US farmers discover the price of globalization

KEN DALENBERG GETS up at 6am and goes to his office to log on to his computer and check the latest global economic research from Wall Street. Today news is breaking about potential defaults from Italy and Spain, and that means his stock is at risk. At 9am he leaves his desk, armed with his iPhone, and walks out of his office into the blazing sun and into 3,000 acres of corn and soya bean crops – his stock. Dalenberg has been a farmer for 30 years in Champaign, Illinois – in the heartland of corn and soya bean production. He has travelled around Asia, Europe and South America with the US soya bean export council.

The small airport that serves Champaign is in the middle of cornfields. Twenty miles down the road, Pete Pistorius runs a several thousand-acre crop of corn and soya bean. "Come and sit in my tractor," he says. It’s a $300,000 piece of equipment kitted out with $50,000 of technology. "That screen logs the positioning of every seed planted." It’s data that Pistorius pulls off to screen on his office computer to forecast and analyse production. A 10,000 acre farm has up to five of these tractors. What are these farmers’ biggest concerns? The weather? "No. China’s economic policy. What will happen to Greece. The US deficit."

One state over in Converse, Indiana, is the headquarters of First Farmers’ Bank and Trust, an agricultural community bank with $775 million in assets. The senior management aren’t available for meetings – they are touring China meeting with agricultural producers and exploring joint ventures.

Think pork bellies

Agriculture is a huge business in the US, and has been synonymous with its economy throughout the country’s history. Think of the longest-surviving futures markets, and wherever you are from in the world you think ‘pork bellies’. If you’re an economist, you’re on tenterhooks each month for the non-farm payroll numbers. The fact that agriculture is differentiated from every other sector of the economy tells you how important it is. Back in time, publishing non-farm data would have been akin to publishing non-oil revenues in a Gulf state today.

If thoughts of bleary-eyed farmers with hoes and pitchforks spring to mind when you think of agriculture, think again. In most of the US, agriculture is one of the most advanced, innovative and financially savvy industries; farmers consider themselves to be in a global, not rural, business.

The food and agriculture industry in California alone, for example, is bigger than the oil and gas industry in Texas. As the US teeters on the brink of another recession, and as demand for food globally increases, economists say that US agriculture might be one of the country’s saving graces. Certainly pockets of the industry have been almost immune to the last three years of financial turmoil. Net farm income in the US is forecast this year to be the highest in 35 years at $94.7 billion. The top-five earnings years for the past three decades have been in the period since 2004. Unemployment in the agricultural states has been lower than in the non-agricultural states. The price of commodities has boomed. Since August last year, corn prices have increased 70% to $7 a bushel, and are up 160% over the past five years. Soya beans are up 35% since last year and 130% higher than five years ago at about $13.50 a bushel.

Filled with smart people and cutting-edge technology, with a product that is only in increasing demand, the future of US agriculture indeed looks bright. But it is an industry plagued with uncertainty. The globalization of agriculture comes at a price for commodities farmers – volatility. One analyst forecasts: "By the end of the year corn has a 10% chance of being $8.50 a bushel, and a 10% chance of being $4 a bushel, and an 80% chance of being in between those." Such predictions are not helpful in managing risk, and farmers, in both grains and livestock, say risk is growing. There is little help out there for them. Government policies that would alleviate some of their challenges are unforthcoming, while investors struggle to find a suitable and profitable means of providing financial solutions. Current prices allow enough margins for farmers to have a breathing space but their fear is that costs and volatility will increase and margins will be eroded, leaving them back to barely breaking even and with nowhere to turn.

The export/import impact

"It’s the golden era of agriculture," says Dalenberg. Margins for crop farmers have tended to average about 3% to 5%. Now that is more like 15%. According to data from Purdue University, profit for an Indiana farmer on high-quality land rotating corn and soya beans is forecast this year to be almost $165 an acre, and since 2007 that profit has averaged $127 an acre. For an average crop farmer with 1,000 acres that’s just $127,000. From 1999 to 2007, however, there were only four years when the same farmers were in the black, and the annual average loss was $16 an acre. Farmers have a good memory. "They can remember to the date a hailstorm or a drought," says Dalenberg, and they also remember those years of losses. Just two years ago the losses were $20 an acre after the crash of the global financial economy. And not everyone is as fortunate as the nutrient-rich Indiana farmers. According to the US Department of Agriculture, last year 42% of farmers had a second job.

The run-up in prices is often blamed on speculators but it is hard to find anyone who thinks that is the case when it comes to agricultural commodities. Joseph Glauber, chief economist with USDA, says hedge funds have been in the market for at least 10 years. "There is always a lot of attention when commodity prices go up – people point to speculators but these interests have been in the market a long time. Price increases have been due to strong fundamentals."

Those fundamentals partly explain why the biggest concerns for farmers are now China, the eurozone and the US deficit. Global demand for food is leading to greater demand for US agricultural exports. The US agricultural trade balance is now $33 billion – nearly double that of 2007, and almost five times as much as in 2006. "We’re at a record amount of exports," says Glauber. "We used to export a third of our cotton, and now that is up to 80%. Wheat, we export about 45% to 50%. Twenty years ago we exported less than 5% of our meat and poultry, and now that is up to 15% to 20%." The increase in demand is undoubtedly driven by China’s growth.

Five years ago China was the fifth-largest importer of US agricultural goods. Last year it was a close second to Canada.

Ken Perkins used to be a livestock specialist and is now a senior commercial lender at First Farmers Bank and Trust. Back from his bank’s trip to China, Perkins says the demand for pork is astonishing. His bank has helped a US client fly breeding pigs over to China on a Boeing 747. "You’ve got 400 million people in China who are now middle class and demanding protein. The word for meat in Chinese is the same as the word for pork."

But the huge demand from outside the US for food has its drawbacks. When figures get bigger, risks get higher. "There is a lot more risk for farmers and a lot more volatility," says Perkins. "The price of producing pork has gone up from 40 cents a pound to 80 cents a pound as feed prices have increased. If a farmer sells his pigs but doesn’t lock in the feed price, or if demand suddenly stops, then he stands to lose a lot more money than in previous days." He says that in spite of the increased risks, the demand from China will be positive. "There is a lot of farmable land in China. But there is also a huge portion of land that is mountainous and not conducive to farming. And housing and development is also battling it out with farms there for the flat lower land. There is also not the row crop expertise. We went to see what the future might be like for our US farmers and there will be a lot of interaction with China."

But a global market works both ways. It is not just exports that are increasing and affecting US agriculture. Agricultural imports are on the rise in the US. Canada and the EU are the two largest exporters to the US but China has doubled the value of agricultural goods bound for the US over the past five years. That’s cheaper food for consumers but greater competition for US farmers. Christianne Carin, chief executive of Elk Partners Global Fund, a clean technology investment firm, says imports have had dramatic effects on some crops. "People don’t realize the impact of China’s food production on US agriculture. For example, its developing carrot industry has the potential to wipe out the US business. Carrots do not perish as fast as leafy greens. And China can grow carrots on land that is nutrient-rich because it is land that has not been as intensively farmed, and they have cheaper labour. Traditional US carrot growers will not be able to compete unless they innovate and target specialized markets. Unemployment might be low in agriculture in the cornbelt but in California, where 50% of US fruits and vegetables are grown, farmers have been hurting and unemployment in the agricultural regions has risen."

Ethanol, oil and volatility

Increased demand for corn to feed the animals that feed China has led in part to stocks in corn tightening to levels that make the market nervous. Sterling Liddell is the vice-president for Rabo Agrifinance and Rabobank International in their food and agribusiness research and advisory department. He says: "The last two years we’ve seen excess stock in corn drop to about 5% to 6% of total production. And historically the market has liked that buffer to be greater than 8% to 10%. When markets get that tight, they become more volatile."

But China’s huge demand is by no means the only drain on corn stocks. Productivity of corn per acre has increased three to four times in the past 50 years because of genetically engineered seeds, fertilizers and technology. Furthermore, acreage under production has increased. In the US, 80 million acres of farmland grow corn – 10 million more than in 2000. But the increased production is being absorbed.

Some in the industry point to the increased use of corn for producing ethanol. A staggering 40% of corn produced in the US this year is expected to be used to produce ethanol, driven by government mandates for the use of biofuel and 50% tax credits for blenders of ethanol with regular gasoline. From 2005 to 2010, US corn ethanol production rose from 3.9 billion gallons to 13.2 billion gallons. Research by Bruce Babcock and Jacinto Fabiosa at Iowa State University released this year says that ethanol is responsible for a third of the increase in the corn price from 2005 and 2009.

It’s a touchy subject among farmers. Although it has pushed up the margins for corn growers, those farmers that rely on corn for animal feed have suffered. And even those farmers who do farm corn are not entirely pleased with expanded production to source ethanol. Research suggests that land used for corn ethanol production causes soil erosion and a run-off of fertilizers and pesticides that fuels the wrath of environmentalists. The debate over whether land should be used for food or fuel is also growing louder.

The USDA’s Glauber says that the tax credits will expire at the end of the year, and will not be renewed, and that the cap for production is 15 billion gallons a year and will not be raised. "I don’t want to sound like an apologist. I just think the impact of production has now levelled off and without the subsidies it will slow."

But ethanol is also a double-edged sword for farmers and plays into perhaps the greatest cause of price volatility of corn, and costs to farmers – oil and gas. Oil and gas prices are highly volatile – as they fluctuate, so does the price of ethanol and, in turn, corn.

Volatility in the oil and gas markets, along with unpredictability of water supply, is one of the largest challenges for farmers. One investor goes as far as to say that energy volatility is the sole reason why private investment into US agriculture has been unforthcoming.

Richard Bookbinder is the managing member and founder of TerraVerde Capital Partners, a New York-based hedge fund of funds that specializes in sustainable investing and includes agriculture. "The reason that there will not be more investors in US agriculture is that the US does not have a comprehensive energy policy," he says. "Oil and gas price volatility wreaks havoc with all farmers, consumers and manufacturers. Until the US develops an effective domestic clean energy policy that deals with depleting natural resources and growing global populations, commodities will be subject to the global swings in oil and gas."

For one thing, many farmers have to transport their products for miles. Bill Bickle, chief credit officer of agricultural community bank Stockman Bank, says that in Montana is it not unusual for ranchers to have to drive 70 miles for supplies and several hundred miles to market their cattle. The average amount spent per acre on fuel and electricity for a corn farmer is $35, compared with $26 in 2005. And producers and distributers of food have even farther to travel. One statistic floating around Illinois estimates that the average distance food has travelled to reach Chicago is 1,500 miles. Those price increases trickle down to the farmer.

But oil and gas have a much larger impact on farmers’ costs when fertilizers, pesticides and herbicides are taken into account. Nitrogen fertilizers contain methane, which is found in oil beds, and fertilizers are estimated to account for 50% of the fossil-fuel usage in agriculture today. Bickle says it is not unusual to see fertilizer and agricultural chemical annual budgets of between $300,000 and $500,000 for a farmer or rancher with several thousand acres. Since 2003, prices of fertilizers have doubled or tripled in price. If fossil-fuel-based fertilizers increase in price – so too do those made from phosphorus or potash. Fertilizers account for about 18% of a farmer’s costs. For a corn farmer, the cost of fertilizer for one acre is $100 – up 30% since 2005. In 2008 and 2009, that cost was more than $130 an acre. It is a more volatile input than fuel itself. The total operating cost for a corn farmer, not including land, which is also getting more expensive, has increased from $189 an acre in 2004 to $537 an acre in 2010.

Contentious issue

Whether or not the price of fertilizer should be so high, uncontrollable, and passed on so much to the farmer is a contentious issue. Carin says farmers are caught between a rock and a hard place. Their supply of fertilizer and seed is tied up by what have become de facto cartels. In many cases the firms that supply the fertilizer or chemicals also supply the farmers’ crop and application services, and are often over-applying fertilizers. And they are controlling the prices because they can.

But what can the farmer do? If he tells the one or two companies serving his region that he wants to buy less fertilizer, use a new type of fertilizer, or change his practices to use less of it to reduce his cost per acre, he will be told that that might adversely affect his supply and the price of the fertilizer and application services he is dependent on. His margins are so small and he fears a risk of lower production without them, yet he is beholden to fertilizer pricing. The farmer has no control over his input costs, which can make the US agribusiness highly volatile.

Carin says that in 2008 many farmers were hurt by high prices for natural gas, which is used in making nitrogen fertilizers. "The price of nitrogen went up from $200 a ton to $800 a ton, and farmers have to buy ahead of time. Many farmers bought it at $800 but by the application time the price was $300. Should farmers be sitting with that volatility? Governments should be enforcing and enhancing anti-trust legislation to prevent this economic burden on the US producer. In Asia, farmers do not face the monopolies and therefore have lower production costs."

She says agricultural policy in the US is antiquated. "The agricultural industry is global and modern but government policy remains outdated, or is turning a blind eye to these obvious questions around volatility of input prices and growing strength of these monopolies. There seems to be a lack of interest or understanding in government about these important topics."

Her firm invests in new agriculture markets and innovations. This includes new technologies and methodologies that provide alternative inputs and increase production efficiencies.

Investments in new technology that help farmers cut input costs will be crucial and are likely to be profitable. However, they are longer-term solutions. At the moment, farmers have few options for ensuring that their margins do not fall below zero. Rabobank’s Liddell says: "Fertilizer prices are as high as they have ever been. The problem is when costs remain high we see a situation like 2009 when we went to razor-thin margins because of the high inputs."

A risk management safety net?

Liddell says government support is decreasing, reducing the safety net for farmers for those difficult years. "After 2006 when corn went above the government target price, several US programmes aimed at helping farmers became irrelevant. Crop insurance is still used but it is really the only safety net." Crop insurance covers farmers for up to 85% of revenues should crops fail; premiums are subsidized, with the government paying half. The average cost of the premium is about 8% of the cost of production. It’s a vital safety net for farmers, but there are cases where more than 85% of revenues are wiped out. "When margins are razor thin, then even with crop insurance you may not cover your costs," says Liddell.

Liddell says risk management has become a way of life for farmers and that they need to adapt. "Margin is critical. They need to understand those margins better than in the past, understand marketing and buying, and try to lock in margins through selling forward contracts for grain when buying fertilizer."

Other than the agribanks such as Rabobank there are few to help. Rabobank has risk management products in the form of commodity swaps for its clients. Glauber agrees that farmers have to be hedging their costs. "They need to be minimizing their risk from volatile prices and through futures and options and cash forward contracts." Champaign’s farmers do hedge, but it doesn’t always save them.

There seem to be few options for farmers to buffer volatility, other than to increase the size of their operations or get out. Farms have steadily been increasing in size since 2000. "Because margins are so tight, the only way to increase profits is by increasing acres," says Pistorius.

Back to the simple life

The desire driven by cost issues to reduce the amount of fertilizer used or corn for feed has serendipitously met a growing awareness of food safety and nutrition issues. Combined, these are leading to the growth of an organic and local (small) farming industry in the US. Just how big that movement is, however, is hard to gauge. Data is patchy from the USDA on organic farming. Its latest statistics are from 2008, where it records 4.8 million farm acres in organic agricultural production – just 0.6% of total farmland in the US. In some instances, local farmers happen to be near land that is chemically sprayed and so cannot be deemed organic. And the USDA does not break out farmers that would categorize themselves as supplying a local market. Anecdotal evidence, though, points to an increase in organic farming and production for local consumption. The number of local farmers’ markets in the US rose 17% last year to more than 7,100. The number of restaurants offering organic or locally grown produce has increased. According to the Organic Trade Association, organic foods accounted for 4% of all food sales in the US last year, compared with 1.2% in 2000. Organic fruit and vegetables accounted for 12% of all fruit and vegetables sold in the US – up 11.8% from 2009.

Carin says organic production and technologies across the industry make for sensible investments. "The issues around energy prices and input prices are less impactful in local and organic farming, which makes for a less volatile sector of agriculture." Other than investing in companies that produce technology for sustainable farming, however, there are few other investment opportunities in agriculture. Bookbinder’s fund of funds, which focuses on sustainable investments and agriculture, does the bulk of its investing in global companies that are addressing such issues as rising cotton productivity, energy prices or water concerns. "There is increased interest from pension funds and endowments in sustainable investing but the organic sector tends to be the realm of non-profits under impact investing," says Bookbinder.

That’s mainly because the organic and localized farming industry is too small for large investors to get behind, unless it is through buying stock in a company such as Whole Foods or large organic brands. Whole Foods sells only local and organic produce, and its stock price on Nasdaq has gone from $9.89 at the beginning of 2009 to almost $60. Its market cap is $10 billion. Year-to-date its stock is up 12% compared with the Nasdaq, which is down by almost as much.

So does the future of farming and meeting food demand lie in small and organic farms that don’t suffer the fluctuations of global markets and oil prices to the same extent as the commodities growers? It is a lifestyle that is attracting an increasing number of wealthy individuals who can afford the land to try their hand at the simple life and leave the city.

For brothers Patrick, Dan and Quincy Horan the dream became a reality just as the organic market started to take off. They started growing organic heirloom tomatoes on a third of an acre in Washington, Connecticut, in 1990 after graduating from college. Now they farm 32 acres of land, with revenues of $250,000, and plan to increase to 50 acres next year. There are dogs running around and fields of tomatoes that can be plucked and eaten without being washed. A pond provides the water for the crops. There are greenhouses stocked with herbs and a nursery of broccoli plants. Quincy’s pest control involves a little organic spray and students plucking off the tomatoes’ nemesis – the hornworm. There are three apiaries on the land providing bees to pollinate the plants.

In summer there is a line of cars 100 long to the market stand on the edge of the farm where different heirloom tomatoes are for sale. "People love these heirloom tomatoes," says Quincy Horan, who is the farm’s chief operator. It’s big business. Many of the farm’s heirloom tomatoes go to Whole Foods or to farmers’ markets in New York City and Connecticut where people will pay as much as 90 cents for a pound compared with 18 cents for a pound of the run-of-the-mill kind. If it costs just 15 cents to produce a pound of tomatoes, that’s a tidy profit.

But it’s not just about the produce. The brothers have been smart about marketing and cutting down waste. As well as hosting tours for Whole Foods investors, the Horans got themselves signed up to a Community Supported Agriculture (CSA) programme that buys from them and other farms an annual quota and distributes boxes of produce to city and town dwellers who buy a share in a season’s total yield. The CSA packages vary in price, and the Horans managed to join a more exclusive one that pays them $90,000 at the beginning of a season. Patrick also runs a business for the farm that takes all the tomatoes that cannot be sold fresh and makes organic Bloody Mary mix and pasta sauce. In the winter when there is little to do, Quincy says life can be a bit boring but the brothers are near enough to go to New York City or take time off to go snowboarding.

No free organic lunch

The Horans are smart businessmen who do a great job of marketing their produce to customers who will pay high prices for heirloom goods. "It’s really about being a salesman. I’m not a particularly good farmer," Quincy Horan admits. The lifestyle, revenues and profits they make might be expected to encourage many others to follow in their footsteps. But the Horans are something of an anomaly. The land they use is on the family estate purchased in 1917, so they have no land costs. Given that land is about $11,000 an acre in Connecticut, it is easy to see that even with great marketing skills, a canning business, a contract from Whole Foods and a CSA payment, it would be hard to run such a business profitably if land costs were factored in.

Emily Brooks, a consultant to farmers in the northeast of the US and the author of several books on farming for local markets, says that for small farmers in the northeast it is more often than not a struggle to make ends meet, and a business is difficult to get off the ground in the first place. Financing options are sorely lacking. "USDA grants have to be matched and farmers don’t usually have that cash lying around – it’s tied up in their assets. They don’t qualify for farm subsidies from the government because those apply only to commodity crops. The businesses are too long-term or small to appeal to venture capitalists. There is really only loans through the Farm Credit Bureau and other agricultural banks they can turn to. It is a shame as there is room for them to grow and there is certainly some social investing that could be channelled their way but as yet the system is not in place."

Ben Freund runs a dairy farm a few miles from the Horans with his family. It has 270 cows and is a third-generation farm. "It’s a great industry to be in. But no, it doesn’t make much money," he says. "People expect food to be cheap, so it is hard to make large profits out of farming."

Local farmers are able to retain as much as 60% of their profits when selling to retail outlets but the issue is that production is often too small to make a full-time living.

Freund’s farm has looked for innovative ways to tackle this issue. His brother’s wife, Theresa, runs a market next to the farm that sells home-grown and local products. Over the past 10 years, the Freunds have also diversified into what are known as cowpots. The manure from the cattle has the methane extracted from it onsite and is turned into mini compost pots for planting. And the methane heats the hot water tanks, barns, farm stand and house. In 2009, however, the farm had a difficult year when dairy prices fell. "You need a strong stomach to be a farmer, and when you are competing with huge corporations it can be an emotional task," says Freund. He says the Farm Credit System has been a lifeline for small farmers, and has "stuck with farms through the downturns". The system was set up 95 years ago as a government-sponsored entity. It has implicit backing from the government and is a dedicated lender to agriculture, with about 90 cooperative institutions across the US.

Farm Credit provides some $160 billion in loans, leases and services to farmers and accounts for 40% of all credit to farmers – the remainder being a mix of home equity lines, grants, credit cards, equipment financing and bank loans. It is financed by users who buy stock in the system and through bond issuance, and is highly capitalized.

Jim Putnam, executive vice-president of Farm Credit East, says: "We are over 14% capitalized and have an insurance fund to additionally protect bond investors." He says it has been business as usual during the crisis, with lending suffering no impact. In the Northeast US, the portfolios have been sufficiently diverse to absorb any sector difficulties. Dairy had a very difficult year in 2009 as the recession hit restaurants. And lumber, nursery and sod producers were hit as the housing crisis hit, but the other types of agriculture, such as fishing, nurseries, grapes, apples, cranberries, crops were relatively unimpacted.

But Putnam admits that there are not enough financing opportunities for farmers – particularly to encourage new ventures. The average age of a farmer is 57 and the agricultural population is ageing further as the high cost of starting a farm deters new blood.

"If you want to start a farm of just 250 cows, that is going to cost millions of dollars," says Putnam. "It’s not like wanting to start a pizza shop and renting a storefront and off you go."

Doug Stark is head of Farm Credit Services of America and is based in Omaha, Nebraska. He says that for now the traditional sources of capital such Farm Credit meet the needs of farmers. But he believes that as farmers’ businesses get larger and the business models change, alternative sources of capital are in greater demand. "Farmers are in a better position financially because of the demand for food, but it is not easy," he says. "They are faced with increasing levels of investment, fewer safety nets in terms of government support and extreme volatility, and are at the mercy of more factors outside their control due to globalization."

In an attempt to encourage new farmers Farm Credit East has started a subsidiary FarmStart Programme for new farmers. "Not all new farmers will pass underwriting standards for loans, and to use credit cards is an expensive and unwise way of financing a business," says Putnam. FarmStart invests $50,000 into promising beginning farmers for five years to get them started, and which, if not paid off is converted to a loan.

Although Putnam is optimistic about the future of farming for local markets, he says the sector faces problems similar to those of the big commodity farmers. Risks are high and margins low. "We need more food on the planet, and the US has good infrastructure and productivity so we are positive on the future," he says. "But agriculture is cyclical and it doesn’t take too much overproduction to drive the price down. It’s an industry where it is hard to differentiate products and increase returns. If you are looking for high margins, agriculture is not the place."

What food crisis?

Brooks says the importance of small and medium-sized farming has to be acknowledged if the industry is to survive and develop. It’s tough to get that point across when obesity levels are rocketing and food in the US seems plentiful. A straw poll of New Yorkers asked for their thoughts on the food crisis yielded the same response: "What food crisis?" Americans spend only 10% of their household income on food compared, for example, with Egypt, where the proportion is 50%. And the USDA is not forecasting higher food inflation, as raw commodity food prices are just 15% to 20% of retail food prices. But as Brooks points out: "Too many non-industrial farmers are operating on the edge. They don’t have cash reserves to cope with swings in volatility and costs as all their assets are tied up. With the demand for food increasing globally, the pendulum is swinging back so that family farming is once again being viewed as an integral part of the economy, but it has not swung back far enough."

Back in Champaign, Dalenberg says that the commodities farmers are in a similar position, and the agricultural industry needs a rethink. "We are in a better economic condition right now, but the risks are there," he says. "Agriculture is cyclical and until the US and the world economies are dealt with in an appropriate manner, we will not be able to solve the longer-term problems in our industry. But it has to be addressed at some point. The risk-reward of farming is just not balanced in our favour."