Anyone reading this well knows that even when the U.S. general economy is humming along at a brisk pace, farming — and managing the inherent risk — is a tremendous challenge. When the economy is tanking, and the commodity markets are made even more complex by the involvement of various hedge and index funds, the risk becomes greater.
Mississippi State University Extension Economist John Anderson had some interesting things to say about managing risk in a turbulent economy during an Extension marketing meeting this past summer.
The volatility of commodity markets, especially in the past couple of years, have created many risks for producers, says Anderson, adding that his primary concern as an economist is that some farmers really haven’t recognized the nature of commodity markets.
An example of this volatility can be seen in the dramatic swings in wheat and corn prices, just in the last two years, he says. “Whatever commodity we’re talking about, we’ve been dealing with a lot of price volatility. Corn went from $8 down to about $4.50 per bushel, but many producers see this and say that corn is still at historically high levels. We need to understand the nature of commodity markets because they have unique characteristics that make the situation dangerous for producers.”
Pointing out some of these unique characteristics is what makes an economist a sort of “wet blanket,” says Anderson, and helps economics earn the nickname, “the dismal science.” But it is necessary that producers become familiar with these characteristics.
The first characteristic of a commodity market, he says, is that there are a large number of producers, and these producers are producing and marketing an undifferentiated product. In other words, if you’re growing corn, your corn is pretty much the same as another grower’s corn. Also, in a commodity market, there is no ability to set prices — producers are strictly price takers.
“And what really makes me a wet blanket is when I tell you that in the long-run, economic profits in a commodity market are zero,” says Anderson. “This is because costs of production quickly adjust when profits are high. Costs go up quickly. Corn was at a good price, but costs adjusted to $8 per bushel.”
Back in 2005, he says, if a producer could look ahead and predict $4.50 corn, he would have thought he wouldn’t be able to spend all of the money he’d make. But now, this same producer is thinking there’s no way he can make money with $4.50 corn.
“All costs have gone up, and that’s why this price volatility is so difficult to deal with,” says Anderson. “While $7 or $8 corn is great, you have to be prepared for when it goes back down. You can get burned on the cost side.”
The implications for producers of these volatile markets are many, he says, including that there is far less margin for error than in the past. “There’s more money on the table in each production cycle, and the consequences of being on the wrong side of the markets is much more severe. There are major input risks as well as output price risks, and there are fewer tools for managing the input risks than there are for managing the output side.”
This is why it’s important that farmers aggressively manage costs at all times, says Anderson. Producers today are good, efficient managers, but they can’t become complacent, he adds. Also, the short gains from high-price periods need to be used to build equity.
“One of my pet peeves is when we talk about ‘new price plateaus,’ because that encourages growers to go out and buy a lot of new equipment,” he says.
There also are implications for policy makers in these volatile markets, says Anderson. “One of these is that policy efforts aimed at raising prices through increasing demand — such as bioenergy policy — will not improve farm profits in the long run. From the supply side, this phenomenon is usually recognized as the technology treadmill. But from the demand side, the effect is usually downplayed or ignored.”
It also needs to be recognized, he says, that there really is no such thing as a new price plateau in the commodity markets. “A persistent increase in price reflects a persistent increase in the cost of production. If there’s a new price plateau, then there’s a new cost plateau underneath it. We get into a lot of trouble thinking prices will be high for the next five years.”