Volatile Prices Rock Farm Businesses
by Jim MarzolfThe global economy has experienced unprecedented commodity price volatility in recent years. Crude oil prices climbed to $150 per barrel in July 2008 and now trade near $72 per barrel. Similarly, corn and soybean futures prices rose to $4.50 and $12.75 per bushel in July 2008, and now the July 2009 contracts trade near $3.95 and $10.50 respectively. This created shocks in agricultural businesses that challenged even the most sophisticated managers.
During this turbulent time, end users of grain commodities scrambled to establish price protection using the futures market. They also tried to improve operational efficiencies and secure competitively priced substitutes. Commodity producers were faced with decisions about how to lock in historic levels of profitability. The shock wave hit the crop, livestock, and ethanol industries when commodities and production inputs like feed, seed, fertilizer, and chemical costs increased dramatically.
Market participants who weren’t prepared to deal with these price swings were forced to take unexpected and sometimes detrimental steps in response. Agricultural producers that used futures contracts to hedge price risk may have found themselves in futures positions with margin requirements beyond their credit limits. For instance, a 1,000-acre corn farmer that hedged 50 percent of his crop and sold corn futures at $2 lower than the current futures price would be obligated to fund his margin account with $180,000 to cover his futures position. Faced with the prospect of a continuing bull market and accumulating margin requirements, some farm businesses were forced to prematurely liquidate their hedge positions.
The ripple effect
Price volatility affects the market like a large stone thrown into a small pond. The first wave is usually the worst, but subsequent waves are sure to rock the market as it responds to supply and demand and tries to make sense of the daily volumes of information to ultimately arrive at a stable price. Agribusiness managers who have planned for economic turbulence have prepared their balance sheets, understand their production breakeven points, executed risk management plans, and effectively communicated with their stakeholders. Unfortunately, even the best managers were not prepared for an event of this magnitude.
Planning for a wave
So what can agribusiness managers do now that a boulder has crashed into the middle of their pond? During the business planning cycle, managers must understand that commodity prices may occur within a range, and some will occur more often than others. Statisticians call this a probability distribution. It provides insight into the question of how likely an event is to happen. For instance, looking at recent events, we know that corn prices could range between $2 and $8 per bushel. While any price in that range is possible, managers must assign probabilities to those price events. Corn prices near $8 per bushel seem very unlikely at this point—just like $7.50 corn futures did prior to July 2008. Managers should consider all possibilities in their planning to ensure they are adequately prepared to react calmly and rationally when faced with the extremes.
The rainy day fund
Just as financial experts tell consumers to accumulate enough savings to cover their expenses for 6–12 months, agribusiness managers should also build their levels of working capital to weather the next round of economic turbulence. During times of economic strength and easy credit, accumulating working capital seems to be less of a priority; however, a business can use working capital to bridge the gap between operating requirements and credit availability when it needs to grow or when it feels the financial pressure from an unstable market.
While operating more efficiently is the best way to create working capital, managers may also consider visiting with their lender to review the possibility of restructuring their balance sheet to create working capital. It will take a disciplined manager to effectively implement either of these strategies.
Preparing for volatility
Preparing an agribusiness for economic turbulence requires a business plan that recognizes the probability of extreme market conditions and systematically builds the financial backstops for dealing with them. This can be done most effectively during periods of prosperity when opportunities and decisions can be carefully considered without the financial pressures of a volatile market.
Assembling an advisory team that can offer insights on production, as well as financial acumen, is the first step in preparing for turbulent times. The team should be responsible for challenging conventional thinking, facilitating communication with key business stakeholders, and helping to ensure that when the next wave washes over the pond, the business won’t be swamped.