number of public and private sector organizations have now become active in offering risk management education to producers - and producers have become much more receptive to these efforts. These changes in the amount of training being offered, and the positive response by growers, have evolved primarily because of the FAIR Act. That far-sighted legislation has created a compelling economic incentive for growers to learn how to transfer the risks inherent in farming. As a result, we have at hand a unique window of opportunity -- a "teachable moment" -- wherein farmers recognize the financial benefit of learning how to manage their business risks.
You just heard the thought-provoking opening remarks by our conference Chairman, Frank Beurskens. Frank is a pioneer in the field of agricultural risk management and one of the most creative thinkers in the development of the innovative private sector tools that agriculture will be using to transfer risk in the 21st century. You will find the remaining speakers at this conference to be similarly expert in their respective fields and I am honored to share the podium with them. The fact that this two-day conference on "Progressive Financial Strategies for the New Era in Agriculture" is actually taking place speaks volumes about the tremendous interest in the many changes on the horizon for agriculture.
In my presentation today, I will pose three questions and suggest corresponding answers - which answers, I hasten to add, represent my own views and not necessarily those of the Commission or its staff. The same holds true for the final segment of my remarks, in which I will try to forecast some of the ways the agricultural community might adjust to a private- market economy.
Question Number One
Has the last Farm Bill significantly altered the mechanisms of American agriculture?
Yes it has, and in a most profound way -- so much so that when American farmers woke up on the morning of April 5, 1996, they found themselves in a new era for agriculture. The Federal Agricultural Improvement and Reform (FAIR) Act had been signed into law the day before. This one Congressional action -- giving producers the freedom to farm for the market and not the government -- has set the stage for the most profound change we have seen in global agriculture since the mechanization of farming.
Let's look at some of the elements of the FAIR Act that are responsible for this profound change. As you all know, the FAIR Act calls for Production Flexibility Contracts (PFC) payments to be made to farmers over the next six years. These payments are in lieu of USDA's past practice of mailing deficiency checks to producers. This means that, beginning with the year 2003, farmers will be totally dependent on the market for the returns they receive for what they produce. However, the FAIR Act has also given producers the flexibility to respond to market signals because Washington will no longer tell them what to plant. Added to this major alteration of past agribusiness mechanisms will be the fact that, by terminating the Farmer Owned Reserve, the FAIR Act has brought to a conclusion a decade long legislative drive to eliminate government-carried grain stocks.
I believe these paradigm shifts in government policy are a harbinger of greater price volatility for agricultural commodities. Why? Because with no government grain in reserve the market will be more sensitive to perceived or real changes in grain supplies caused by the weather. In addition, if farmers misinterpret market signals and plant what turns out at harvest to be the wrong mix of crops, that will further exacerbate the supply situation and also contribute to volatility.
For a tangible example of what I am talking about, consider the 1996 volume in the Chicago Board of Trade corn futures contracts -- 19,620,188, a 23 percent increase over 1995. In that same phenomenal year the life of contract high and low prices for representative contract months were as follows:
Futures Contract MonthHigh (date)Low
March$4.02 (3/14/96)$2.49 (11/30/94)
July$5.54 (7/12/96)$2.54 (7/11/94)
December$3.89 (7/12/96)$2.39 (7/5/94)
Dr. Bob Young, co-director of the Food & Agricultural Policy Research Institute (FAPRI) at the University of Missouri- Columbia believes that in the future, once prices trend down, "they will do so more quickly and stay there longer."
Another important element in the price volatility equation is the improving incomes of millions of people in China, India, and the Pacific-Rim. One of the first things these people do with their additional disposable income is to increase the protein in their diets. That is one of the reasons why the demand trend-line for food and feed grains is increasing at two percent per year while supply is rising by only one percent annually.
Another way the FAIR Act has significantly altered the mechanisms of agriculture is its termination of Congressional ad hoc crop disaster payments. As a result, some experts estimate that farmers will face potential production losses of $30 per acre for soybeans and $100 for corn. If losses of this magnitude actually occur, few, if any, producers could sustain them for more than one or two crop years. Realizing this record numbers of growers in Iowa and Nebraska have transferred those production risks by using a product called Crop Revenue Coverage (CRC). This is a revenue insurance contract that guarantees the producer revenue if he or she sustains crop damage or receives low prices. The CRC policy is offered by private sector crop insurance companies with reinsurance provided by USDA. It was introduced in 1996 as a pilot program in only those two states.
There is talk at USDA of making CRC available in a number of other states in 1997. However, in a November 7, 1996 letter to Dan Glickman, the Secretary of Agriculture, Senator Richard Lugar (R-Indiana) expressed concern about such a move. Senator Lugar, who is Chairman of the Senate Committee on Agriculture, Nutrition and Forestry, wrote the following:
The Federal Crop Insurance Corporation Board Of Directors is considering further expansion of Crop Revenue Coverage (CRC), a revenue insurance pilot program. If the expansion is approved, CRC will be available for corn, soybeans, wheat and grain sorghum in states representing up to 80 percent of national production. I am concerned about the propriety and wisdom of this expansion.
Before leaving the crop insurance issue I would like to make two observations that come from my 35 years of farming and ranching as well as the comments many producers have made to me over the past five years. First, as production agriculture comes to be driven by more sound business planning and less by emotional attachment to farming as a way of life, the geographic areas that are economically marginal for agriculture will be forced to find non-traditional uses. This will be a gut wrenching experience for many growers. Second, I have often heard farmers say they tried using crop insurance but it didn't pay because they failed to get more money back each year than they paid in. That view of transferring production risk totally misses the mark.
In the new era of agriculture, a farmer should be able to determine the amount of production risk he/she can self-insure and then understand how to transfer pass off the rest in the most economical way possible. It takes time and effort to learn how to do this, but it is one of the best investments a producer can make.
Question Number Two
What long term impacts can be expected?
Because the FAIR Act has created a new era for agriculture we will witness an unparalleled transformation of this industry in the 21st century. Farmers will move from an agrarian mind- set one of "business first" -- and the ripple effect will be felt by all stakeholders in agriculture.
By way of explanation, let me expand on two of the points I made at the beginning of this presentation. For some 60 years before enactment of the FAIR Act, public policy encouraged producers to farm for the government. In return, Uncle Sam attempted to do most of the marketing and risk management for farmers. As a result of this quid pro quo arrangement, augmented by producer mistrust of the cash and futures markets, and a natural aversion to business plans and practices, most of the two million farmers in the U.S. found marketing and risk management to be an alien concept.
Now that the FAIR Act is in place, all of this will change. Producers are now at liberty to farm for the market. However, this new found freedom comes with a price. In the future, farmers will have to establish their own financial safety net. In order to do this they must become astute marketers and risk managers. Along with this new responsibility comes new opportunity - the chance to break new, fertile ground in areas ranging from marketing and risk management to the information super highway and 21st century technology in equipment and crop input products. In this new era, a farmer's rate of return on his capital and sweat equity will not be limited by government control of production and prices. On the contrary, tomorrow's agricultural enterprise will succeed or fail depending upon the operator's ability to combine a high level of competent business management skills with his/her innate talent to till the soil. Thus, today's farmer will become tomorrow's business specialist in production agriculture.
At the outset of this process, U.S. agriculture will have a definite comparative advantage over our international competitors. How long that advantage will last remains to be seen. Public policy for agriculture is changing in other countries as well. Australia began a similar process in 1990, Mexico in 1992 and the European Union has made a number of changes in its Common Agricultural Policy over the past several years. Japan is in the early stages of considering changes as well.
To give you an idea of the private sector response to these changes in government programs let me note the following: in October of 1996 I was in London, to chair a conference on "Risk Management in European Agriculture"; a month ago I was in Sydney, and met with officials of Australia's three largest agricultural commodity
marketing associations whose combined exports are approximately ten billion dollars. Leaders in both places are developing innovative marketing and risk management strategies to fit the new era for agriculture. I have been invited to Tokyo this coming April to give the keynote lecture at the "Forum on Risk Management" sponsored by the Tokyo Grain Marketing Institute. In stating the purpose of the Forum, the Institute makes the following observations:
The trading world, after the Uruguay Round, operates in a different environment. Agricultural markets will be influenced less by government policies. Particularly in the US and EU, prices will be more inclined to be determined by free market mechanisms and less by the price supports of the past, ... As a result, producers, processors and distributors of petroleum and agricultural products may face a wave of price fluctuation. ... We can learn from the US experience, in both theory and practice.
Question Number Three
How will internal U.S. prices and production be affected in the long term?
As I have already suggested, the future will bring increased price volatility for agricultural commodities. For farmers, this reality is what Steven Covey, author of the "Seven Habits of Highly Effective People," calls peoples' "circle of concern" -- situations they worry about but can't change. For some, volatility will be the bad news about agriculture's new era. The good news about price volatility in the new era is that nothing will preclude a producer from locking in a profit or protecting against a crippling loss. This scenario is what Covey refers to as peoples' "circle of influence" -- things they have some control over. Farmers have control over their willingness to expend the time and money necessary to learn how to develop a written marketing program that includes a risk management plan. The ones that haven't taken this step should see guidance from the successful producers who have. They will tell you this is a crucial part of the mix of sound business practices necessary to stay on the profit side of the ledger.
Another perspective on the long term affect that the FAIR Act will have on U.S. prices and production comes from Marvin Duncan and Won W. Koo, North Dakota State University economists. Their study indicates that through 2002 incomes for small, medium and large farms will decline. They also project that profitability will take a dive when Production Flexibility Contracts (PFC) payments end. Duncan says, "After 1999, net farm income will be much lower," and he adds, "Farmers who don't do everything right almost all of the time have little margin for error." Koo adds this advice, "Learn the optimum strategies for using crop insurance and marketing techniques."
Forecasting the agricultural community's adjustment to a private-market economy.
I should tell you up front that my view of the industrialization of agriculture in the 21st century, begins and ends with marketing and risk management. The reason is simple. The goal of each stakeholder in agriculture is to make a profit. The efficient and economical production of a crop, in and of itself, does not guarantee profitability. It does put the farmer in a position to move to take the next two steps necessary to achieve maximum profitability. These steps are, first, the astute practice of those business activities involved in moving goods from the producer to the consumer. And, second, using the most economically efficient tools to prudently transfer the business risks inherent in each step of the process.
Forecasting future events is a precarious exercise at best. However, for the sake of stimulating discussion, here and in other forums, let me use some facts concerning current practices as the basis for hazarding a guess about the agricultural community's adjustment to a private-market economy in the future. Consistent with my belief that we are entering a new era for agriculture because of the FAIR Act, allow me to begin with one example of how farmers are reacting to the removal of production controls.
When USDA released its January figures for supply/demand, quarterly grain stocks, and winter wheat and durum seedings, they revealed the lowest U.S. winter wheat acreage since 1978. Apparently, farmers took a hard look at the 1996 fall prices for wheat, corn and soybeans and felt that soft red winter (SRW) wheat didn't have as much profit potential as corn and soybeans. Producers saw CBT SRW wheat futures prices go from $4.00 in early September to $3.30 in late December. In response, growers in Arkansas, Missouri, and Illinois indicated they will plant 32 percent less SRW wheat acres in 1997 than in 1996.
While it appears the 70 cent price drop convinced some growers not to plant SRW wheat, the reduction in hard red winter (HRW) wheat acres seems to be caused by other factors. The late 1996 fall harvest in western Kansas of a large number of grain sorghum acres kept some farmers from putting in a wheat crop. Also, good moisture encouraged producers to try the more economically attractive corn or soybeans. And finally, some growers think a corn-soybean rotation would be better for them than the government dictated corn-wheat planting sequence of the past.
What I have just described -- farmers making their own decisions about what crops to plant based on weather conditions and prices -- will be repeated time and time again in the future. This makes eminently good economic sense. The world's most successful corporations use the same management technique -- let the decisions be made by the people at ground zero, the people who are responsible for production, and who have the most up-to-date information on production costs and consumer demand -- rather than executives in some headquarters office a thousand miles away.
The next issue I would like to address in trying to forecast the agricultural community's adjustment to a private-market economy is the replacement of the government financial safety net. The methodologies currently available from the private sector to take up the slack are revenue insurance and revenue assurance. Private sector alternatives are continuing to evolve as they seek to fill the gap caused by the government's exit from controlling the production and prices of certain agricultural commodities.
The principle organizations involved in developing safety net products are crop insurance companies, agribusiness firms, farmers' associations and co-ops, grain elevators, marketing advisors and the futures industry. I have already mentioned the most popular safety net product on the market today, Crop Revenue Coverage. This same type of revenue guarantee may be offered by numerous state Farm Bureau associations if the Federal Crop Insurance Corporation (FCIC) grants their requests to offer this product.
The availability of Revenue Assurance is limited at the present time. However, it has the potential to become the most economical of the safety net products in the not too distant future. Competition among agribusiness firms, including grain elevators, in the race to gain market share of the seed, fertilizer, chemicals, fuel, and crop marketing business will drive the development of revenue assurance contracts. In order to sign up new customers and hold on to old ones, input suppliers and bulk handling facilities will offer contracts that guarantee the farmer a certain level of revenue. The key to the success of such a contract lies in the merchants' ability to transfer to a third party the production and price risks it takes from the farmer.
Among the tools that may be used to accomplish this are a CBOT area yield futures contract, coupled with an exchange-traded futures contract covering the commodity's price -- or options on those futures. Alternatively, the agribusiness company could offer to pay all or part of the premium of a CRC contract for the customer who used its input supplies.
As Revenue Assurance contracts become more commonplace, they will provide a win/win situation for both the farmer and the merchant. The farmer doesn't have to suffer the consequences of poor yields or low prices, rather he/she can transfer those risks and secure a guaranteed source of revenue. That is what it takes to build net worth -- the most meaningful kind of safety net a producer can have. The agribusiness firm benefits because it knows the grower will have the revenue to pay for the input supplies. And just as important, it has a customer who will continue farming and will probably use its products for years to come. This arrangement might also lead the agribusiness company to finance all of the farmer's annual operating expenses.
There is one slight problem with this rosy scenario. The Commodity Futures Trading Commission (CFTC) currently has in place a ban on agricultural trade options. This means that an agricultural revenue assurance contract with option-like features may suffer from a lack of legal certainty. That could deter the use of such contracts by giving either party to the agreement an opportunity to refuse to settle up, after the fact, by claiming the contract to be illegal under CFTC rules.
Another tactic producers will use to adjust to a private- market economy will be to find and fill niche markets in the food business. An article in the December 14, 1996 issue of ProFarmer explained how four farmers' co-op elevators financed construction of Rocky Mountain Flour Milling, Inc. of Platteville, Colorado. The mill will offer farmers a $1.50 per bushel premium for organically grown wheat that it intends to turn into specialty flours for "boutique bakers."
At this time, allow me to depart somewhat from row crops farming and the FAIR Act to talk about the poultry, pork and beef segments of the agricultural community. These industries have always been free to produce whatever quantity they want for the market, with no direct government subsidy.
Among the classic examples of the industrialization of agriculture is the highly integrated poultry industry. I respectfully submit that this industry's ability to increase its market share by a phenomenal 17 percent in just two decades is predicated on the combination of two things. First, a sufficient number of individuals willing to acquire the knowledge, provide the land and facilities, and put in the work to raise broilers, while at the same time enjoying what they do. Second, the use of modern business management practices in every aspect of production, processing, and merchandising. Furthermore, this is an industry that transfers production and price risk by quantifying how much self-insurance the contract grower has to assume, with the rest handled by the agribusiness firm. Its exposure is shifted by being able to operate on the average market price of a tremendous volume of product over the course of a year. Parenthetically I might add, there is a futures contract for broilers on the Chicago Mercantile Exchange, but it is currently not trading.
For those who think the poultry business is so different that its level of integration is not likely to be duplicated by other segments of agriculture, I would respectfully point to the hog business. This industry has been restructuring for two decades. It has been able to attract the necessary capital, utilize the existing pool of experienced hog producers, improve genetics, modernize business management practices, and achieve economies of scale -- which in turn have lowered the cost of production. Add to these improvements a state-of-the-art slaughter and processing capability and you have a competitively priced, appetizing food item for U.S. and foreign consumers. The pork industry handles risk somewhat like the poultry business, but it also has recourse to Live Hogs and Pork Bellies futures and options traded on the Chicago Mercantile Exchange.
I believe the beef industry will eventually go the way of poultry and pork. The challenge will come in transforming over 900,000 frequently unprofitable commercial cow-calf producers into a lesser number of cattlemen who direct all their energy into turning out a consistently high-quality food product -- one that meets consumers' demands and is competitively priced. This will require extensive use of improved genetics in the cow herd in order to change the current practice of just producing a generic commodity. Among the elements necessary to accomplish this change are recognizing the need to develop a business plan to manage risks, and creating a marketing system that rewards quality. The current practice of marketing most weaned calves and many yearlings is similar to what the Texas traildrivers did over one hundred years ago -- round `em up, drive `em to market, take whatever you get for `em -- and if that doesn't cover your expenses keep trying because the odds are that two out of every seven years you'll make a slim profit.
The ink was barely dry on the FAIR Act when critics began to predict a return to government controls as soon as farmers experienced a couple of bad years. Such skepticism is not surprising when you consider that, after 60 years of government intervention, many people are convinced that is the only way agriculture can survive.
I believe, however, that this grand experiment called the FAIR Act will give farmers more profit opportunities than they ever had when they farmed for the government. Will farmers take advantage of this watershed change in public policy for agriculture? Will they seize the moment and make it work for them? Will they respond to the challenge of the marketplace by developing their own creative solutions in marketing and risk management? Will they become truly self-reliant by initiating their own financial safety net? The ones who are willing to become business specialists in production agriculture will. The others, sooner or later, will have to find themselves another way to make a living.