8 Things You Need to Know About 2008
By Nancy Jorgensen

We asked these economists to offer their outlook on the 2008 economy and what it means to Today's Farmer readers.

Pat Westhoff, Ph.D., Associate Professor, University of Missouri Food and Agriculture Policy Institute, Columbia, Mo.

Mike Boehlje, Ph.D., Professor, Purdue University Department of Agricultural Economics and the Center for Food and Agricultural Business, West Lafayette, Ind.

Chris Hurt, Ph.D., Professor, Purdue University Department of Agricultural Economics, West Lafayette, Ind.

1. With input costs up, are we seeing a true increase in profitability from higher commodity prices?

Westhoff: Average crop-producer returns have increased, even after considering rising variable production expenses and reduced government payments. For example, compare corn returns for the 2005 harvest to 2006. Corn market receipts increased by $156 per acre based on national average prices and yields. Variable production expenses increased by more than $17 per acre. Average marketing loan benefits on the 2005 crop were $61 per acre and countercyclical payments averaged $34 per corn base acre, but both of those payments were zero for the 2006 crop.
For an average farmer with one acre of corn base for every acre planted, the increase in net income was about $43 per acre. That’s a lot less than the increase in the market value of the corn crop, but it is still significant. However, the calculations don’t consider changes in rent and other fixed costs. For producers paying a lot more in rent, the bottom line may have been no more favorable than it was 2 years ago.

Boehlje/Hurt: Farmers are expected to face both margin compression and greater margin risk in 2008. They will encounter higher input costs and cash rents, and prices for commodities are expected to be more volatile given record-low world stocks. Higher costs will likely result in margin compression for corn and soybean producers—more for corn than soybeans. These cost increases, combined with commodity prices well above the government price safety net, result in significant risk to margins.
To illustrate, with a $3 price for corn and cash cost per bushel of approximately $2.30, margins per bushel would be approximately $0.70. In this situation, the potential of a negative margin is almost zero since the government support price system provides a safety net price equivalent of almost $2.30 per bushel, assuming the farmer gets normal yields or protects yield risk with crop insurance. On the other hand, if cash costs increase by 20 percent to $2.75 in 2008, average margins would decline to $0.25 per bushel assuming $3 corn, and the margin risk exposure increases as well because prices could decline below the cash cost of production of $2.75. In a worst-case scenario, assuming no change in government programs, the government safety net of $2.30 per bushel results in up to a $0.45 loss if prices decline below the cost of production.

2. How should farmers approach the volatility in input costs and crop revenue?

Westhoff: Ask yourself how much financial risk can you handle? If you cannot handle a lot of downside, it may be more important than usual to protect yourself against higher input prices, lower output prices and reduced yields. Risk management tools include crop insurance, forward sales, futures and options, and booking a portion of inputs in advance. Appropriate strategies depend on your operation’s risks and market opportunities.

Boehlje/Hurt: In the next several years, focus on managing margins. Consider costs and revenues at the same time. Constantly evaluate anticipated margin levels and risks. Develop a plan to deal with margin threats, including trigger points. Crop insurance will be a critical tool.
Be conservative. Avoid taking major positions based on a hoped-for outcome. For example, don’t pass up buying $4 corn futures because you feel corn will go to $5. Don’t purchase a large amount of land at $5,000 because you believe it will go to $10,000 per acre. A tenant should not lock in above-market cash rents for the next 3 years based on the hope that crop returns will continue to increase as more corn is used for ethanol.
Also, diversify. This new era is being influenced by factors such as energy prices and policy, which can change quickly and adversely. Avoid putting too many financial eggs in one basket. Increase your odds of survival by managing downside risks while leaving an acceptable amount of opportunity in place if outcomes move to the upside.

3. Will farmland values continue to rise? How will that affect rents and farm debt?

Westhoff: For several years, much of the increase in land values was driven by motives other than just crop profitability. Urban investors bought farmland for recreational uses, for tax reasons or to diversify their portfolios. Higher interest rates and a weaker housing market may have reduced some of this demand, but the increase in crop returns has resulted in another wave of increased farmland values in the Midwest.
It is not safe to assume that land values will continue to increase at a rapid pace. Suppose, for example, that our projections are about right and corn prices average a little over $3 per bushel and soybean prices a little under $8 per bushel over the next several years. These strong prices will support today’s farmland values. However, we don’t project the type of large year-over-year increases in net returns to crop production that would justify further large increases in land values. You face real risks in both directions—crop prices could be much lower or higher than we currently project.
Many people bought houses over the last decade assuming real estate was always a safe investment. At least in some parts of the country, that is no longer true. We know what happened to farmland values in the 1970s and 1980s. This is not to suggest farmland is a bad investment or a downturn is imminent, but it is important to remember the downside risks.
Cash rents have increased primarily because of higher crop returns. Higher rents are a sign of a healthy farm economy. Producers paying high rents are vulnerable to any unexpected decline in prices or yields, or increase in costs. Rents are likely to be driven primarily by crop profitability, not by land values. It is dangerous to assume that just because last year was good, next year can only be better.

4. Is ag in line for a credit crunch? What’s your interest rate outlook for 08?

Westhoff: Recent action by the Federal Reserve to reduce interest rates was intended to head off the worst effects of tighter credit. Early indications are cautiously positive, but credit problems will likely cause lenders to be more cautious, which could affect highly leveraged borrowers. Some loans may not be approved that might have been a year or two ago. Other borrowers may benefit from lower interest rates.
The key question is whether the Federal Reserve will worry more about inflation or an economic downturn caused by credit problems. Former Fed Chairman Alan Greenspan indicated he is concerned about inflation. If he’s right (and it’s always dangerous to bet against Alan Greenspan), it might be hard for the Fed to further reduce interest rates, and rates might actually increase. Significantly lower rates appear likely only with an economic downturn.

Boehlje/Hurt: Clearly, the financial and capital markets have seen a resurgence of risk, resulting in increased premiums in interest rates. Generally higher interest rates put downward pressure on asset values and undermine the financial feasibility of highly leveraged assets. Current turmoil in financial markets is not expected to have a major impact on interest rates in agriculture—in fact, it may encourage the Fed to lower interest rates further to encourage stability. If so, the cost of short-term operating funds might fall. However, capital markets may need a larger risk premium, which may result in a 0.1 to 0.3 percent increase in long-term mortgage financing for farmland.

5. What’s the general state of farm debt?

Westhoff: According to USDA, total farm debt increased from $175 billion in 2003 to an estimated $214 billion in 2007. Over the same period, the value of farm assets grew much more quickly, primarily because of farmland values. Farm assets increased from $1.4 trillion in 2003 to $2.2 trillion in 2007. That means the average debt-asset ratio declined from almost 13 percent in 2003 to less than 10 percent in 2007—exceptionally low for the sector. However, producers with above-average debt levels may be at risk should a downturn occur.

Boehlje/Hurt: In 2007, the equity position of Indiana farms [which are closely studied by Boehlje and Hurt] improved by the equivalent of about 7 years of average income. The increase was mostly driven by 17 percent higher land values in 2007. Equity per farm in Indiana, estimated at approximately $1 million on average, has grown by an estimated $330,000 in the past 4 years as land values have risen 47 percent. The standard measure of risk-bearing ability in the agricultural sector—the debt-to-asset ratio—declined to a 50-year low.

6. What will 2008 hold for farmers and agribusinesses?

Boehlje/Hurt: The financial performance of farm and agribusiness firms was strong in 2007, and improved earnings, sales, equity growth and stock prices should continue for 2008. For example, Deere reported a 23 percent increase in second-quarter 2007 earnings compared to 2006, and projected a 7 percent increase in 2008 sales in spite of a construction slowdown. Others in the fertilizer, seed, chemical and grain storage and merchandising industries expect similar strong performance.
Indiana farm income was about 25 percent higher in 2006 than the average annual income for the previous 10 years. Purdue estimates 2007 farm income to reach an additional 45 percent above 2006. These strong farm incomes are not expected to fade in 2008. Contributing factors include high prices for crops, milk, broilers and eggs. Hog and turkey producers have not shared equally in the income improvements due to higher feed costs without major increases in the products they sell.

7. How is the dollar affecting agriculture, and what can we expect for exports?

Westhoff: The lower value of the dollar has been a major boost to U.S. agricultural exports. The weak dollar makes our goods more affordable to foreign buyers and reduces the prices that competitors can get for their products. Farmers in Canada and Brazil, for example, have not increased production as much as they might have because commodity prices expressed in their currencies have increased much less than prices measured in dollars.
Asian economic growth has been a major driver of world demand. While growth in China and the region will likely continue, the risk of slowing is real.

8. What’s in line for livestock?

Westhoff: The most pleasant surprise of 2007 has been that the livestock sector has done better than expected in spite of higher feed costs. The biggest surprise came in dairy, where strong international demand led to record milk prices. Average milk production profitability increased in 2007 as milk prices rose more than the cost of corn, hay and other inputs.
Looking forward, we find reasons for both optimism and concern. As long as global and U.S. economies remain strong and the dollar relatively weak, we can expect consumer demand for meat and dairy to continue at a healthy pace. On the other hand, livestock sectors are cyclical. We have seen weakness in pork markets because of rising production, and strong milk prices will likely eventually induce a strong supply response by dairy producers. Feed prices are likely to remain higher than the pre-2006 average, and any weather problems that reduce corn and soybean supplies could result in even higher feed costs.

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