Where can you find the profit in agriculture?
Michael Swanson, Ph.D., Wells Fargo Chief Agricultural Economist
Financial pain and suffering has hit hard throughout the majority of the row crop and forage economy. Producers can see $4/bushel corn on the Chicago Mercantile Exchange (CME) for 2016, 2017, and 2018, and they know that their cost structures won’t yield profits, and in many cases, will mean more losses.
The recent USDA forecast for 2015 net farm and ranch income called for profits of $58 billion. This roughly matches 2006’s net farm income of $57 billion. However, the $58 billion in profits in 2015 is worlds apart from the $57 billion in profits in 2006.
So, how can $1 billion in profits make such as difference?
First, I always say “every number depends on from which side you approach it”. In 2006, profits had declined $30 billion from 2004’s record profits of $87 billion. And 2004 was seen as a great year, not a repeatable event. In 2015, profits have declined by $66 billion from 2013’s all-time record of $124 billion. In 2013, the agricultural industry was told that growing populations and growing income would yield farming and ranching unstoppable growth. This 2015 setback in farm income hurts more because many producers have increased their family living expenditures to match their expected increase in long-term earnings. And, many of these expenditures are recurring expenses that will be difficult to unwind without taking a loss on another asset.
Second, in 2006, farmers and ranchers produced the $57 billion in net farm income by spending $217 billion on inputs and other production expenses. In 2015, farmers and ranchers spent $377 billion on inputs and other production expenses to net $58 billion in income. Said another way, an extra $160 billion in spending was put forth to net about the same amount of income. This speaks to the risk and reward aspects of the commodity business. The agricultural sector is risking ever greater amounts of money on inputs and other expenses to produce approximately the same amount of income. Quantitatively and qualitatively, producers know that this represents a poorer, risk-adjusted return.
There is an important difference between 2006’s and 2015’s net income number in one crucial aspect. Today’s gross revenue offers a lot more opportunity than it did in 2006, and the 2006 gross revenue was $274 billion versus the 2015 gross revenue of $435 billion. This top line growth is down from its peak in 2013 of $472 billion, but it still shows volume and pricing that can support significant economic activity. Big profits need to start with even bigger revenues. After that, a cost structure that allows those bigger revenues to flow through to the bottom line is required.
Compared to the proceeding 10-year average, what is out of balance in today’s financial ratios? In the proceeding decade, 23% of gross sales ended up as net farm income, but in 2015 only 13% of revenues ended up as net farm income. A line-by-line analysis shows that most cost categories match their previous decade ratio, with a few important exceptions.
The biggest variance comes in the form of capital consumption. This cost serves as a catch-all for many different elements and increased from its decade average of 7% of revenue to 12% of revenue, and reflects producers taking advantage of accelerated depreciation to increase equipment and building expenditures. So, while this investment helps with production capacity, it comes with a high price tag. Just getting the capital consumption back to “normal” would increase net farm income by $19 billion.
The remaining adjustments are spread across multiple line items. Intermediate farm purchases being driven by seed technology and genetics in livestock need to be reduced by $11 billion. Payments to stakeholders, such as landlords, need to decrease by $5 billion in order to be in line with the decade average. Lastly, miscellaneous inputs are $3 billion above their long-term ratio. A variety of inputs are slightly out of balance, and some actually are in the operators’ favor. One that has helped to offset the increased expenses is fuel costs. Energy-intensive operations like farming and ranching are realizing savings with the drop of crude oil prices.
Farmers and ranchers will get the ratios back to their long-term averages through tough decisions and the markets pushing suppliers to re-evaluate their economic contributions to the outcome. None of this will happen overnight, but the operators who make the difficult decisions based on the right numbers will be rewarded in a big way. Simply getting cost ratios to match the decade previous average will add $41 billion to net farm income, pushing it up from $58 billion to $99 billion. This translates to a great reason to stay focused on agricultural production and its future promise.