The watchword for 2014 is caution. Many agricultural producers, especially those in the Midwest and Upper Great Plains, and owners of farmland nationwide have experienced an economic boom for the past several years. The question is, has that era come to an end?
Land values in the Midwest and Upper Great Plains have been increasing at annual rates of 20 percent to 30 percent for several years. Using the Rule of 72, if land values were to increase at 24 percent per year, they would double every three years. While increases in other regions have been somewhat tempered by drought and other factors, historically large rates of increase have been experienced throughout farm country, propping up farm sector balance sheets. We believe that recent rates of agricultural land value increases are unsustainable. The likelihood is land value will flatten. Whether they fall depends on several factors:
- Does farm income fall; by how much, and for how long? The big corn crop of 2013 is essentially in the bin; grain ending stocks are rebuilding, and overall U.S. farm incomes are certainly projected to decline from the record levels of recent years. If incomes fall significantly, land values may weaken fairly rapidly. If income falls modestly, say by no more than 20 percent, then it will depend on if it stays down for an extended time.
- How will the removal of several farm program safety nets affect both farm income and asset values? During the recent years of high farm incomes, farm commodity programs, in general, have not been a major factor in contributing to overall farm profitability. However, historically when farm incomes are lower the safety net becomes a more important contributor. The uncertainty regarding the makeup of farm programs in the future is a concern.
- Do the U.S. dollar exchange rate and interest rates remain low? With Janet Yellen replacing Ben Bernanke as chairman of the Federal Reserve Board of Governors, there doesn’t appear to be much change in monetary policy philosophy in the near term, but the question remains, will federal politicians continue their current path of brinksmanship and kicking the fiscal policy can down the road?
- Will export customers such as China be able to continue growth rates that have fueled the agricultural export market?
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These and other factors give reason for a cautionary outlook, especially for U.S. commodity crop agriculture. On a brighter side, lower feed costs will help the livestock sector. Also, because of herd liquidation and pasture conditions, beef supplies are short and will take several years to rebuild. In the short run, profitability may shift some from the crop sector to the livestock sector.
The continued development of oil and natural gas production in the U.S. due to shale fracking and the slow but steady conversion to natural gas should continue to provide a stimulus in a number of rural areas as well as to the general economy.
In this highly uncertain environment producers should consider several sound management practices. If you haven’t done so yet, switch to analyzing business performance based on accrual adjusted net income rather than cash basis. You can still use cash basis for tax purposes, just don’t kid yourself that cash basis reflects actual business performance. Numerous studies have shown that cash basis can lag the accrual adjusted basis net income by 2 to 3 years in reflecting upturns or downturns in the business.
Watch liquidity and leverage position carefully. A farm or ranch business with a debt/asset ratio of over 50 percent is skating on fairly thin ice at lower margins. Liquidity measured by net working capital / gross revenue needs to be kept above 30 percent and even higher if annual net cash flows are highly variable, the business is highly leveraged, or the business is operated primarily on cash rented land with multiple year leases.
Producers would also be well advised to fix interest rates even if it means restructuring some debt from short term to intermediate or long term and paying a slightly higher rate. Interest rate risk is real and in the current environment only one direction possible for a significant interest rate move—up.
Producers should also monitor actual cash flows versus projected cash flows on a regular basis and focus closely on variances to address problems, capitalize on opportunities or adjust future plans on a more timely basis. The ability to indentify problems or opportunities early and respond is an increasingly important key to business success.
Alpha farms that have grown rapidly and that haven’t mitigated the associated risks, will make headlines when they fail. But, a far greater number of farms/ranches have not continued as operating entities because they were not large enough or profitable enough to attract a successor, or as the result of management obsolescence in areas of increasing importance such as cost/managerial accounting, risk management, personnel management, financial analysis, informational technology and the latest developments in production technology.
From an overall credit perspective, adequate of loanable funds remain available, but both lenders and their regulators will be more proactive in risk assessment and risk mitigation due to the increasing uncertainty regarding the future of profit margins, land values, weather and government farm programs.
Danny Klinefelter is an Honor Professor, Regents Fellow and Extension Economist in the Department of Agricultural Economics, Texas A&M University.
Rodney Jones is an Associate Professor and Oklahoma Farm Credit Professor in the Department of Agricultural Economics, Oklahoma State University.