Category Archives: Risk and volatility

RISK MANAGEMENT IN A VOLATILE IRISH CLIMATE

A subject that was particularly disliked by many of our agricultural business management students was statistics. So why did we teach it? The rational was simply that farm management planning is about risk management and it is imperative that decision-makers understand probabilities. Preferably. it need to become intuitive as much as formalized. That said, if one is adroit at using spreadsheets for planning, looking at the possible downsides is not onerous.

One should also remember that planning is not solely about cash flows; there are many situations that would not be first considered in financial terms. Feed supply is an obvious one. Although resolving an on-farm fodder crisis will have financial implications, it is preferable not to get into it in the first place. In the days when a farm was entirely self-reliant, farm planning involved ensuring that there was a safety margin between expected supply and anticipated need. Nowadays one wonders if an expectation of government crisis support has led to farmers risking operating closer to the margin than they would have in the past.

I remember commenting in 2014 that the Fodder Crisis of 2013/14 should have been immediately followed by a review of the Food Harvest expansion plans. Just what would the implication be if it was repeated with an extra 300,000 dairy cows on the island? It would certainly mean [yet] another ‘Dear Taxpayer’ letter emanating from those who represent Irish farmers. At present, one wonders how some farmers are coping with the quality of their silage this winter.

Prior to Ireland, my previous dozen years had involved farming in a climate that had warm to hot summers and long cold, dry, windless winters. We did not have long grass-growing seasons but leguminous forage crops grew in abundance. The summers were good enough for hay-making and conservation could be back-stopped with haylage. Land costs were low and we could farm on a low-cost, extensive system that meant a fodder safety margin could be built in. I would say it was an easier location to farm cattle, sheep and, as it was, water buffalo.

How different Ireland is. Yes, it has a long grass-growing season but it has an unpredictable, maritime climate. As I often say, the country has low variable costs of production for milk and meat but those are more than dissipated by the small size of Irish farms. Consequentially, it is not a low-cost producer. And endlessly repeating the statement that it is does not turn the myth into reality. It is a myth based upon partial costing and it is one that continues to undermine the future of Irish farming. That this has led to a processing / exporting model that assumes that Ireland can produce low-cost raw materials is the farming tragedy of our times.

Apparently, the solution of more than a few who advise Irish farmers [and write agri-food strategy] is to recommend that farmers intensify their farming systems. The logic being that if one aims for a greater production per acre [land being a major constraint for most farms] costs per unit of farm produce can be driven down. The more intensive grassland use will lead to greater ‘profits’. Whether this will provide a sustainable return on the farmer’s labour, management and assets is an issue that partial costing does not properly address.

One would also ask if this model can be successful in Ireland’s volatile climate? Is there a gap between the theory and what farmers can achieve year-on-year within risk-set safety parameters? If those who advise are frustrated by farmers’ willingness to adopt their ideas [regardless of how many discussion groups they attend] it is probably because the farmers are weighing up the risks involved and concluding that intensification is not a sustainable solution for them.

One read a headline the other day that referred to producing 44 DM t/ha from grass in Brazil. It was under centre-pivot irrigation. Intensive farming invariable means operating in a controlled environment [indoor livestock or protected crops] or where climatic variation can be mitigated [as with irrigation]. Yes, it rains in Ireland and an awful lot at times. When and how much is less predictable. One wonders how many advocates of intensify grassland use, more stock and greater forage reliance have run the economic models [and risk assessments] necessary to fully assess the wisdom of going down that route on an island that is quite so exposed to the Atlantic Ocean? I suspect that many farmers have [at least intuitively] gone through the processes.

It is why I keep questioning the idea that Ireland is [or can be] a low-cost food producer. The farming structure is unsuitable and the climate too variable. I tend to consider Ireland as more akin to those European regions that have a difficult climate, constrained to small-scale farming and remote to market. It requires a different mindset and farming/food model.

Sadly, many in Ireland’s farming establishment are fixated with New Zealand’s large-scale farms as a model. Sadly, many in Ireland’s agri-food establishment believe that Ireland’s farmers can survive on low farm-gate, commodity prices. Realistically they cannot; regardless of the taxpayer support that flows their way. Irish farming is exposed [by their supply-chain partners] to the wrong markets and they are being advised to rectify the problem by adopting farming systems that simultaneously and increasingly expose them to the vagaries of Ireland’s climate.

The strategic advise given at all levels to Irish farmers should be built upon risk-based farm planning but, one must ask, just who has done such? Has anyone? And, not least, was it done for Food Harvest 2020 or Food Wise 2025? And if not, why not? I for one am left with the impression that there is just too little rigorous farm business planning around.

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PRICE CYCLES IN AGRICULTURE AND MARKET VOLATILITY

An issue in Ireland that concerns me is the understanding of price cycles. They are nothing new. For a brief read on the subject I would recommend ‘An introduction to economics for students of agriculture; first published in 1980 and written by my former colleague at Wye College, Berkeley Hill.

To quote from the first edition; “Often they [farmers] are aware of periods when prices are depressed and of others when prices are above the anticipated levels. They also have the impression that a long-run downward trend in prices for their products has been occurring. Part of the difficulty in interpreting and anticipating price movements is that the price mechanism reflects a number of changes which are different ibn cause but which are occurring simultaneously”.

As a note, the long-term downward price trend can be attributed to the continuous investment in technology that occurs in agriculture. It has ensured that supply continues to move ahead of demand. At least that is the case with commodities that do not benefit from any product differentiation that adds value.

The existence of price cycles for agricultural commodities is well known in Ireland and that the accepted wisdom is that prices will move from trough to peak and vice versa. At times, it appears that the confidence in the cycle is such that one can plan their future secure in the knowledge that high will follow low as surely as night follows day.

For the author this is a cause for alarm. More so when it comes to loan finance. To put it simply, is it wise to borrow to survive the bad times on the assumption that rise will follow fall? And how sure can one be that the good times will allow the repayment of bad time loans?

The critical long-term planning factor should be the expected price at the bottom of a price cycle. Investment and borrowing should be made based on this downside price [with sensitivity analysis used to delve deeper]. Borrowing and investment should go hand in hand. Borrowing to plug cyclical downside shortfalls is not to be recommended; not least when the future repayment capacity is entirely reliant on the cycle providing a sufficient upside price.

One should also ask what triggers the ‘classical’ agricultural price cycles. Do they function in a comprehendible way in a globalized market? The classical cycle rational is that there is a time lag between investment and produce sales dates as it takes time to increase productive capacity; either breeding stock or farming infrastructure. A high price stimulate investment but sales volume expansion occurs later. As many individuals make the same decision, a volume surge occurs that depresses prices as the supply increase exceeds any demand rise. As prices fall, farmers then exit the market and supply falls. Lower supplies mean prices rise etc. etc.

Now how effective are the signals in a global market? Can we assume that the global markets for, say, milk powders are going to follow cyclical pattern? Are there too many variables at play? Are there too many supply-side influences at work? What about the numerous factors that impact upon demand? This is not just your local market but the many markets that compromise the ‘global’ market. So how great an influence will politics play within those markets? And what influence will the behaviour [and power] of market players have?

The above are far from the simple assumptions that underpin the ‘classical’ agricultural price cycle. Therefore, is it naive to assume that what goes around will come around? It is risky to borrow and lend on the assumption that the price cycle will enable loan repayments to be made.

By way of further explanation let us return to the milk powder markets of recent years.

The tainted milk powder scandal in China was a significant demand-side event. As was the Chinese economic boom. The combination turned China into a major buyer. These were market signals that the supply side responded to. Did, nevertheless, the supply-side players all make independent decisions without due regard to what other players were doing? Did this create a rapid rise in the stainless-steel capacity dedicated to supplying China? Almost certainly [apparently, the shipping industry did likewise]. Do we now have excess capacity?

We then had the Russian sanctions, the oil price fall and the slowing of Chinese economic growth to cause a demand-side slow down. Meanwhile production and processing capacity was on the increase. In theory, demand-side changes should follow through to processing capacity closing and farmers stopping production [although the ‘pain’ from excess processing investment may have been passed on to the farmer by more powerful processors].  Will it happen or will, for example, low grain prices over-ride the demand side influences on price? It all gets rather complicated.

We appear to be coming out of the milk price slump. It has, however, taken a significant intervention by the European Union to do so. It has funded intervention buying and a scheme to reduce milk production. Are these normal functions within the market? Will the EU repeat its effort next time prices fall? It may not. Just how much political will has it taken to pull the market out of its slump? These interventions are not a part of a normal agricultural price cycle and they should not be taken for granted; they may not happen next time.

So, the question is; just how many of the above factors will be repeated and with a regularity that provides the foundations of a well understood cycle? Probably none.

Hence, should one plan their own farming future on the expectation that rise will follow fall? It may not be so wise as the cycle may not be a cycle after all.