The last decade has been a rollercoaster of profits and losses for the hog producer. Historically, a low cost hog producer could count on their expertise and skill to insulate them from the worst of the down cycles, and they expected very strong profits in the up cycles. The most recent down cycle generated large losses for even the low cost producers erasing too much of their equity. So what has changed and what can hog producers do about it?
Economic and commodity price volatility have increased for any number of reasons: globalization, speculation, government fiscal and monetary policies, and the new linkage between agriculture and energy via biofuels. None of these factors appear to be getting less volatile going forward. In fact, it could be argued that they will stay highly volatile for the foreseeable future. If that is the case, all agricultural producers and agribusinesses will need to change how they structure and manage their businesses. While it’s everybody’s right to complain about this situation, it’s owner/operator’s responsibility to do something about it.
There are two straightforward business responses neither of which are particularly “fun”, but they aren’t reasons to get out of the business either. Hog producers need to reduce leverage and increase working capital to get through the down cycles, and/or they need to engage in more active margin management. Both of these approaches have their costs and benefits. Which one is best depends on who you are and your preferences.
Decreasing leverage and increasing working capital only works if you have profits to retain or access to outside equity not debt. As you decrease leverage through additional equity and working capital, your “return on equity” will decline unless your profits rise. The trade-off of keeping more equity in your operation means that you can’t invest it in other assets or spend it on family expenses. This approach will challenge you to really know your financial goals and trade-offs. Will you be happy with a long-term rate of return on equity of 3 to 5 percent? Lower leverage long-term to increases your chances of surviving volatility, but it will also lower your long-term returns on equity.
The other approach (which isn’t mutually exclusive) is more active margin management. It can’t be stressed enough that margin management isn’t buying and selling futures. It is an integrated plan involving simultaneous/proportional buying of inputs and selling of output to lock in margin. Sometimes this activity will require you to lock in small negative margins as well as healthy positive margins. The combination of the futures markets for corn, soybean meal and lean hogs usually offers the low cost producer some reasonable opportunities. More often than not, those opportunities are not sitting in nearby contracts in screaming neon letters. The opportunities are further out in contract time horizons when the market has moved revenue and cost curves in opposite directions for whatever reason.
One attitude that really separates many agricultural producers is their belief in their ability to manage margin. One group just throws their hands up at the prospect of managing margin. They point to basis risk, unfair markets, uncertainty around yields and other uncontrollable events. Every single one of these factors is a complicating factor, but they can be minimized or simply endured with a clear plan. The other group sets up a plan that doesn’t involve predicting the future but rather taking advantage of opportunities when they appear. The margin management group knows they relative trade-offs, and they work to improve those trade-offs by changing elements that are within their control. Like good sailors, they don’t always expect the wind to below at their backs. They know that they’ll spend plenty of time “tacking into the wind”.
Either of these two approaches will also yield a key benefit; access to borrowing. Hog producers who can go to their banker with a clear plan that involves reducing leverage or better margin management will find an enthusiastic response. A never changing principle of banking is “the more certain the cash flow the more certain the loan”. When a hog producer commits to making the cash flow more certain, they will find that financers will be more open to making loans on better terms and interest rate spreads. This change in the financing piece can be an important offset to some of the new challenges from reduced leverage or additional margin management.
At the end of the day, you need to ask yourself. Is commodity volatility getting better or worse? If your answer is worse, then you need to do something about it starting today. The challenge is committing yourself to a clear plan and starting it and sticking to it. Either approach will help. Which is best for you can only be answered by yourself with some honest reflection.
