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Break the cycle

In every industry, it’s the decisions made in good times that sink the ship when times turn tough. Here’s how to keep ahead of the curve

Picture yourself in a boat on a river. It’s a fine summer day and you’re drifting lazily along, without a spot of trouble in sight. The water is smooth, the current is steady, and you nod to the locals as you pass them by on the shore, thinking how much luckier you are than them as you go.

There’s virtually no chance anything is going to go wrong. If there are rocks, they’re too far down to cause trouble. If there are rapids — well, not on this river.

It’s clear sailing ahead.

Maybe. Perhaps. Probably. As ever, all you can really be sure about is the person driving the boat, and that different captains drive differently when the boating seems good.

Will you stick to a prudent course, or veer too close to shore while showing off and run aground? Will you resist the temptation to load the boat down so the gunwales are barely above water? Will you always leave some room to manoeuvre just in case something unexpected comes up?

By now you know that the boat is your farm. The river is the agriculture economy. The water in the river is the level of income and profit your farm can generate. The rocks and rapids are the things that may punch a hole in your hull if you’re not careful.

And you’re the captain of the ship, steering the boat and watching the depth display. Only you can prevent major errors in judgment that may look like good decisions now, but might come back to haunt you if the river levels fall around the bend.

Predictable

While times are undeniably good on a lot of Canada’s farms right now, they’ve also got a lot of farmers wondering if that old adage that Dad and Grandpa used to recite really is true. You know the one — that more farmers get themselves into trouble in good times than in bad.

That’s not to say you can expect a round of penny auctions in your district any time soon. Rather it means right now you and your neighbours are all making decisions you’ll have to live with for a good long while. Some of these decisions are going to be good ones. Others will be poor choices.

Trouble is, how do you know which is which?

In turns out that there may be a way to tell. It’s to check your assumptions. Are you assuming that the good times will last forever, and that decisions that boost your per-bushel or per-pound production cost will be OK because the pundits all say there’s sure to be more margin to work with?

It’s a pattern we’ve seen before — think the ’70s boom and the ’80s bust.

Mike Pylypchuk is a farm business management specialist with Saskatchewan Agriculture who says that while there can be bull and bear runs in the farm economy, nothing is likely to change its fundamentally cyclical nature — which makes keeping your farm operation ready for anything one of your most important jobs.

“If you’re not careful you can stretch yourself so tightly that a bad year or two can put you under,” Pylypchuk told Country Guide during a recent conversation. “You have to be prepared, because when this change comes, it could be drastic.”

Pylypchuk explains that for an operation stretched too tightly, anything from a price shock to a production shortfall can make for very quick trouble. One of the most common errors, he says, can basically be boiled down to biting off more than you can safely chew — buying high-priced land and equipment for example, and bringing fixed overhead costs too high relative to cash reserves or long-term income prospects.

One of the fundamental fallacies that’s likely to encourage farmers to make this error is the assumption that today’s high prices are the new norm — that it’s somehow different this time. Proponents of that world view are partly right — we seem to be in a new era of higher prices that are sticking — but they’re also likely wrong where it counts the most.

Grain market analysts describe what periodically happens — and what we appear to be living through — as moving to a new level, where roughly speaking the old ceiling becomes the new floor price. It’s happened before, most recently during the 1970s, and veterans who lived through that era will tell you this rule largely held — but that it also didn’t prevent a painful workout during the 1980s when prices fell and bounced along the bottom end of that range for years on end, leaving overleveraged farmers struggling to pay the bills and coping with dramatically rising interest rates.

Grain market analyst David Drozd, who owns the Winnipeg-based Ag-Chieve marketing firm which has hundreds of farm clients across the country, confirms there’s mounting evidence we’re in a new pricing environment. “Yes, I think analysis of support and resistance levels on nearby futures contracts confirm we’re in a new era, but that doesn’t mean the prices of today will be the price for years to come,” Drozd says.

Drozd says he sees the new floor price of ICE canola somewhere around $350 to $375 a tonne, compared to an old floor of $225 to $250 a tonne. CBOT corn is likely going to see a floor in the $3- to $3.50-a-bushel range, compared to an old floor around $1.75 to $2.25 a bushel. CBOT soybeans should see a new floor of $8 to $9 a bushel, up from a $4- to $5-bushel floor, and CBOT wheat is likely to bottom out at $4 to $4.50 a bushel, up from the $2.50- to $3-a-bushel floor during the last grain price era.

So the challenge for farmers is going to be delicately walking the tightrope, making investments in their farm that allow them to grow and become more productive, while at the same time ensuring they don’t slip and fall because they’ve overextended themselves and can’t make adjustments when they need to.

“I think this underlines the need for farmers to take a structured approach to their marketing, and to incrementally make sales, rather than miss opportunities to lock in profits,” Drozd says.

The dangers

So what are the rocks you might inadvertently be dumping into your own path, submerged for now, but lurking below the waterline, waiting to punch a hole in your hull?

It basically boils down to overleveraging yourself without paying enough attention to how that might play out if prices fall — and one agriculture economist says there are a couple of obvious weak spots that a lot of farmers seem to share. Al Mussell, of the George Morris Centre agriculture think-tank in Guelph, Ont., says farmers of all sizes, shapes and colours love land and equipment, and good times seem to encourage spending on both.

“There’s what I call the yellow and green disease, and there’s buying land,” Mussell told Country Guide. “I don’t really offer them in any particular order, I just think both of them are major risks.”

Buying land is an interesting question — clearly a farm needs land to do business. It’s also inarguable that the farms that have steadily and incrementally expanded have been the ones that have enjoyed success in recent years — but again biting off more than you can chew is always a danger, especially during boom time when land prices appear to be on a bull run.

At least partially responsible for this is the perception, if not the reality, that land never falls in value. Over the course of many years, that’s likely true, but in shorter time frames, prices can advance and retrench, and markets can be hot or stone cold, with farms sitting unsold for years.

“We know that land can fall in value — we’ve seen it fall, in the 1980s, for example,” Mussell says.

That means for a farm, land can represent a potential double whammy. You might pay too much for it on the way up and catch what is, in retrospect, the top of the market. Then, when times have turned and you need the value of that land to be there, it may have fallen in value just when you need it most — and unfortunately your banker, no matter how sympathetic they might be, has no choice but to use actual current value when calculating your assets and liabilities, rather than what you might have paid for it.

Then, there’s the psychological question of how carrying that overvalued asset affects you, your farm and your outlook towards running it, Mussell says.

“It’s one thing to pay too much for something — none of us like that obviously — but it’s another thing to pay too much for something that you’re then still paying for 10 or 20 years later,” Mussell says. “That can definitely take a toll, and not just on a farm’s bottom line.”

As for the equipment question, it’s a fairly straightforward proposition — there’s a temptation to load up on equipment now, while the getting is good, and purchase the biggest and best of everything.

Many farmers might argue that having larger — and more expensive — equipment makes them more efficient, and that could well be so when it comes to field operations. But overspending on equipment will also make your operation less economically efficient, Mussell insists.

“There’s a cost to buying too much equipment, to having that line of equipment that’s basically sized for the most challenging season you’ll ever have, that you might need one year in 10,” Mussell explains. “You’re still carrying that cost the other nine years.”

Perhaps, Mussell says, the best answer in both cases might be to separate the ownership of assets somewhat from your core business, which is to profitably produce agricultural products. In the case of machinery that might mean hiring a custom combine or renting equipment where necessary, to name just two strategies. As for the question of land, it might help to forget the question of land values entirely when doing the pencilling for your business, Mussell says, since that’s really tiptoeing into the territory of land speculation.

“Do you really want or need to own land, or at least own all the land you farm?” he asks. “Isn’t access to land, at a reasonable cost, what you really need?”

That metric might make long-term lease and rental arrangements a better bet, as might holding off land purchases if your gut tells you the price tag is too high.

Not nothing

So what’s the captain of the ship to do? One thing is for sure. You can’t afford to stand on the bridge paralyzed with fear, afraid to do anything.

“If you do nothing at all, because you’re afraid to assume some level of risk, you’re implicitly assuming a whole other set of risks,” Mussell says.

For example, you might find yourself left behind in the dust as the industry advances in scope and scale gaining greater efficiencies that you can’t match with a smaller operation. Or everyone else may adopt game-changing technology that again makes them more efficient than your operation.

Saskatchewan Agriculture’s Mike Pylypchuk says what it really boils down to is that farmers should treat debt like a loaded gun. It can be a powerful tool when it’s handled correctly, but you can also shoot yourself in the foot if you’re not exercising the appropriate precautions.

“You need to be using debt to succeed these days. There really is no other option,” Pylypchuk says. “There’s no other way to buy land and machinery — but you should be cautious when you do. Make sure you’re not overextending yourself so the slightest problem puts you into trouble.”

Even Farm Credit Canada, Canada’s biggest agricultural lender, encourages farmers to act cautiously and take their individual circumstances into account when making decisions. Michael Hoffort, FCC’s senior vice-president for portfolio and credit risk, said there’s still plenty of reason to be bullish on agriculture, but everyone has to recognize that it will still be a cyclical business.

“Within the long-term trend, I would expect to see periodic reversals,” Hoffort says. “I think there’s still plenty of reason for overall optimism, but recognize that there are these dangers, and act accordingly.”

In the end there’s no one-size-fits-all solution, Pylypchuk says, but rather a handful of rules that all farms should be applying to their operations.

They need to take advantage of any production and income protection programs available to them, like crop insurance or AgriStability, to ensure that short-term production or income shortfalls don’t sink them.

They also need to structure their farms so they’re not so heavily indebted that they’re vulnerable to even a modest change in conditions, such as an increase in interest rates.

“What would happen if today’s low interest rates shot up in a year’s time? If they were suddenly five, six, seven, even eight per cent? Don’t for a second think that it couldn’t happen,” Pylypchuk says. “It’s not likely we’ll see what we did in the ’80s when those rates were 18, 19 per cent, even as high as 24 per cent — but if you’re overleveraged even at lower rates you’re still in trouble.”

Pylypchuk also says that the time to run these stress tests is now, while the sailing is good, rather than in a few years’ time when you’re forced to chart a new course right in the middle of the rapids.

That way you can make any adjustments now, while you’ve got plenty of room to manoeuvre, instead of when that noise you hear sounds so like a waterfall ahead. CG

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