Too Much Of A Good Thing Can Spoil Ag’s Party
January 31, 2012 Over the last five issues of CropLife® magazine, starting in September 2011, we discussed our views on various dimensions to a question that we have been concerned about since late 2010: “Is Agriculture Facing a Bubble?â€� Recently, this concern generated serious discussion beyond the ag media, not only in the business/financial press, but also at a recent (November 2011) conference sponsored by the Federal Reserve Bank of Chicago entitled “RisÂing Farmland Values: Causes and Cautions.â€�
In this article, which is the last in our series focusing on Ag Bubble 2.0, we re-emphasize our view that agriculture — especially Midwest agriculture — whose profit dynamics is dominated by corn, has reached a long-term strategic point of inflection. It is important to note as you read that in our view, despite the broad diversity of agriculture from both a crop and geographical perspective, the market and profit dynamics of corn and the value of Midwest farmland are good barometers of the health of U.S. agriculture.
The End Of The Story — No, A New Beginning
In our view, we are at or near the peak of a “long cycle� in agriculture which started in the mid-1980s.
As discussed in our article in the December 2011 issue of CropLife, there is no better gauge of agriculture’s current long cycle than the appreciation of Midwest farmland. For example, based on Iowa State University’s annual “Iowa Land Value Survey,� average farmland values in Iowa increased at a compound annual growth rate of 8.9% per year from $787 per acre in 1986 to a recently reported $6,708 per acre in 2011, including a 32.5% year-to-year gain in 2011. Iowa’s average value in 2011 was dwarfed by many Midwest farmland transactions in 2011 that reached $10,000 to $12,000 per acre, with a well-publicized recent farmland sale (for farming purposes) in Iowa that reached $20,000 per acre.
The recent multi-year rise in corn prices and profits to record levels in 2011, along with the current ultra-low interest rate environment, have driven the dramatic escalation in Midwest farmland values. However, these values are not supported by corn’s price and profit outlook. As a result, Midwest agriculture is at a tipping point and at the beginning of a new long-term cycle, which will be characterized by a multi-year decline in crop prices, a significant squeeze in farm profits, and a dramatic decline in farmland values over the intermediate-term — and possibly the long-term as well.
It is important to point out that we are focusing on a long-term cycle trend, around which short-term, weather-induced production cycles are expected to continue to cause short-term price/profit spikes. Additionally, we recognize that the peak could be delayed from 2012 to 2013 if the current second year of the La Nina weather pattern dramatically reduces production in South America and North America in 2012.
Nevertheless, the script for the long-term structural change in trend has been written by a combination of the marketplace, Economics 101 and the “Power of the Dark Side.�
Structural Shift In The Long Cycle — Catalyst For Competitive/Structural Disequilibrium
The anticipated long-term cycle change in trend will create broad and dramatic ripple effects not only at the farm level but also through the entire ag supply chain, comprised of suppliers and the ag distribution/dealer system. The structural dynamics in play have the potential to not only create a multi-year period of competitive disequilibrium between players, but also trigger structural disequilibrium, which will strike at the heart of business strategies and business models.
It is likely that these dynamics will not only dramatically intensify consolidation at the farm level, but also catalyze a dramatic industry consolidation and transformation of the ag supplier/dealer chain. Some companies, who do not meet the challenge of transformational change, will face corporate obsolescence. Structural change will also create new business opportunities and the birth of new companies with forward looking business models and strategies. Thes companies will focus on meeting the evolutionary needs of the “farmer of the future,� who in many cases will think and operate very differently compared with today.
The Power Of The Dark Side — Catalyst Of Transformational Change
As discussed in our article in the January 2012 issue of CropLife, we believe the key driver of transformational change is the “Power of the Dark Side,� reflecting a developing structural change in agriculture’s supply side dynamics. This emerges as a response to the step-function rise in prices for major ag commodities, most notably corn. This developing transformational dynamic reflects the convergence of three cycles, that will likely create significant U.S. and global upside supply surprises over both the short- and long-term.
In agriculture, attention is always placed on the growth dynamics of the demand side of the food equation, reflecting the well recognized economic/income growth drivers of developing economies. However, we believe what is under-appreciated is the accelerating momentum of the global supply side, especially outside the U.S.
The impact of improving economic/income growth in developing economies is expected to have a multiplier effect on the adoption of technology and modern ag management practices, as well as support changes in government policy that support the growth of agriculture.
Collectively, these changing dynamics are expected to accelerate ag productivity gains. This trend is evidenced by accelerating yield and production gains for corn outside the U.S. The growth in corn yields and production gains outside the U.S. has outpaced U.S. gains since 2000, even adjusting for the weather-impacted shortfalls in the U.S. crop yields in 2010 and 2011.
U.S. Corn Industry Faces The Power Of The Dark Side — Potential Structural Oversupply
From a big picture perspective, the impact of the Power of the Dark Side on the long-term global supply side cycle, suggests that corn prices have hit a peak from a long-term cycle perspective and could be in a new long cycle downtrend over the intermediate- and longer-term. Within a continued volatile market environment, we believe the that corn prices could trend down towards a $2.50 to $5 per bushel (bu.) price range over the intermediate- to long-term, with a market equilibrium price level of $3 to $4 per bu.
We have taken a closer look at the impact of these expected market dynamics on the supply/demand and pricing dynamics for corn, over the next five years. There are key corn market drivers looking out five years, based on detailed supply/demand forecasts for three cases, given the uncertainties over the potential of a repeat La Nina impact in 2012. (It is important to point out that the U.S. corn industry did not see a significant yield impact in the second year of a three year La Nina event during 1973-75.)
The corn market is approaching a tipping point in 2012 and is peaking from a long-term cycle perspective. If the current La Nina trend strengthens and meaningfully impacts U.S. corn production in 2012, thereby limiting a U.S. stocks buildup, the peak will only be delayed a year to 2013.
All three cases suggest that corn prices will trend downwards from a forecasted $3.50 to $6.50 price range in 2012 to a new base price level of $3.75 to $4.25 per bu., over the next five years. From a profit standpoint, prices below $4 per bu. will push many farmers into red ink, especially those with a high percentage of high cost (over $250 per acre) farmland rent agreements.
While one could argue about the precision of the numbers, it is important to note that all three models result in a stocks buildup that will drive prices to the $3.25 to $3.75 per bu. level during the next two to three years, before prices recover somewhat to the $3.75 to $4.25 per bu. level in response to expected acreage cutbacks.
Case 1: Moderate La Nina Impact In 2012 — Corn Yields 5% Below Trend Line — Most Likely Case/50% Probability. Although yields in 2012 are reduced, a buildup of stocks still results in a price decline to $4.75 per bu. in the 2012-13 marketing year from forecasted $6.40 per bu. in the current 2011 -12 marketing year. Corn prices bottom at $3.50 per bu. and then recover to the $4.25 per bu. at the end of the five year period.
Case 2: No Impact From La Nina In 2012 – Corn Yields Are At Trend Line – 25% Probability. A strong rebound in corn stocks to close to 2 billion bushels in the 2012-13 marketing year will drive prices to the $3.50 per bu. level. Subsequent acreage cutbacks will strengthen prices back to the $4.25 per bu. level at the end of the five year period.
Case 3: Significant La Nina Impact in 2012 — Corn yields 10% Below Trend Line — 25% Probability. Prices are expected to surge back to the $6.50 per bu. level in the 2012-13 marketing year, in response to limited change from the current low U.S. stocks level, at the same time that foreign stock levels are likely to continue to build.
A subsequent upside supply response in the following years is expected to drive prices down to the $3.25 per bu. level before recovering to the $4.25 per bu. level at the end of the five year period.
Farmers’ crop decisions do not occur in a vacuum, and are based on the relative economics for competing crops. While inter-crop competition will become important when corn economics become marginal from a profit standpoint, corn acreage reduction decisions are expected to be sticky on the downside. In our view, the direction of corn prices acts as a catalyst for the directional pricing of competing crops.
Corn Industry Faces The Lack Of Major Growth Drivers
Looking at the next five to 10 years, the key problem facing the U.S. corn industry is simply the lack of a step-function demand growth driver, at the same time that yields are expected to continue to increase, potentially at an accelerating rate.
Even with acreage cutbacks to 90 million acres, inventories build to over 2 billion bushels, which suggest the potential for corn prices falling to the $3 to 3.50 per bu. level. This price level would create significant red ink for most farmers, and near breakeven levels on a cash basis, excluding land costs.
Although there is always the potential for more significant corn acreage cutbacks, farmers tend to focus on maximizing production, especially for corn due to the higher relative profits.
U.S. Corn Market Has Been Driven By The Step-Function Growth In Ethanol
The key to the demand-driven marketplace for corn since 2005, apart from the supply constraints due to adverse weather impacts on production over the last two years, has been the step-function growth in ethanol demand. The result has been a 3.4 billion bushel increase in corn demand over 2005-10.
Ethanol demand for corn reached 5 billion bushels in 2010, with only modest growth expected in 2011. Ethanol’s demand for corn is reaching a plateau, since ethanol production, estimated at 13.8 billion gallons in 2011, is approaching operational capacity of 14.2 billion gallons.
A Potential Step Function Growth In U.S. Exports Expected To Be Blunted By Growing Global Competition
U.S. exports have fluctuated around the 2 billion bushel level, plus or minus 400 million bushels, over the last ten years. While lower corn prices will boost exports, possibly buoyed by China’s expected opportunistic buying at low prices, we continue to believe that the U.S. will remain the “supplier of last resort� given increasing corn competition from other producing areas of world, reflecting their continued yield/acreage gains. As shown in our article in the January 2012 issue, non-U.S. corn producers have significant yield increase potential. In 2011, compared with an estimated weather depressed U.S. corn yield of 147 bushels per acre, the average yield for non-U.S. producers was 65 bushels per acre. If both U.S. and non-U.S. corn production continued to sustain its average production growth rate of close to 4% per year (demonstrated over the last decade) over next ten years, global corn production would increase by close to 50%, which would appear to be conservative, given expected accelerating yield gains in the U.S. and non-U.S. areas.
U.S. exports could surge in the short-term time above moderate trend line growth, if there is a production shortfall in a major consuming area, especially in China. However, it is important to note that non-U.S. producers, including China, have been steadily building their own stock levels over the past few years and the U.S. will have to compete with other global suppliers for any short-term demand spikes. While exports gains, prior to 2011, were supported by a weak U.S. dollar, the turnaround in the strength of the U.S. dollar in 2011, which could continue beyond 2012, will create headwinds for stronger U.S. export growth.
Key Wildcards That Would Delay The Pricing Peak
The key wildcards that would delay the timing of our peak pricing outlook, but would not invalidate our fundamental long-term downward cycle outlook, are two different “what if� factors: (1) if erratic global weather patterns continued to impact production over the next few years, major consuming countries, especially developing economies, like China, would likely build-up inventories further, in order to enhance food security; and (2) if the current euro debt crises triggered a global recession in 2012, which would reduce demand and prices, another near-term spike in prices would likely occur.
Dramatic Decline In Corn Prices/Profits Increase Land Price Vulnerability
Based on forecasted corn prices, our net present land valuation model (based on a detailed multi-year corn profit model) suggests that our current valuation of $7,800 per acre for high productivity farmland (180 to 200 bushels/acre), could decline 43% to 52%, to $3,700 to $4,500 per acre. Our $7,800 per acre value is somewhat less than the $8,198 per acre value for high-grade farmland, based on Iowa State’s recently announced 2011 land value survey. It is important to note that our estimated downside value range would fall in line with comparable Iowa farmland values in 2006 and 2007.
Secular “Long Cycle� Down Trend — Catalyze Structural Disequilibrium And New Business Opportunities
In an environment of sustained downward pressures on prices and profits, both farmers and all companies in ag supply chain will face new risks and opportunities. While beyond the scope of this article, key business opportunities will focus around strategic concepts:
Farmers — The farmers of the future will become the “New CEOs of Agriculture,� reflecting the need for a transformative change in mindset around farm management and decision making, based on expertise, knowledge and a laser-like focus on profitability. Downward pressures on corn prices, profits and farmland values will create a massive acceleration in the ongoing farm consolidation, especially for those farmers who have allowed their cost structures to balloon, due to the expectation that high, $5 to $7 per bu. corn prices were the “new normal.�
Many farmers, who have limited the escalation in their cost structures and have built significant financial resources, will take advantage of opportunities, including anticipated distress sales of farms and farmland, to grow their business. The path for financial success for farmers of the future will be a laser like focus on becoming low cost producers by managing/expanding margins from both ends of the income statement, as well as constantly improving returns on investment.
Ag Suppliers And Ag Dealer/ Distribution System — The agricultural supply/distribution system will be a victim of how it grew up, reflecting a broad array of suppliers selling products/services directly to the farmer, or indirectly through ag dealers. At the end of the day, ag-related companies of the future will focus on developing new business models and strategies based on an “integrated� expertise/knowledge/innovation mindset, which is focused on a simple marketplace need — how to enhance farmers’ decision making and execution in order to improve profitability. In addition, a key value driver, and the “holy grail� for future business success will be to make farmers’ decision making “simpler,� what we would call the “Apple� mindset, namely creating simplicity out of complexity.
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