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0809 PD: Where are production costs headed?

Larry Davis Published on 18 May 2009

A year ago at this time, crude oil was well on its way to a record of $147 per barrel, and farm commodities were going along for the ride. Fuel, fertilizer, seed and dairy feed commodities were reaching record price levels, and everyone was asking if it was time to forward purchase the inputs needed for the foreseeable future.

Conversely, many operators were considering the forward contracting of grain and milk since price levels for those commodities had reached record levels, and it was difficult to see an end to this run-up in prices. Clearly, we were in a very confusing and volatile time, where all agriculture sectors were in some sort of transition, and where equilibrium was being redefined on a daily basis. Many experts felt that the future of agribusiness had the best outlook in more than a generation.

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What a difference a year can make. Today, we have oil that has traded in mid-$30-per-barrel range within the last several months. Farm input costs, including fuel and fertilizer, have come down significantly from their highs less than a year ago. Farm commodities have also come down, including feedstuffs for dairy. However, the price of milk has also declined significantly to levels that make it very difficult for many operations to survive.

It is fair to say that we are in a time of highly volatile prices. Given the history of the past 12 months, several questions come to mind that dairy operations should consider regarding production costs and commodity prices:

1. What type of strategy is appropriate when purchasing feed or other production inputs?

2. What type of strategy is appropriate when forward contracting milk or other farm commodities?

3. How does an operation best manage #1 and #2 above in order to maximize the operation’s efficiency and profitability?

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4. How do these strategies influence the financing, cash management and overall banking relationship with outside lenders?

5. How do these decisions influence the relationship with the suppliers of farm inputs and the buyers of farm commodities of the operation?

These questions provide a framework for dairy operations to use in deciding the best course of action for price management. Price management is a form of risk management. It would be expected that each operation would employ a different set of priorities as it relates to this very important aspect of the business. Like many risk management decisions, individual preferences based upon individual competencies will prevail in using this framework. A sound, well thought-out price management strategy is needed in order to minimize risk and price shocks.

Another key component to understanding and developing a sound price management strategy is being able to see the financial impact of various decisions. Developing something as simple as a spreadsheet can greatly aid in answering “what-if” scenarios. This tool can also be shared with other external stakeholders in the dairy operation, most notably the bank. Dairy operations that can present a comprehensive financial plan that exhibits a sound price management policy are more likely to gain acceptance of these plans. More importantly, when an operation uses facts and figures to explain their intended strategies, this exercise helps the operation to better think through their actions and the consequences of those strategies. It will help them solidify their beliefs and strategies before they have been implemented.

Looking back on the events of the past year, you will be able to relate many remarkable stories to future generations. Depending upon what decisions and strategies you have employed in your operation in the past will determine what stories you can share at this time. Some agribusinesses have been very successful during this volatile period and have the financial results to prove it. Many of these operations had sound price management strategies that served them very well. Others just plain got lucky. Over time, luck will run short and you will need sound strategies in price management to survive.

Most importantly, the question of where production costs are headed is not the relevant question. The correct question is what price management strategy have you incorporated in your dairy operation, and how well can you defend that strategy? Then, and only then, will your operation be well prepared for volatile price periods. PD

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Larry Davis
Vice President
KeyBank Food and Agribusiness Team

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