GRAIN INDUSTRY MUST EVOLVE,
ADJUST TO A NEW MARKET PARADIGM

Maintaining Strong capital base
critical for country elevators

By Phil DiPofi
Executive Vice President,CoBank

t’s no secret that the U.S. grain industry has undergone radical changes over the past two years. Prices for corn, wheat and soybeans began climbing steeply in the fourth quarter of 2006 and climbed steadily to near historic highs earlier this year. Strong international demand, a persistently weak dollar, biofuels production and capital from institutional investors all played a key role in that remarkable run-up.

More recently, with the sudden onset of the global credit crisis and a strengthening dollar, grain prices have dropped sharply once again. Though they still remain well above historic norms, the latest downward swing further illustrates the volatile shifts that have come to punctuate the current commodities market. Traditionally, it has been rare to see corn prices move by much more than 50 cents over the course of a growing season. Today, price swings of more than $1.50 per bushel in a single month have occurred. The same dynamic holds true for wheat and soybeans.

Obviously, no one can predict the future with certainty. But it seems the reality is that we have entered an era in which significant volatility is now the market norm for grains. It’s also time for the grain industry — in particular the country grain elevator — to evolve in order to remain appropriate for this new business paradigm.

Many country elevators — a linchpin of the U.S. grain handling and grain marketing system — experienced financial stress during the run-up in grain prices due to the huge new working capital requirements of their businesses. Much of that stress related to hedging positions taken in the futures market to mitigate price risk. In fact hedging, the very tool used to reduce price risk, has in some circumstances become a risk itself due to soaring capital requirements created by large and frequent price swings in the futures market and resulting margin calls.

In today’s volatile markets, hedging has become extraordinarily capital intensive and is one of the primary drivers behind the increased demand for debt capital on the part of grain elevators and agricultural businesses in general.

At CoBank, one of the largest financiers of grain in the country, we have seen dramatically increased borrowing needs for virtually all of our grain customers during the climb of grain prices. We and other financial institutions, both inside and outside the Farm Credit System, have worked to accommodate these customers during workable when prices soar continue to do so.

But credit is not an unlimited resource — especially in the current economic environment. And borrowing more, without a commensurate increase in earnings and equity capital, is not a long-term solution to this problem. In our view, the grain industry needs to make two key adjustments going forward:
  1. A new approach to price-risk management — Historically, the lion’s share of hedging risk in the system has been borne by the country elevator. Elevators, furthermore, have often been willing to contract to purchase crops for multi-year time periods – agreeing to purchase grains at a specific price even before crops were planted. Elevators have used the futures market to hedge against potential price drops in the market. More recently, country elevators have continued to bear the majority of the cost of these price-risk management programs.

    But what was an acceptable business practice for elevators in the days of $2- a-bushel corn is proving far less workable when prices soar.

    No one party in the grain industry should assume the financial burdens associated with protecting prices for another level in the system. Since everybody benefits from hedging, the risks and costs need to be spread across a broader base – one that specifically includes producers. For farmers, that may mean less pricing flexibility from elevators for future crop years. Recognize, however, that farmers will always have the option of using a broker to access the futures market on their own.

    Most farmer-members of the nation’s grain elevator co-ops will recognize and appreciate the merits of this approach. After all, they have an ownership stake to protect in their local elevator – as well as a vested interest in the overall health of the U.S. grain delivery system in which the elevator plays such an important part.
  2. Maintaining a strong capital foundation — Even if elevators successfully shift some of the risks associated with hedging to their member producers, the working capital requirements of their businesses will have the potential to spike upward as long as volatility in the grain market persists.

    Managing those higher capital requirements, first and foremost, will require solid business practices that create the basis for a strong capital foundation. On the most basic level, that means having a well-designed business plan that is flexible enough to respond to market conditions. It means doing an excellent job of offering farmers pricing options on crops as well as timely service in accommodating high production at harvest.

    It means understanding and pricing sales with appropriate margins. And it means making sure that operating overhead is balanced and appropriate. In some cases, preserving working capital may require some tough decisions, such as putting off planned plant expansions, selling assets that are not critical to the business, holding off on new property and equipment purchases, or reducing dividend distributions to owners to strengthen liquidity.

    Looking at the bigger picture, there are a variety of steps that grain elevators can consider as they look to preserve and build working capital. Deciding on which, if any, of these options is right for a given grain elevator requires careful scrutiny and analysis. A profitable course of action for one operation may not be the right solution for another.

    One of the biggest ways a cooperative grain elevator can build capital is by retaining more earnings. Operators should be looking closely at their future liquidity needs as they calculate how much patronage they return to members. More of that capital may need to stay at the elevator to fund inventories of higher priced farm inputs or margin calls. While producers certainly appreciate cash payments, they also will appreciate having a financially sound grain elevator that will be able to buy their crops in the future.

    Another option worth exploring is partnering with other grain elevators. Working with another co-op in a joint venture may be a practical and efficient way to spread risks and costs over multiple balance sheets. These kinds of arrangements may allow smaller operations to realize the benefits of the economies of scale that larger organizations enjoy.

    All members of the grain industry value chain — farmers, elevators, lenders, shippers, millers, exporters, biofuels producers and consumers — have a vested interest in guiding the sector through this important transition period. By making these changes in behavior and building foundations of financial strength, elevator operators will help the industry fulfill its longterm promise.






November/December Table of Contents