Market Preview: Questions to Answer Before Expanding

by 5m Editor
7 February 2009, at 7:18am

US - Weekly US Market Preview provided by Steve R. Meyer, Ph.D., Paragon Economics, Inc.

A few weeks ago, a banker friend called and asked for some advice. He has a client in the heart of the Corn Belt with 300 sows, farrow-to-finish, who was contemplating a move to 600 sows. But the producer was concerned that there was no place at all for small producers in the future. He wanted to know what I thought. Having given it considerable thought, I decided to share my comments with North American Preview readers.

First, as I said, this producer is in the heart of the Corn Belt. He can arbitrage DDGS vs. corn when prices allow it. He is within easy transport distance of five slaughter plants owned by four different firms. By his banker’s account, it is a really good, well-run, 300-sow operation. All of those are important background to the questions and answers that follow:

  1. Can he compete on a cost/cwt. basis – with all hog production costs covered? This implicitly means that he has records that accurately tell him what these costs are. It also means paying market price for his corn, paying for full shares of the tractors, telephone, pickup, labor, etc. The critical concept is “all”. Many smaller producers are diversified and they don't put enough costs against the livestock business.

  2. Can he deliver a high percentage of full-value pigs? This is a concept championed in recent years by independent economist Dennis DiPietre and others who challenge our assumptions about some “natural” number of tail-enders and dropouts, and the optimum weight at which we sell market hogs. It is even more critical now, given the amount of capital it takes to get a hog to market weight. With so much money invested, we can hardly afford to take less than full value for any animal. Accomplishing this goal takes tremendous attention to detail. A 600-sow operation may not have any one person who can or will accept that responsibility.

  3. Are his hogs and his relationship with one or more packers good enough that he will have a place to sell 12,000 pigs per year? That is a pretty small number by today's standards, but it is still a lot of hogs even to Tyson, Farmland or Swift. I would think he could secure a formula hog contract to guarantee 70-80 per cent of his hogs’ shackle space as long as the hogs are good and he isn't a jerk to work with. Packers, like most people, don't like to do business with jerks, regardless of how valuable that business may be.

  4. Does he have a competitive advantage vs. a specialized pork producer? If this producer has some grain production, it is definitely a competitive advantage. He can live off his grain revenue (while still paying full price for corn for his hog operation) if grain goes high and hogs do not. Specialized companies can't do that. If we have another year like last year, those companies may be in a bind unless they do some very good risk management. Some succeeded and some failed on that count in 2008. Raising a good portion of your own corn may be an acceptable strategy to handle this risk.

  5. Does he have the ability and time to manage risk effectively by forward pricing feed and hogs when it is called for? The big boys have someone whose sole job is to buy feed ingredients and sell hogs. It is difficult to match them on this point, but I think it is a pretty important question. An option is to sit down and define some pricing objectives for both feed ingredients and hogs, then hand this function over to someone who does it full time. This can be handled by someone completely outside of the operation. I think a lot of producers would be better off if they took this approach. They won't win 100 per cent of the time but, over the long haul, they'll gain from having a person focused on the subject and removed from the emotional connections.

  6. Finally, is there anywhere else to invest the money that he is considering investing in the expansion that would earn a higher rate of return than he has been making in hogs? That is a basic investment question, but one that many farmers never ask themselves. Equities are very low right now and it may be a better, safer play to buy a good mix of diversified mutual funds. He's probably talking some pretty good coin for the purchase and any remodeling that needs to be done. With the equity market price-to-earnings ratio at a very low level, I find it hard to argue against investing there. And, he can do chores sitting at a computer indoors where it is 72°, year 'round.

I think this producer must answer "yes" to numbers 1 through 3 to proceed. He would be better off if he can say "yes" to #4 and #5, as well, since both reduce risk. If he says "yes" to #6, the hog deal is off, I suppose, but he still needs to answer that question. He may be far better off diversifying away from agriculture and this could be a great time to do it.

The outlook for the economy is still very negative, but farmers need to expand their idea of diversification. Corn, beans and hogs are diversification to a small degree. Corn, beans, hogs, small-cap growth stocks, large-cap income stocks and emerging market stocks is diversification on steroids – at least by the standards of most farmers.