By Michael Swanson, Chief Ag Economist
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Land prices have risen sharply as U.S. biofuels policy, global demand, and ultra-low interest rates have combined to produce record income for Midwest crop producers. What has been an unalloyed win for crop producers has had mixed benefits for livestock producers. Higher feed costs have hurt profit margins, but livestock operators with larger land bases have benefited as well. It’s too simplistic to suggest that livestock or crop operators “go get more land.” At current prices, acquiring new land is a doubtful investment. So what other options do crop and livestock producers have? And what are the key risks they need to mitigate to survive?
The combined effects of U.S. biofuels policy, global trade, and ultra-low interest rates over the past six years have moved agricultural crops prices to a significantly higher price range. U.S. biofuels policy and global trade directly affect agriculture, but the ultra-low interest rates drive valuations of cash flow in all sectors. The long-term expectations for U.S. biofuels policy and global trade are certainly debatable, but their impacts are generally positive to neutral. Ultra-low interest rates (measured nominally and in real terms) have had an outsized impact, and the long-term outlook ranges from neutral to severely negative. A large percentage of the gain in value for agricultural land comes from improved profitability. The U.S. agribusiness sector had a five-year average for 1998 to 2002 of $48 billion, and a five-year average for 1997 to 2012 of $92 billion. During the same periods, average mortgage rates for farm ground in the 7th Federal Reserve District (Chicago) dropped from 8.1 percent to 5.7 percent.
Using a simple net present value (NPV) calculation, the value of farming/ranching operations in 2002 would have been approximately $593 billion. With the increased income and lower cost of capital in 2012, the NPV gives a value of approximately $1,614 billion. The $1 trillion increase in NPV would be almost equally split between the increased income ($543 billion) and the lower cost of capital ($478 billion). Of course, the increase in income was not evenly distributed by sector or geography, but it is easy to see why there is such investor and agricultural producer enthusiasm for buying agricultural assets. However, what should agricultural producers and investors do now?
One approach is to consider improving crop production based on land improvements. Ultra-low interest rates make tilling and irrigation better avenues to increasing production than simply overpaying for your neighbor’s marginal 80 acres. It is more complicated to improve productivity, but given the pricing situation, you need to run the numbers. Both irrigation and tilling can be irritating subjects for farmers. A common response is, “If I could, I would have already.” However, both these subjects are much more nuanced than most producers readily admit. For example, farmers will say that their fields are already tilled, and it’s true. However, tilling technology has improved significantly, and much of the tilling was done 20 or more years ago with vastly outdated technology and precision. Or, they will say that they don’t have access to water for irrigation purposes. What they should say is, “I think the available water is too expensive for irrigation purposes.” And that is a much more debatable problem than absolute lack of water.
What is irrigation worth to a farmer? The following table shows the difference between irrigated and non-irrigated yields in southeastern South Dakota. Average irrigated corn yield was 54 bushels more per acre, and at $5.01 per bushel (last 5 year average) that increased revenue by $272 per acre.
Ag District Southeast Chart
Of course, there was additional cost to pump the water, but there was significant economic gain from irrigating. In many districts, the drought threat is not as strong as in South Dakota, but that isn’t an argument against irrigation; it is an argument for how irrigation should be handled. Many acres in the prime Midwestern corn growing areas might only be 5 to 12 inches short of water during critical growing phases. Unlike western Nebraska, Iowa and Illinois corn farmers do not need to apply 36 inches of irrigation, but if they could have applied 10 inches over a 21-day stretch of dry and hot days during critical periods, it would have made a 45 bushel or more difference per acre.
Agricultural producers and owners of agricultural assets need to revisit the question of acquisition versus “organic growth” based on the relative change in prices. The supply schedule for land sales has exhibited a “backward bending” tendency with land owners holding land off the market waiting for the peak. They don’t want to be one of the sellers who sold too early and let another 20 percent or more of appreciation slip through their fingers. At the same time, the supply curve for tilling and irrigation is much flatter. Competitive suppliers have a low marginal cost for expanding their offering. In some areas, farmers have to wait for tilling because of strong demand, but the overall price of tilling has not risen to the same degree as land values. Likewise, irrigation companies have a strong incentive to sell based on a competitive market price and relatively modest marginal cost curve. The different dynamics of supply curves give a strong signal for different choices in the current market. Agricultural producers and investors owe it to themselves to reevaluate their options.
Wells Fargo Agricultural Industries presents this analysis as a complimentary service to its employees and customers. It cannot guarantee the accuracy of all the sources of data. And, commodity prices are extremely volatile based on unforeseeable changes. These estimates will change with all new market changes.