AFBF Task Force

My postings to this blog have been few and far between lately and I’d be surprised if anyone is still checking. I hope to do better going forward.

Last November, I was appointed to an American Farm Bureau Task Force charged with studying the long-term federal deficits. The Task Force absorbed most of my free time between December and July. It was made up of nine farmers from around the U.S. (Iowa, Connecticut, Virginia, Mississippi, Kentucky, Missouri, South Dakota, California, and Oregon) and was set up by the AFBF Board of Directors after they heard a presentation from the “Fiscal Wake-up Tour” about the dangers posed by the large projected federal deficits over the next forty years. The “Fiscal Wake-up Tour” is sponsored by the Concord Coalition and includes both a conservative economist from the Heritage Foundation and a liberal economist from the Brookings Institution — to show that reducing the deficits isn’t a partisan issue. The Task Force had monthly meetings through the spring, mostly in Washington, D.C. We heard interesting presentations from experts on many topics related to the deficits.

The charge for our Task Force was to develop background materials to help Farm Bureau members develop resolutions at their county and state meetings this fall. You can read this background material and view a video featuring the members of the Task Force at

http://deficittaskforce.fb.org/

The video is about 15 minutes long. The AFBF staff did a great job in putting it together and it is worth watching.

I’ve learned a lot over the last six months. Before I joined the Task Force, I thought the major obstacles to balancing the federal budget in future years would come from the looming retirement of the baby-boomers and the resulting insolvency of Social Security. I was mostly wrong. Making the Social Security system solvent is politically difficult, but can be accomplished with some relatively simple changes. The real elephants in the room are exploding medical costs that affect the Medicare and Medicaid programs and a structural imbalance that has developed over the last thirty years between federal revenue and expenditures. I will discuss what I’ve learned about each of these topics in future blog entries.

Appreciating Raleigh

Raleigh Curtis officially retired from his senior management position at Mid Columbia Producers (MCP) on May 31, 2009.  He will still be advising MCP for the next couple of years and has kept the title of “Grain Position Manager.”  However, we won’t see him in the office much anymore.

I’ve known several good coop managers during my 35 years of farming, which included serving 11 years on the Sherman Cooperative Board.  Raleigh is the best — both as a manager and as an innovator.  In his decade managing MCP, Raleigh’s achievements include: dramatically increasing MCP grain trading income by using his knowledge of hedging and futures markets, paying off all MCP’s qualified capital credits, and providing farmers with new marketing tools — such as base price contracts that allow farmers for the first time to take advantage of high prices for future crop years.

My main interaction with Raleigh has been during his biweekly early morning “marketing meetings.”  Although parts of these meetings are used to discuss policy changes or new ventures that MCP is considering, the main focus was always on Raleigh in his favorite role — as an educator.  Raleigh is a enthusiastic teacher and delights in challenging the thinking patterns of farmers.  When Raleigh arrived, attendance jumped from 6-8 farmers to 15-20 farmers — with more after harvest, when farmers have grain to sell.

Farmers come to marketing meetings to learn which way wheat prices are headed.  They want to make sales that hit the top of the market.  Raleigh played along with this desire to predict, but in his heart I think he knew that farmers are wasting their time trying to predict short-run price movements.  Instead, Raleigh tried to convince farmers to change their approach — focus on managing risk and grabbing profitable opportunities.  He taught the techniques that made him a successful trader.

I sometimes wasn’t convinced by the way Raleigh justified his recommendations.  However, if I mulled them over long enough, I always concluded that the recommendations themselves were correct — basically, use all the tools that the government and futures market provide and, most important, sell as soon as you see a profitable price even if it is for a crop that won’t be produced for several years.

Raleigh has made a big contribution to our cooperative and to our area.  I’m glad he’s planning to stay in Rufus and look forward to learning much more from him in the future.

MCP’s average price pool

Until May 15, 2009, Mid Columbia Producers is allowing farmers to put wheat into this year’s average price pool. When a farmer enters wheat into the pool, he selects an ending date between August 19, 2009 and February 28, 2010. MCP’s pool manager then divides the amount of wheat by the number of weeks between May 20, 2009 and the ending date selected and sells an equal amount of wheat each Wednesday using the price MCP is then offering for the ending date.

I always use MCP average price pools to market some of my wheat. For the 2008 crop, the average price pool (ending October 15, 2008) returned a Portland WW price of $8.45 per bushel. In 2007, 2006, and 2005, the prices I received for wheat entered in the average price pool were $6.44, $4.25, and $3.72, respectively. Last year, for the first time, MCP also offered a “high-risk” pool that it managed. The return on the managed pool (for an October 15, 2008 ending date) was $8.71 per bushel — 28 cents more than the average price pool.

I believe farmers should seriously consider putting 10-30% of their wheat in the average price pool. The pool is most attractive when prices in the spring are “high” (as they were in 2008). This year, predicting the direction of wheat prices is more difficult, but plausible arguments can be made that WW prices could be lower at harvest and during the early fall. I regret that this year’s average price pool didn’t start earlier. If prices decline at harvest, I’ll wish I had more $5.70 spring sales in the average.

Direct seeding in the dry areas of the PNW

I’ve seen too many floods and and too much erosion during my 35 years of farming. Watching a flood always doubles my desire to take action and we have made progress in reducing erosion by 1) installing many miles of terraces and dams and 2) steadily reducing tillage so more crop residue is left on the soil surface. The next logical step would be to eliminate tillage altogether and go to chemical fallow and direct seeding.

I hope to make this switch in the future. However, switching to chemical fallow and direct seeding now will reduce average wheat yields and cause big yield reductions when dry falls cause emergence of direct seeded wheat to be delayed into late October or November. I examine these difficulties and attempt to estimate the size of the yield reduction in

Why I haven’t switched to direct seeding

Without significant rainfall in August and/or September, chemical fallow does not have enough moisture in the top 6” to germinate fall seeded wheat. The summer sun bakes much of the moisture out of the top foot of untilled ground. Hence, wheat seeded on chemical fallow must wait for fall rains. If rains are delayed until October or November, the yield of fall seeded wheat is reduced.

Tilled summerfallow has one big advantage. Properly done, tillage establishes a “moisture line” about 4-5 inches below the surface. Wheat seeded into this moisture will usually germinate, even after long dry periods.

I examined the most recent 30 years of rainfall records from the Experiment Station at Moro, Oregon. I estimated that in 15 of the 30 years enough rainfall occurred in August and September to germinate wheat seeded on chemical fallow in late September/early October (the optimum seeding date). Hence, in about half of the years, wheat seeded on tilled summerfallow and wheat seeded on chemical fallow would emerge at the same time. In 10 of the years of the 30 years, significant rains did not occur until October and the germination of direct seeded wheat would be delayed a month. In five of the 30 years, significant rains did not start until November and the emergence of direct seeded wheat would be delayed by two months.

Several studies have examined the effect of delayed emergence on wheat yields. I discuss three studies in the above article. The studies indicate a yield reduction of about 18% if emergence is delayed a month and a reduction of 40% if emergence is delayed by two months. Hence, I estimate the average yield reduction from switching to direct seeding to be

( ( 0% x 15) + (18% x 10) + (40% x 5))/30 = 13%

Assuming a 50 bushel yield and a $5 per bushel price, a 13% average yield reduction would reduce gross revenue by $32 per acre.

The fall of 2008 was very dry and significant rains didn’t arrive until November. The 2009 wheat yields should highlight the yield reductions caused by late emergence. I took the picture below on April 2, 2009. The wheat on the left was seeded in mid September 2008 on tilled fallow and the wheat on the right is direct seeded on chemical fallow.

To make direct seeding more profitable in the dry areas of the PNW, new wheat varieties must be developed that produce good yields when the crop emerges late in the fall. Finding these new varieties should be a research priority.

In the article, I don’t discuss the differences in production costs between tilled and chemical summerfallow. Tillage can be reduced to one primary tillage plus a rodweeding or two by using a reduced tillage system such as the “undercutter.” Hence, I don’t expect much cost savings when chemical fallow is compared with reduced tillage systems. However, I would be interested in your comments.

Hedging WW when futures and cash aren’t converging

Several years ago, my grain cooperative, Mid Columbia Producers (MCP), started offering farmers a new marketing tool — a “base-price” contract. This new contract (which is similar to the “hedge-to-arrive” contracts used in the midwest) allows farmers to hedge their cash white wheat (WW) sales using Chicago soft red wheat futures. If a farmer sells wheat using a base-price contract, he first selects a Chicago futures contract for a month after his grain will be available for sale on the cash market. The price he ultimately receives for his wheat is then the Chicago futures price on the day he enters into the contract plus the WW basis on the day he decides the hedge should be lifted minus MCP’s service charge . The WW basis is the cash price of white wheat for the payment month he selects minus the current price of the Chicago futures contract he selected when the hedge was set.

A base-price contract is particularly useful for pricing wheat that will be produced in future years. The Portland grain trade normally has bids available for future months during the current crop year. However, the exporters are usually unwilling to buy wheat for delivery in future crop years and any bids they do offer are heavily discounted (i.e.,the basis offered is much less than the basis expected).

Since the WW basis fluctuates as much as the WW cash price, using a base-price contract does not reduce price risk for WW growers and is not really “hedging” in the traditional sense. It just shifts the risk from cash price fluctuations to fluctuations in the WW basis and provides a way to price wheat in future crop years. The WW basis exploded to almost $6 per bushel the fall of 2007 when the market realized that the extreme Australian drought was going to last for a second year. Two back-to-back years of drought in Australia have never happened before. For at least the 25 years before the fall of 2007, the WW basis showed no trend and fluctuated around an average value of 44 cents per bushel. See my discussion and graph on page 4 of Rules for Marketing White Wheat.

Transportation costs and market competition should normally cause the WW basis to average between 40 and 50 cents. In most years, the competition between WW and soft red wheat for export sales should cause the price of soft red at the Gulf ports to be about the same as the price of WW at the port of Portland. The cost of transporting wheat from Chicago to the Gulf is about 44 cents, so wheat in Chicago should be worth about 44 cents less than wheat at the Gulf (and wheat in Portland). If the Chicago futures prices reflect cash prices in Chicago, the difference between cash WW in Portland and Chicago futures, i.e., the WW basis, should be around 44 cents. Hence, if a grower wanted to sell his 2010 crop now with a base price contract, he could reasonably expect to receive the current price of the September 2010 Chicago futures contract plus 44 cents minus MCP service charge. Of course, the final price will be much less if the basis turns out to be negative when the contract is settled.

The above discussion assumes that the Chicago futures market is operating as it is supposed to and that the futures and cash prices of soft red wheat in Chicago converge — at least when the contract expires. Recently, futures prices have been much higher than cash prices in Chicago. According to the USDA “Chicago grain terminal report,” cash soft red wheat in Chicago on Monday (October 6, 2008) was $2 per bushel less than December Chicago futures. According to the U.S. Wheat Associates website, soft red wheat at the Gulf cost $4.84 per bushel (FOB) on Friday, October 10, 2008. Assuming a 45 cent transportation cost from Chicago to the Gulf, soft red wheat in Chicago should have been selling for around $4.39 per bushel — $1.25 per bushel below the Chicago futures closing price on Friday of $5.635 per bushel.

The “convergence” problem has been going on for several years now and may be related to the big influx of index fund money into the commodity markets. Regulators and the exchanges are discussing changes to the delivery rules for the Chicago futures contract to force greater convergence between futures and cash prices in Chicago. Forcing convergence would not be difficult, but nothing has been done to correct the problem yet.

How does all this affect a farmer who wants to price his 2010 crop now? I believe it reduces the basis he should plan on receiving when a base-price contract is settled. Assume that Chicago futures prices stay $1.25 per bushel above cash wheat prices in Chicago. I would expect the basis at settlement to then average a negative 81 cents ($.44 – $1.25). Using actual prices for yesterday (October 14, 2008) when the December 2010 Chicago futures contract closed at $7.0275 per bushel, his expected return would be

Chicago December 2010 futures                $7.0275
plus
Expected basis                                                 – .81
minus
MCP service fee                                               – .90

Expected return                          5.3175 per bushel

If the effort of force convergence is successful, the expected return would increase to $6.57 per bushel. Since changes in the rules seem likely, $5.3175 is probably a lower boundary on the the expected return. However, the recent lack of convergence adds additional uncertainty for those using base-price contracts.

Additional thoughts about exchange rates

During the late 1990’s, I started paying close attention to exchange rates. The steady increase in the value of the U.S. dollar that started in 1996 is an important cause of our low wheat prices between 1998 and 2001. See the articles in the Exchange Rates section.

Since peaking in 2002, the value of the U.S. dollar relative to a trade-weighted average of all other currencies (as measured by the Federal Reserve Board’s Broad Inflation-Adjusted Index) has declined by about 10%. The decline has been much more relative to currencies that trade freely and less relative to the currencies of the oil exporting countries and the countries (mainly in Asia) that buy dollars to keep their currencies undervalued and their exports cheap. China now has over $1 trillion stashed away in its currency reserves and has allowed the inflation-adjusted value of the Yuan to appreciate by only 8.5% since 2002 (as its trade surplus increased to over 10% of its GDP).

U.S. wheat growers have been lucky. The currencies of our competitors trade freely without government intervention. Since 2002, the U.S. dollar has declined by 40% relative to the Australian dollar, 34% relative to the Canadian dollar, 42% relative to the Euro, and 26% relative to the Argentine Peso. According to the USDA exchange rate website, between 2002 and April of 2008 the value of the U.S. dollar declined by 34% relative to a weighted average of our competitors’ currencies and by 20% relative to a weighted average of our customers’ currencies. This falling value of the U.S. dollar is one of the important reasons for the recent rise in wheat prices.

Problems for the U.S. economy

The falling dollar has stimulated U.S. exports and caused the U.S. overall trade deficit to start declining — from 6% of GDP in 2006 to 5.3% of GDP in 2007. However, the excess of imports over U.S. exports is still more than $700 billion. With rising oil prices, a 10% decline in the value of the U.S. dollar has not been enough to make much of a dent in the trade deficit. The U.S. imports over $3 trillion of goods each year from other countries. To purchase these imports and all the goods produced by U.S. economy for our domestic market, the combined deficits of the U.S. household, business and the government sectors were 5.3% of GDP in 2007. A trade deficit requires total spending in the U.S. economy to be greater than U.S. income.

Until recently, rising housing prices made deficit spending attractive for U.S. households. Mortgage lenders were aggressively soliciting new business and more than willing to refinance existing mortgages so homeowners could spend their rising home equity. In 2007, U.S. households saved only $43 billion and borrowed $361 billion for new housing — so the overall deficit of the household sector was $318 billion or 2.3% of GDP (down from $460 billion or 3.5% of GDP in 2006) . Business investment was almost exactly equal to retained profits in 2007, so the business sector had no deficit. The government deficit in 2007 was $412.3 billion or 3% of GDP.

With housing investment collapsing and households no longer able to spend the rising equity in their homes, U.S. households will be forced to reduce borrowing. I’ve often read that “one of the best ways to lose money is to bet against the ability of U.S. consumers to increase spending.” However, I don’t know where U.S. consumers will find financing for additional spending. With economic conditions weakening, businesses are also unlikely to increase spending. If consumer spending slows, government borrowing will need to increase to offset the huge drag on our economy from the trade deficit. Unfortunately, much of the required growth in the federal deficit may come from the recently passed Wall Street rescue bill. For an interesting discussion of these issues by a great economist, read Martin Feldstein’s article.

A final point

As discussed above, the U.S. trade deficit is stuck above 5% of GDP largely because of rising oil prices and because developing countries are intervening (buying dollars) to prevent their currencies from appreciating in value relative to the U.S. dollar. These countries are following the classic beggar-thy-neighbor policy of using currency manipulation to expand their exports. China is by far the most important example. China’s actions are clearly in violation of the International Monetary Fund’s (IMF) rule against “protracted large-scale intervention in one direction in the exchange market.”

The IMF was established to police the international financial system and exchange rates in particular. Recently, it has done almost nothing to enforce its own rules. This seems to be a source of some embarrassment at the IMF. I think two reasons account for the IMF’s inaction. First, when the countries in emerging Asia started using currency intervention as a development strategy several decades ago, they were a small share of world trade and could be ignored. Recently, China passed the U.S. to become the world’s second largest exporter and is challenging Germany for the top position. China can no longer be ignored or be given a “free pass” as a small developing country. However, forcing China to play by the rules of other large economies has a big downside. Evidence has been accumulating that an undervalued exchange rate is a key part of a successful development strategy. I don’t know of a good non-technical summary of this evidence, but you might check out this article.

China has been wonderfully successful in moving 400 million people out of extreme poverty. Does the IMF (or any of us for that matter) want to take responsibility for forcing changes in a strategy that has achieved so much?

Second, the IMF has lost its ability to force countries to follow its rules. Until the last decade, all currency crises involved countries trying to maintain overvalued exchange rates. An overvalued exchange rate causes trade deficits and a loss of currency reserves. An example is the Asian financial crisis in 1996-7. Then, countries were forced to go to the IMF for help and to make the changes required by the IMF as a condition for receiving its assistance. The current situation is exactly the opposite. Countries are maintaining undervalued currencies with trade surpluses and growing currency reserves. Asian governments have more reserves than the IMF! They can easily ignore the IMF. It is striking that in just a decade the IMF has gone from the feared policeman of the world to irrelevance.

The current financial crisis and economic slowdown are spreading rapidly around the world. During the last financial crisis in 1996-7, the world turned to the U.S. and the IMF for leadership and resources. Both the U.S. and the IMF are in much weaker positions today. Where will the leadership come from to resolve the current crisis? For a pessimistic view of the IMF’s current role, see Barry Eichengreen’s article.

Evaluating marketing advice

Advice on when to sell the crop is available from many sources: e.g., magazines, marketing clubs, newsletters, and the trading department of the local grain company. Which of these information sources should I use and how should I set up my marketing plan? I’ve discussed these questions previously in

President’s Half Acre – Marketing Plans

and

Rules for Marketing White Wheat

I have a few additional comments to add — especially about using cost of production in deciding when to sell.

Thousands of farmers and traders are trying to profit every day from buying and selling futures and cash wheat. Some of these traders have substantial resources and can quickly spot patterns in the market or important new information. New information is reflected in market prices very quickly, making wheat markets highly “efficient.” For “efficient” markets, future price movements are pretty much random. Consequently, exceptional returns produced by a particular strategy in a particular month or even an entire marketing year are due mainly to luck. Most strategies will produce similar results when the returns are averaged over a ten-year period. For example, if I tell you to sell all your wheat on September 5th every year (you could pick any other day in the year), the average results over a ten-year period will differ by less than 10% from the average returns of any other strategy. The big exception is a strategy that causes farmers to hold wheat too long — so the net return is significantly reduced by storage costs and foregone interest.

The “efficiency” of the wheat market is what makes deciding on a marketing strategy so difficult. Since no one knows how a strategy will work in the future, the only way to evaluate strategies is to check their average returns in the past and, as I argued above, past returns (neglecting storage costs) will usually be similar. The people selling marketing advice or writing magazine articles don’t want to be proven wrong. Hence, they usually don’t provide a strategy that covers all the possibilities. If the strategy isn’t fully specified to cover all situations, its average ten-year returns can’t be calculated. The reason I like the marketing framework developed by Professor Larry Lev is that his rules cover all situations and hence can be tested. He calculates that the average return using his rules is approximately 5% more than selling the crop at harvest. Increasing your returns by 5% over selling at harvest is about as good as you can do over the long-run.

The manager of our grain cooperative, Raleigh Curtis, is a very knowledgeable trader. Raleigh advises farmers to use their cost of production in deciding when to market their crop. First, farmers should decide on the net return they want, expressed as a percentage of their cost of production. Next, they should calculate the wheat price that is needed to give them their desired return. Raleigh has developed spreadsheets that make calculating this target price easy. Finally, farmers should sell their crop when the market price exceeds their target. He also advises checking the market prices being offered for future crop years and pre-selling part of the crop if the available market prices will produce the desired net return for future crops.

I have never understood why cost of production is relevant in marketing wheat that has already been produced. A farmer’s cost of production is very important in deciding what lease terms to accept, what crops to produce, or whether to continue as a wheat farmer. However, once the crop is harvested, production costs are sunk costs and I don’t see how they are relevant in marketing. A farmer wants to use the strategy that will produce the highest average return.

Although I don’t understand its rationale, I believe Raleigh’s approach would produce acceptable long-run results if he will just fix one important deficiency. As I’ve argued above, all strategies will produce similar long-run returns as long as they don’t cause farmers to hold wheat too long and rack up unnecessary storage and foregone interest costs. A farmer following Raleigh’s approach this year probably has already priced most of his crop, so excess holding costs are no problem. However, what should a farmer do during a year when the market never offers him a price that will produce the net return he wants? Raleigh needs to provide additional guidance on this issue.

I happened to have all the data necessary to test Raleigh’s approach for the nine crop years from July 15, 1993 to July 14, 2002. For each year, I calculated the minimum wheat prices necessary to produce 20%, 30%, and 40% returns and then used these target prices to determine when a farmer using Raleigh’s approach would have sold his wheat. For the 1993-4 through the 1996-7 marketing years, the triggers were achieved before the end of November for all three levels of net returns. During the 1997-8 marketing year, farmers seeking a 20% return would have sold early, but wheat prices never were high enough to achieve a 30% or 40% return. For the 1998 through 2001 marketing years, wheat prices were never high enough to achieve any of the three net return levels.

Raleigh has not specified what a farmer should do if prices remain below his trigger price during the entire marketing year. To be able to test his strategies, I assumed that a farmer sold at the end of the marketing year if wheat prices never reached the target. This meant that farmers were holding wheat unsold for long periods during the latter part of the test period, significantly reducing average returns. The average returns for the 20%, 30%, and 40% strategies were 77%, 39%, and 52%, respectively, of the returns achieved by selling every year near September 15th. If farmers using Raleigh’s approach gave up and sold their wheat at the end of November during years when prices stayed below their trigger price, the average returns were much higher — close to or higher than selling on September 15th.

Raleigh needs to provide some additional guidance to farmers using his approach to prevent them from waiting too long and having their net returns significantly reduced by storage and foregone interest costs.

Setting up a website and starting a blog

For the last five years, my TO DO list has included “set up a website.” A couple of weeks ago, the WSJ featured a section on websites for small businesses. The article motivated me to buy a “domain name” and get started.

Why am I setting up a website? Over the last 25 years, I’ve written articles on many topics related to wheat farming. See the different sections listed above. A few of my articles were published in farm magazines, but most were just sent to people who I thought would be interested. Often, I could think of about 60 people who might read the article. The great advantage of the web is that it makes publishing to this very small audience possible and easier than mailing articles. I can email the link and the person can download the article if he or she is interested. Also, it provides a way my articles can be accessed by people who may be interested, but who aren’t on my distribution list. Finally, a website is a place where I can post classic articles by other authors that aren’t easily available elsewhere. The articles by Bob Drynan and Larry Lev are examples.

I hope to post new blog entries once a week or so during the parts of the year that I’m not too busy farming. I know from my own experience that readers are more likely to check a blog if new material is available on a regular schedule — so I hope to fall into some kind of pattern.

I am interested in experimenting with a blog for two reasons. First, the PNW wheat industry has some excellent websites. However, I’m not aware of any that post regular commentary. Perhaps there is a hole I can help fill.

Second, we are all carrying around “great” ideas in our heads and being forced to write them down can be beneficial. When I was president of the Oregon Wheat Growers League in 2001, I was required to write a column for the magazine. I made a list of ten ideas I thought would be interesting. When I sat down to write them up, I was surprised to find that most weren’t really very interesting and could be discarded. I cleared out a lot of mental clutter during that year. I hope this blog will have the same good effect.