A new study released this week by The Centre for Development Research (ZEF) at Bonn University looking at how agricultural producers respond to commodity prices has interesting implications for farmland investors, suggesting that farmers who are overly risk averse may be missing out on profits from rising commodity prices.
Managing farms under a broad variety of conditions as we do at Land Commodities, we are used to the decision making challenges posed by fluctuating commodity prices. At the beginning of the season decisions need to be made over which crops to plant. As the season progresses, the decision becomes when to sell grain forward, how much to sell forward and what price to lock in. This is made all the more challenging by the fact that agricultural commodity markets increasingly appear to be driven more by financial investors and less by real supply and demand fundamentals.
Few investors appreciate the challenges this poses both to crop investment decisions at the beginning of the season and to the investment outcome by the end of the season. Indeed, getting these decisions right can be the difference between making and losing money in any given year.
The ZEF study looks at how commodity prices affect farmers' decisions by investigating the responsiveness of the annual cropland area allocated to each crop to changes in commodity prices. The study does this by modelling farmers' price expectations using price information available during planting. International spot and futures prices at planting time are used to assess how much producers expect harvest-period prices to affect the amount of land they allocate to planting a particular crop.
Global acreage responses were assessed for the major producer countries of the four key agricultural commodities (JJG and WEET): wheat (WEAT), corn (CORN), soybeans (SOYB) and rice. Taken together, these crops comprise three quarters of global food calories. As such, they play a crucial global role from both the demand and the supply side perspective. They are also partly substitutable on the consumption side due to their interchangeable use as biofuel feedstocks and feed for livestock and dairy purposes (a strong driver given rising protein demand associated with rapid economic growth in the emerging and developing economies).
Unsurprisingly, the study supports previous research showing that over the long-term:
- The world has experienced significant land use changes including the recent shrinkage of arable land due deforestation and degradation, the expansion of urban areas, and more recently, an increasing production of biofuels.
- Several countries have been expanding cropland by shifting land away from forest and pasture, mainly due to the higher crop prices.
- The crop acreage changes have been met both by adding marginal land into cultivation and by bidding away from low-demand crops. The report sites other research demonstrating that a quarter of the increase in area of the high-demand crops for the period 2004/2005 to 2010/2011 was composed of displaced low-demand crop area while the rest came from the expansion of marginal land.
Of course, these are the cumulative effects of how commodity prices affect decision making in the short-term. When deciding cropping ratios at seeding time, the study confirms that farmers do indeed respond to higher commodity prices by planting more of a particular crop. The graph below from the study showing the annual change in global acreage for the four major crops demonstrates how an increase in one crop is offset by a reduction in another.
(click to enlarge)
Looking forward, the study provides support to some commonly espoused views on the future of global food production:
- Ongoing cropland expansion along with increased productivity has been (and will be) needed in order to sustain the associated population growth (forecast at approximately 50% in the next half century given current trends).
- There is little room for bringing more land into crop cultivation in South and East Asia, the Middle East, North Africa, and many advanced economies.
- In regions where there is potential for further cropland expansion, such as Sub-Saharan Africa, Latin America and the Caribbean, land conflicts, population pressure, desertification and other climatic factors will make global cropland supply more inelastic in the future.
This implies that the acreage response of countries to high and volatile agricultural commodity prices will be predominantly via land reallocations (i.e. changing the use of existing cropland to produce more profitable crops). This is good news for agricultural real asset owners as returns per land unit should continue to increase over time.
A surprising / interesting finding of the study is the extent to which agricultural commodity producers respond to price volatility. The study found that when the expected price of wheat rises by 10%, farmers respond by increasing their land allocated to wheat cultivation by about 1%. However, the positive response of wheat acreage to rising price levels is overshadowed by farmers' response to price volatility, with a 1% increase in the volatility of wheat prices leading to a 0.4% decline in average wheat acreage.
In other words, volatility in prices is a strong disincentive for risk averse agricultural producers who shy away from uncertain returns. This suggests increasing agricultural price volatility is likely to slow the expansion of land for cultivation of staple crops and hence, place additional pressure on the supply side. As per the study, this supports the view that those agricultural producers (and by extension, farmland investors) that don't shy away from making investments to obtain the higher returns associated with greater price risk will continue to be well rewarded.
Farmers are price takers. Each year we put a lot of money in the ground with no certainty of what the prices are going to be when it comes out the other end, but by applying a few simple rules the commodity rollercoaster can be both a relatively safe and highly rewarding ride:
1. Don't gamble with your principle: Agricultural investors should focus primarily on land investments which will continue to benefit from the rising relative price of commodities making up the core calorie complex; namely the high-demand, interchangeable use crops like wheat, corn, soybeans and rice.
2. Don't gamble with your cash flow: Irrespective of the relative price of different grain commodities at seeding, always maintain at least some diversification in the annual cropping mix.
3. Don't gamble with your profits: Sell forward portions of your crop throughout the season when moderate price opportunities arise-- even if you think that prices could improve by harvest time.
4. But still be aggressive: Strive for scale, and even if prices look a little low at seeding, always make sure you commit the resources required to maximise your cropping plan within the sustainability constraints of your land.
For such producers, output price volatility becomes the ally, rather than the enemy. Or in the vernacular: you have to be in it to win it.