Much Closer Management Needed
For Market-Based Agriculture

By Jose G. Peña
Extension Economist

The Freedom to Farm concept put in place by Farm Bill '96 appears to be unraveling as a result of the serious economic problems in the agricultural sector this year.

While the $5.9 billion package in emergency aid to farmers approved in the 1999 Omnibus Appropriations Act will help provide a temporary reprieve from the imposition of the strict discipline that farmers will need to transition to a free market system, a large portion of the Freedom to Farm concept was left in place.

So, while it appeared to farmers and Congress that less regulation and freer production systems would benefit the agriculture sector, this year's financial crisis in agriculture poses the question: will a complete free market system help agriculture make needed changes or will it hinder it?

Initially, the Freedom to Farm concept was readily accepted. Markets were strong during the first year of the concept's inception, and since farmers were no longer required to idle part of their land as part of the supply management requirements mandated by the old farm bill, thousands more acres went into production. Downscaling and changing the focus of the Conservation Reserve Program also put a lot of acres back into production. With more acres under production, everyone from equipment and fertilizer dealers to seed vendors was busier.

Now markets are weak and the agricultural sector is so depressed that at about 20 percent or more of the farmers are in serious jeopardy of leaving farming.

Since millions of acres are planted annually in a mega-crop agricultural production infrastructure which evolved over a long period of time, it is difficult to make timely annual changes without serious consequences. Most producers actually have very few production alternatives for the millions of acres annually planted.

If a substantial number of farmers quit farming, for example, it isn't as though the land will sit idle. Unless prices fall to unprecedented levels, the land will simply be farmed by someone else, someone with economies of scale advantages who could employ advanced technology profitably and survive with very low profit margins per unit of production. Some farmers would speculate and attempt to continue to operate the land, but most likely bigger operators, able to spread costs over thousands of acres, would end up operating the more fertile land. Another important financial consideration is that asset valuations on less productive land would decrease, thereby adversely affecting the operators.

So the question arises, how are farmers going to survive in a complete free market system? The immediate response to this question is that it is going to be very difficult. Keep in mind that switching to a complete free market system in production agriculture means that 1.8 percent or a whole lot less of the U.S. population (depending on how you define a commercial farmer) will carry all the production risk of feeding and clothing the entire population.

Financial Analysis

Those who are going to succeed will need to manage their operations as a farm/ranch business. They must increase their emphasis on recordkeeping, planning, profitability analysis, repayment-based financing and better production and business monitoring and controls. Financial recordkeeping has improved substantially since the financial crisis in agriculture of the early 80s.

What has not changed radically is the analysis of financial records and use of the results in the decision-making process. Use of detailed financial record analysis is basic to most businesses, yet not widely used in the production agriculture sector. A shift to better financial analysis does not imply a neglect of the production aspects of an operation, it simply identifies a need for a better balance between the key performance areas.

More emphasis must be placed on justifying the purchase of inputs based on economic analysis rather than simply whether or not the practice(s) will increase output. Successful producers will need to obtain more information pertaining to financial analysis, marketing, analysis of alternative enterprises and the "bottom line" contribution of each existing enterprise.

This shift applies equally to lending institutions. Lenders will have to be involved in more in-depth financial and risk analysis, not just in the business of marketing capital. "Equity/collateral" and "character" lending protect the lender, but if the producer can not generate sufficient profits and cash flow to service debt, the lender is doing a disservice to the producer by providing capital which may end up actually increasing risk, jeopardizing the producer's operation and equity.

Price Risk Management

Price risk management means the preparation of a detailed written marketing plan which is driven by the financial situation and goals/objectives of the preparer. This means learning and using all forward pricing systems available, such as the various type of forward contracts and the use of marketing tools such as the futures and options market.

Learning and using the futures market may be difficult for some. While some producers store their crops at harvest to find market opportunities, many producers sell their crops at harvest. Storing a crop has a cost consequence which must be recaptured in the marketplace.

The futures and options markets provide an 18-month forward pricing tool. Studies have shown that the futures and options market usually provide a profitable pricing opportunity for most producers of that commodity during that 18-month period. This year's corn crop, for example, could have been priced at about $3 per bushel last fall, yet ended up being sold for about $2 per bushel during the July — Oct. '98 harvest period in Texas. Next year's cotton crop, which could have been priced in the low 70 range as late as Oct. '98, is now facing a mid 60's market.

Price risk management will form an essential component of a program to survive and profit in a complete free market system in agriculture.

Importance Of Management

The importance of management was emphasized in a 13-state study of factors contributing to farm profitability. This study analyzed the difference between the top 25 percent and the bottom 25 percent of a group of producers. It found that the top group averaged only about five percent better than the overall group in terms of yield on comparable quality land, cost per unit of production, returns per dollar invested in machinery and equipment, and average net price received for commodities produced. The bottom group, on the other hand, was about five percent below the overall group on the same performance measures.

Strangely enough, the debt-to-asset ratio for the two groups was about the same. While the differences were marginal in each performance area over the six years the study covered, net income averaged a positive $50,000 per year for the top group and a negative $25,000 for the bottom group.