SAN ANTONIO (DTN) -- This year's crisis in the livestock industry is just one fallout from 2008's over-heated commodity markets. Add to that dozens of ethanol reorganizations, the bankruptcy of the largest poultry integrator in the country and fertilizer dealers stung when the value of their inventory depreciated 70 percent in one year.
Swings in fertilizer prices may force more dealers to insist on written contracts. (DTN photo by Greg Horstmeier)
Speakers at the National Agricultural Bankers Conference in San Antonio Nov. 15-18 cautioned that more volatile commodity prices could be the norm for agriculture -- not the exception -- as worldwide demand for food and fuel increases. They shared six crucial lessons at the bankers' meeting that they think farmers and agribusiness should consider when adapting to 21st century agriculture's extreme price swings.
1. DON'T CONTRACT WITH THE EASTER BUNNY
By that they mean a limited liability company (LLC) or limited liability partnership (LLP) that doesn't include a personal guarantee on big-ticket obligations. Take a pork producer who raised weaner pigs under a five-year contract and had borrowed to build a $5 million building to fulfill his side of the deal. "The only thing worse than having a semi-load of weaner pigs be rejected [when finishers couldn't make money] was discovering his buyer had the legal status of the Easter Bunny," says Jacob Bylund, an agricultural attorney with Faegre & Benson in Des Moines, Iowa.
LLCs are often paper shells that don't own any assets to back their business, not the good person who attends your church or coaches your kids' baseball team or plays golf at your club, Bylund observes. Before entering a business relationship, clearly identify the exact person or legal entity being contracted with from the outset of the relationship. He advises that you obtain a personal guarantee on all contracts over the size threshold you'd feel uncomfortable losing. Whether that's 20,000 bushels or 200,000 bushels depends on your risk tolerance.
2. BANKRUPTCY JUDGES DON'T CARE IF YOU'RE OWED $7 CORN
Grain merchants have the upper hand in bankruptcy court, since a little-known provisionallows them to cancel futures positions and forward contracts in the event of bankruptcy. When ethanol giant VeraSun elected bankruptcy, thejudge gave it the right to reject forward cash contracts worth $6.50 to $7 per bushel. Growers could resell grain at $4 or less in a depressed market, and file claims in bankruptcy court for the difference.
"Like all unsecured creditors in the VeraSun case, they'll be lucky to get a penny on the dollar," says bankruptcy attorney, Michael Stewart, a partner with Faegre & Benson. "It's not much comfort to anyone expecting a significant distribution."
Moral: Be very cautious dealing with any party you suspect may seek bankruptcy protection. For farmers, "it's a heads-you-win, tails-I-lose proposition," Stewart says.
3. THE HONOR SYSTEM DOESN'T WORK
Grain and fertilizer dealers should quit contracting on the honor system, lawyers advise. Many grain elevators met margin calls in 2008 by over-extending their credit lines, something banks warn they can't repeat. At one point, one of Faegre & Benson's elevator clients estimated it had $50 million in outstanding forward contracts at risk because it couldn't be sure that growers would deliver pre-priced corn worth $2 to $3 more per bushel on the open market.
Likewise, fertilizer dealers with verbal orders found themselves holding products that depreciated as much as $400 per ton in the space of a few months when the norm was $20 per year. When a wet 2008 fall precluded normal applications, buyers attempted to renegotiate prices and dealers took losses on the chin.
The solution is to begin enforcing contract confirmations, the attorneys say. Oral buy-sell orders are generally considered contractual arrangements, but they are sometimes hard to enforce, Bylund says. Companies will likely be more diligent in making sure farmers sign a written confirmation order within three business days of the agreement in the future. He's drafting a standard written contract for the Agricultural Retailers Association and expects fertilizer dealers will use it.
Bylund thinks written agreements will ease tensions between growers and dealers during the next price shock. What's more, he thinks it's far preferable than dealers insisting that farmers prepay their fertilizer orders, leaving growers as unsecured creditors should the dealer fail. Suggestions to set up escrow accounts aren't easy to administer. "My dad asked my opinion about making a fertilizer deposit, and I told him absolutely not," Bylund says. "Fertilizer retailers can't push all the risk back on their customers."
4. BOTCHED OR OMITTED MARKETING CAN BE FATAL
Disciplined marketing will be key to credit approvals in the future. "Ethanol company after ethanol company lost millions in the futures market" in 2008, Stewart says. He estimates two-thirds of the ethanol bankruptcies he's studied were due to inept marketing that led to losses of $1 million or more. "It's clear they didn't have the skill set to handle moves of this magnitude," he says. Firms that outsourced their marketing to larger entities during this same period tended to fare better, bankers add.
Sadly, risk management inaction was common in the dairy industry. Central California dairies lost an average of $6 per hundredweight in the first half of 2009, missing opportunities to both forward price their feed and lock in profitable milk prices.
With futures contracts in dairy so new and margins tight, many producers felt uncomfortable managing risks with futures or options before the latest crash. "Marketing is a whole new ball game to the dairy industry," says financial consultant Dave Kohl, a professor emeritus at Virginia Tech. "Frankly, dairies just haven't gone through enough cycles to get comfortable with marketing."
But going forward, lenders like Curt Covington, manager of ag and rural banking for Bank of the West in Fresno, Calif., say they will insist that dairy customers outline and implement formal hedging and marketing agreements. "If they can lock in $15 or $16 per hundredweight milk for 2010, it will be the first time in a year that many dairies will start producing positive cash flows," Covington says. "The whipsaw effect we've seen in commodity markets is now becoming standard. Commodity markets are no different than stocks. Price changes aren't driven by humans, they're driven by algorithms." That's exposure that neither producers nor lenders can ignore.
5. FARMLAND OWNERSHIP IS A LIFE RAFT
"Real estate papered over a lot of mistakes," says Kohl, a professor emeritus at Virginia Tech. Refinancings or farmland sales provided the equity that kept many Midwest dairy and pork producers afloat in 2008, he notes. The days of pork, poultry or dairy buildings squeezed on just a few owned acres may be harder to sell to banks in the future, since producers have few financial reserves. The same is true for crop producers with more than 50 percent debt who've chosen not to buy farmland, Kohl adds. "We call them earns and turns. In up cycles, they generate a lot of cash, but they have no backstop when there's an industry-wide shakeout and the value of collateral like machinery collapses."
6. STASH MORE LIQUID RESERVES THAN YOU THINK YOU'LL NEED
To build a financial fortress, Kohl thinks growers should hold 30 percent of their gross revenue as working capital, a term he defines as assets that can be sold within 60 days in an emergency. Producers with more than 50 percent debt might need to set aside more.
"It's a lot easier meeting that liquidity goal when corn is $7 than it is when corn is $3," he notes, since inventory values slide just when you'll need cash the most. Reserves of that magnitude also take years to accumulate. But industries subject to extreme price volatility typically must shoulder lower debt loads and more disciplined risk management plans.
"In this climate, strategic, diversified and disciplined are the buzz words," Kohl says.
Marcia Zarley Taylor can be reached at marcia.taylor@dtn.com
(AG/CZ)
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