U.S. Agriculture In 2018

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by: John Abbink

Summary

Although farmers got a small respite in 2017, the recession is about to enter its fourth year with little sign of a recovery.

Small farmers are becoming increasingly marginalized, and many of them are selling out to large operators.

Recession is finally eroding cropland prices, at least in the corn/soybean/hot heartland. This is not, or at least not yet pressuring balance sheets.

USDA forecasts for 2018 offer little prospect ofrelief.

We are entering the fourth year of the farming recession, with no end in sight. Farmers - who as a group earn a noticeable premium over median U.S. incomes − received a small respite in 2017.

But for the overwhelming majority of them, this was due to general economic improvement that increased their non-farm earnings rather than to increased farm income. The median farm's loss is expected to widen by 16% in 2017. That is, the slight increase in their median incomes came despite the fact that they farm, not because of it.

There are some 2.04 million farms in the U.S., ranging from a gentleman's farm operated by a retired NYSE specialist (yes, I know of one - I do not know if there are others) to operations with thousands of acres and multi-million-dollar revenue. Their fortunes are very different: the data below are from 2015, but the contrast they illustrate is even more dramatic today. Given the need to cover interest and tax costs, the U.S.D.A. regards operating margins of less than 10% as unsustainable. Of the 74.9% of all farms in this predicament, 5.7% posted an operating loss that year.

With few exceptions, the small family farm is not a means of earning a living but a lifestyle choice that is rarely self-supporting. In most cases it is viable only because opportunities for rural employment (for spouses, children and operators) and for non-farm entrepreneurship are more plentiful than they once were. There are, of course, small U.S. farms that prosper, most of them specialists in high value, low-volume products such as venison, macadamia nuts, mink or (this is new) chanterelles. Other small farmers with outside employment can make their farms pay for themselves by taking the opposite course, and restricting themselves to hay, a low value crop which requires little labor or mechanization and few inputs. But large farms can extract nearly four times the value of production of major arable crops or principal livestock breeds per acre that small farmers can. Since acreage constitutes 83% of average U.S. agricultural sector assets, the economics are clear.

As an example, a corn farm with $5,000,000 revenue and average yields sold at average prices would have had to operate 8,525 acres in 2017 - thirteen square miles or a bit less than half the area of Manhattan. Yield is, of course, partly a function of weather and receipts are partly a result of successful hedging. But such a farm is more likely to achieve better-than-average yields and prices than its smaller brethren, and much more likely to incur lower unit production costs. Nevertheless, as the table above indicates, a quarter of large farms are in trouble.

The enormous productivity of such farms is the primary cause of U.S. agriculture's woes. The productivity gains from mechanization had largely played themselves out by the end of the 1960s, and land under cultivation has gradually decreased. The gains in factor productivity that allowed output to increase 1.5% per annum for the period shown have largely come from more productive techniques in animal husbandry and the use of pesticides. Pesticides' index of factor productivity rose a remarkable 5.1% annually during this period.

Unfortunately, the data lump together seeds and feed as a single factor input, so they do not highlight the contribution of biotechnology to agricultural productivity. I suspect, however, that some of its contribution is bundled in with, and accounts for some of the continued high growth of pesticide factor productivity. Combined sales of pesticides and pesticide-tolerant seeds are crucial to America's two biggest crops. They made up all of the increase in genetically modified soybean seed shown below.

Not all important have received so much biotechnical attention, but corn, soybeans and cotton, which definitely have, together contributed nearly half of total arable farm revenue in 2016. No genetically modified variety of wheat has been approved for commercial planting, and although approved, genetically modified tomatoes and potatoes are no longer in production. But the shares of genetically modified alfalfa, sugar beet, zucchini and summer squash grown in the U.S. are comparable to those for corn or soybeans.

The USDA expects total 2017 farm receipts to decline for all of the major arable crops except cotton. In contrast, all the main livestock and animal products will see increased revenue. And given the continued weakness of corn prices, margins for beef, dairy cattle and poultry are solid.

Wheat saw strong prices but an offsetting drop in production; since final sales declined only 3.9%, this caused the first inventory draw-down in years. Cotton saw solid increases in both prices and production, allowing stocks to be rebuilt after last year's mediocre recovery from its 2015 collapse. The corn harvest was once again strong, further depressing prices, and more than 500 million bushels were added to inventory. The situation was different but the results similar for soybeans: prices rose but quantities sold declined, and year-end inventory increased nearly 53%. Animal products all enjoyed volume improvement, between 1.6% and 4.7%, as well as price increases, although the latter were uneven over the course of the year, and declining for beef and pork by Q4.

Although price-related federal aid has certainly helped U.S. farmers through their current problems, it has not in fact increased substantially over payments available to farmers before the current recession.

There is no question that some federal agriculture price supports are egregious - most notably in the case of cane sugar. But they are expected to increase total farm receipts by only 3.6% this year. This is no doubt welcome, but for most farmers, unlikely to relieve them of the need to get an outside job. Price-based payments tend to favor large producers.

A factor that helped some American farmers −primarily large ones − was improved international competitiveness. As I have written previously, the U.S. is the Saudi Arabia of agriculture: the low-cost, high volume source which acts as the swing producer for several of the world's most important farmed commodities. Its position has been somewhat eroded as farmers in overseas markets have increasingly adopted modern farming techniques (parallel to the erosion of Saudi Arabia's position by fracking). But the U.S. is likely, over the long run, to retain dominance at least in corn, soybeans and (because those are feed crops) livestock. However, much of America's cost advantage was eroded by currency appreciation over the last five years. 2017 saw a respite, but by no means a recovery of the ground lost in previous years.

Only Argentina saw its competitive position improve. But 'only' is an odd usage in Argentina's case. It is a traditional breadbasket, the potential of which was stifled by spectacularly ill-advised policies. A new government in 2015, reinforced by 2017 elections, is changing them. It has freed agriculture from absurd export restraints and devalued the peso. It now proposes tax incentives for fertilizer use, a measure that would particularly benefit corn growers. If enlightened policies continue, Argentina could overtake Brazil in corn and perhaps soybeans. It also has untapped potential in wheat and livestock, other traditional exports throttled by bad policy.

Dollar strength also facilitated imports into the U.S., and no longer invisibly. For example, Australian beef, which previously only found bulk purchases, now appears in supermarkets. Imported beef accounts for nearly 10% of U.S. supply. It is unlikely that American beef will go the way of American lamb (can anyone remember when they last saw any?). But it is so unaccountably expensive at retail that it is no surprise that lower-cost imports are making inroads.

Entering the fourth year of a recession, farm balance sheets are in surprisingly good shape.

In contrast to the late 1970s farm crisis, farms did not enter the downturn heavily indebted, and balance sheets have been bolstered by long-term appreciation in farmland values. The increase in real estate leverage over the last eleven years reflects the consolidation of small farm properties (many fully paid off) into large farms. Some of it may also reflect a resort to mortgage debt where operating loans are unavailable.

However, it is no surprise, given three years of recession to date and the prospect of more years to come, that cropland values have ceased what had seemed like an inexorable rise.

But national statistics disguise what is happening in detail. Farmland in most states has continued to appreciate - spectacularly California and Wisconsin, solidly in Texas and Florida (respectively the first, ninth, third and eighteenth largest farming states). But the situation is otherwise in the core soybean/corn/hog region that is the backbone of U.S. agriculture. Given their importance to American agriculture, fairly minor price declines in these seven states were enough to offset increases in thirty others.

Despite the increase in farm sector leverage, average debt-to-balance sheet ratios have been flattered by the appreciation of property values. This may have stopped, at least for the foreseeable future. In principle this should slow the growth of large farms, but since smaller farms are under increasing cash flow pressure, distress sales are likely, implying further declines in the price of cropland. Large, still-profitable farmers can finance these purchases. The spiral of large farm productivity making small farms unprofitable, creating larger farms that make less small farms unprofitable will probably continue.

Changes in real estate values affect wealth rather than income, and do not, in and of themselves, force small farmers to liquidate. But operating costs affect income, and these continue to work against all farmers. Small farms are most vulnerable to increased operating costs, due to lack of purchasing power and economies of scale.

Declining energy prices (all farmers require fuel and many need ammonia fertilizers, derived from natural gas), reduced acreage and reduced fertilizer and pesticide application gave farmers a respite on the cost front in 2015 and 2016, but this has ended. Oil prices are rising, less productive land has already been sidelined and further reduction in fertilizer or pesticide application would affect yields detrimentally to net income. Much is made in the press of the increased cost of labor as a result of a more restrictive immigration environment, but this primarily affects labor-intensive crops such as vegetables rather than the major staples and livestock.

Against a background of weak cropland prices, rents should decline, but increased leverage will increase the burden of interest expenses. Livestock farmers can probably count on low and likely decreasing feed prices over the next year or two. But on balance, farm input prices are likely to resume their long-term tendency to increase faster than inflation. It is in purchasing more than in revenue capture that large farms are most competitive, so rising input prices tend to foster their (relative) success.

Large farms can also take much greater advantage of various incentives than small ones - most notably the ability to expense equipment purchases in the year of purchase. They are more likely to have earnings against which to make such write-offs, and can use this often very expensive equipment far more efficiently.

Conditions have not become so extreme as to put a stop to farm consolidation. But U.S.D.A. forecasts for 2018 offer little hope that they will improve. This is the third year that I have written an annual look at the farm economy, and frankly, it has become rather repetitive. It is difficult to see what the catalyst would be for a return to prosperity. No single foreign competitor - not even Brazil - is so large that a year's crop failure there would significantly draw down U.S. inventories. So even among large farms, the number that fall into the 'Critical' category will inevitably increase. The farming recession is perhaps only half over. The latter half will not be pleasant.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.