Allan's Observations: The good times will eventually end for commodity beef

by Allan Nation

A well-read book of mine is The Art of Profitability by Adrian Slywotzky. I typically re-read it every two weeks or so as it is very information dense. However, that doesn’t mean I necessarily like its core message.

This message is that every business, industry and economic activity starts at a level of zero profitability for everyone involved, traverses an arc to an apex of peak profitability for everyone involved and eventually returns to a level of zero profitability for everyone involved.

I found this very sobering.

Most of us prefer to think in the terms of an ever upward trending chart line in which the good times only get better. That we will eventually have to periodically totally recreate our businesses just to survive is daunting.

The Spanish have a word for the art of living life to its fullest while remaining fully aware of one’s eventual death. This word is duende.

And, I think that is what all of us have to learn to do.

We have to enjoy the good times but realize that they will eventually end.

I was reminded of Slywotzky’s arc when I got a press release on Peter Apedaille’s keynote speech to the Christian Farmers Federation in Canada from Elbert van Donkersgoed in Wingham, Ontario.

Apedaille is professor emeritus in the Department of Rural Economy at the University of Alberta and a founding member of the Canadian Rural Revitalization Foundation.

He said that after 50 years of decline, net farm income in Canada is now approaching zero. This is due to a combination of a high Canadian dollar and to overcapitalization.

Things are not much better south of the border.

The Wall Street Journal pointed out recently that despite record yields and government subsidies of $30 to $50 an acre, the average acre of corn in Nebraska lost $88 an acre in 2005.

A key point Apedaille made is that there is little the government can do to “fix” what currently ails North American agriculture.

I often think of a letter to the editor in a commodity farm journal in which an American farm wife asked, “Why can’t the government just set the prices at a level that we can just farm the way we want to and live well?”

I guess this is the argument for farm parity prices.

Parity is that a bushel of wheat or corn should buy the same amount of goods and services it did in 1914.

The reason you can’t have parity prices is that the way we all want to farm is bigger than last year.

You can’t constantly produce more of anything and sell it for a higher, or even the same, price.

And this law of economics does not just apply to agriculture.

The book Bull! said that all economic cycles, not just agricultural ones, are inevitable because they reflect human nature.

It is in our nature that when things are good we want more of it and if we see our neighbor doing well we want some of his as well.

The end result of these two urges is that all industries eventually become overcapitalized and overproduce.

For example, what happens to the billions of dollar the taxpayers pour into agricultural subsides each year? The majority of them are bid into inputs, the biggest of which is the price of land.

Currently, $1000 an acre of the price of land in Iowa are said to be due to capitalized government corn subsidies. Soon, it will be $2000 an acre. Then $10,000 an acre.

The longer subsidization goes on the more unrealistic the price of inputs become and the less competitive you are as return on investment shrinks.

Let me put this is a steam analogy.

Government subsidies are like coal to a boiler. If you just keep stoking, you will eventually blow the whole thing up.

The last time this happened was in the early 1980s. This explosion released the pent-up pressure of over-capitalization and allowed the process to slowly start over again.

Now, 25 years later we are back at the same level of over-capitalization and the government is stoking away thinking that more coal is what is needed to keep the darn thing moving.

Remember the old saw, “The unintended effect of government action is always far larger than the intended affect.”

Apedaille said the best government agricultural policy could do was to try to manage the decline. It cannot stop it.

The forces of globalization are ensuring this is not just another cycle but probably the end game for undifferentiated commodity agriculture in the North America.

I believe in 10 years time people will marvel at the incredible stupidity of our farm policy in the last few years. This was a stupidity born of arrogance.

Remember, we were going to force the Europeans to buy GMO grain because they had no alternative to American corn?

Guess what, they found an alternative in South America and Eastern Europe and now buy NO American corn.

Remember, we didn’t have to dance to the Japanese tune after Mad Cow because they had no alternative source of grain-finished beef?

Guess what, they quickly found an alternative to American grain-finished beef in Australia and bought NO American beef.

In 2003 the USA was the world’s third largest beef exporter. Now, we are not even in the top 10.

Does no one in Washington read marketing books?

Rule one. The customer is always right even when he is wrong.

We all admit that grain farming is in the tank right now but things are great in beef, right?

Yes, indeed! Things are so great that the whole beef world is in a herd-building mode.

In the last year Cattle-Fax noted:

* The USA increased its cowherd by 194,000 head.

* Canada increased its cowherd by 300,000 head.

* Brazil increased its cowherd by 1,400,000.

* China increased its cowherd by 2,500,000.

* And the world altogether increased its herd by 4,600,000 cows.

Keep in mind this is in just ONE year!

In the beef business, a replacement heifer is a heaping scoop of coal in the boiler. Eventually there will be a big explosion and the only way out of a beef oversupply is to eat our way out.

The key point to note here is that high beef prices create low beef prices even if we Americans don’t increase our own herd by much.

The country to watch in beef is Brazil.

BRAZIL IS THE NEW BEEF GORILLA

Brazil has zoomed past Australia as the world’s leading beef exporter and has millions of acres of under-developed pasture land that it can continue to expand into.

While Australia was diddling around trying to learn how to feed grain for Japan, Brazil’s grass fed beef has taken away most the rest of the world. Brazil’s beef exports grew from 18% of the world’s share to 24% in just one year.

Brazil now has 100 million more cows than the USA and as I just showed a lot more on the way.

The NCBA says that American’s preference for grain fed beef will protect the domestic market from Brazil’s tidal wave of beef.

I guess none of these guys have been to Whole Foods lately and noticed that imported Uruguayan grass fed beef sells for 20% more than American grain-finished “natural” beef.

Oh, by the way NCBA, Whole Foods is paying a live weight price of 30 cents a pound more for domestically produced grass fed beef than the domestic grain finished beef market is paying.

This year Congress will write the 2007 Farm Bill. While I would love to march on Washington and demand that the government totally get out of agriculture, I know this is hopeless. More farm subsidies are the only thing Democrats and Republicans currently agree upon.

Farm subsidies provide work for entire bureaucracies at the USDA, support university research and extension, farm organizations, input sellers and manufacturers.

The best that can result from the 2007 Farm Bill is an agricultural Amtrak. This is something that sort of looks like what a for-profit American agriculture looked like but serves no defined market and makes no real money.

As I have told you before, as far as the USA is concerned, export agriculture is O-V-E-R. It was killed by the CRP program in the early 1980s and every farm program since then has been just another nail in its coffin.

In contrast, Australia and New Zealand eliminated their farm subsidies at the same time. Today, their agriculture is still world competitive but North Americans and Western Europeans now have no stomach for the rough and tumble, extreme cost control an export-based agriculture requires.

As John Phipps recently wrote in Top Producer Magazine, that while none of us particularly like where our government’s Farm Policy is leading us, we are getting there with “stunning efficiency.” Unfortunately, Phipps said every alternative to producer subsidization would require the complete re-education of both the producer and the extension service.

The big question now is, “Do we have the wherewithal to compete for our own domestic market?”

The good news is that the USA still has the world’s largest domestic beef market. The bad news is that everyone else in the world wants a piece of it.

And, guess what? The same guys who lost the export market will be running the defense of the home market.

I want to warn our overseas readers that once Washington finally realizes it has totally lost export agriculture it will start building high tariff walls and import restrictions to protect its domestic market.

As much as we love you guys, you don’t vote here and our Congress knows this.

When push comes to shove, you guys will get shoved.

Remember, the only people who are for free trade are the winners.

Okay, no more politics. Back to today’s high beef profits and where they are taking us.

COMPETITION KILLS PROFITS

Ironically, future trouble always starts with high profits. Here’s why.

Profits attract capital which increases production which eventually lowers prices.

There is no scenario of restricted supply or increasing demand that can prevent prices from eventually falling. Anything that creates a high price sets in motion a chain of events that eventually results in low prices.

Restricted supply creates competitive alternatives which also eventually lowers the price and erases the profits.

Increased demand attracts increased production which eventually lowers the price and erases the profits.

Even worse, much of the capital that gets invested during the high profit phase is invested in what are known as “sunk costs,” or fixed overheads that cannot be easily turned back into cash.

As a result, all over-capitalized industries keep producing to utilize these costs even though they are selling below their true capital replacement costs.

This makes for a very long de-capitalization period and is eventually accomplished by depressed producers leaving either voluntarily or involuntarily. This eventually drops supply below demand and starts the next profit cycle.

The point Slywotzky makes in The Art of Profitability is that the highest profits occur, not at the apex of the arc, but relatively close to the start of the upward profit arc.

This is because most of the remaining producers are still traumatized by the downturn and outside capital is not paying attention. The net result is lowered competition for approximately six to seven years.

In a totally new industry, this high profit phase can last up to 20 years. This is why pioneering pays. There is little or no competition.

While psychologically most of us want to do what others are doing, that’s not where the profits are.

To have a sustainable profit cycle you must have three things:

1. An exceptional product.

2. A profitable business model.

3. A source of control over your competition.

Why are doctors, lawyers, dentists and pharmacists highly paid?

Because they control their competition with rigorous licensing requirements.

The vast majority of what you pay a doctor for could be done just as well by a well-trained nurse or medic. But, just try to practice medicine without a license!

If you want to sell your production wholesale for the highest price you need to be Certified Organic. Why?

Because the hassles of organic certification offer an effective competition control!

You don’t think non-organic Nebraska corn farmers who sold their corn for $1.60 a bushel last fall wouldn’t have preferred to have sold it for the organic price of $8.00 to $12 a bushel? The certification program kept the supply restricted despite a massive oversupply of corn.

Grass fed beef producers are sitting in the catbird’s seat right now because most producers are ignoring the market due to high commodity beef prices and therefore the competition is low.

Now, let the price of 850 lb feeder steers fall to 60 cents a pound.

Will most producers take their licking and just buy back cheaper calves? Or, will they suddenly notice the $1.00 plus a pound grass fed guys are getting and decide they will just grow them another six months?

History says that a great many will do the latter and there will be a glut of non-organic grass fed beeves on the market.

Certified Organic producers will be protected from this, and any short-term cattle glut, by the time, aggravation and three year wait of certification.

I am as disgusted by the meaninglessness of the USDA Certified Organic program in producing a truly healthy food product as you are, but it does fulfill this third function of providing a source of control over the competition well.

Where most organic producers have totally missed the boat is with the second item - the business model they are using.

Most organic beef and dairy producers have taken the industrial grain-based production model and just changed the source of the inputs. Yes, Certified Organic production sells for more but your inputs cost a lot more as well. For many, it’s just a higher level money swap with no increase in net profitability.

Colorado sheep rancher, Richard Parry, said that he went to a Certified Organic program for the competition protection it provided but also added an Argentine-style year-around forage chain sequence to eliminate having to buy expensive organic alfalfa hay.

That’s the way to do it!

Use the Certification program to build a moat against competition but keep your production input costs low by using Nature as a guide.

A totally direct marketed product can often avoid the need for Certification but it will help you immensely if you are selling on the Internet. Most consumers start their search with organic and if they find what they want there they go no further.

However, keep in mind that all successful direct marketing starts with the first item - an exceptional product.

To keep marketing costs low, you have to have a product that creates a lot of positive talk among your customers. You want your customers to do your selling for you.

Way too many people have rushed to market with a less than exceptional product and are having to spend a lot of money in advertising, promotion and price discounts to get it sold.

Remember, the purpose of marketing is to avoid having to sell. An exceptional product will sell itself.

Concentrate your time and energy on producing something truly exceptional.

Go for it!

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