Narrow Profit Margins? Cutting Costs May Not Be The Answer!

Profit margins for 2006 corn and soybean production are expected to be narrow, some wonder if there even are margins for profit! Input prices are increasing and grain price outlooks are discouraging. USDA's February 9, 2006 World Agriculture Supply and Demand Estimates project record 2005-06 carryover of soybeans (555 million bushels) and the largest corn ending stocks (2.401 billion bushels) since 1987-88. These large carryovers, along with export competition as the South American harvest begins, are expected to continue downward pressure on grain/oilseed prices.

Outlook for 2006 production also appears bearish. Baseline projections by USDA and FAPRI, along with early supply/demand projections by a number of market analysts, suggest large supplies and disappointing prices for the upcoming 2006-07 crop marketing year. Most expect some reduction in corn acreage due to high input costs, but trendline production could still result in large 2006-07 corn carryover, 1.9 to more than 2.0 billion bushels and price expectations near $2.00 per bushel or less. The reduction in corn acreage is expected to add acres to soybean plantings. An increase in soybean acreage, even with strong demand, is expected to lead to 2006-07 soybean ending stocks ranging from 320 million bushels to more than 650 million bushels with price estimates varying from as low as $4.50 to not much more than $5.35 per bushel.

While corn and soybean prices are expected to decline, input costs are expected to continue increasing. Fuel prices have slipped from their earlier highs, but remain at high levels. Energy prices, transportation costs, and foreign competition for supplies are among the factors that led to higher fertilizer costs during the past year and fertilizer is expected to remain expensive. Energy prices also may provide upward pressure on pesticides and other inputs. Seed costs continue to increase. Machinery prices are trending higher, along with increasing repair and maintenance costs. Federal budget deficits are expected to keep upward pressure on interest rates, which are increasing. It appears that nearly all input cost categories have increased and will continue to squeeze already tight profit margins.

As profit margins are being squeezed, there also are concerns about production potential. Severe drought in Texas and Oklahoma continues to spread into Kansas and southwest Missouri. Dry soil conditions persist from last year's drought in the central Corn Belt and the soils in the western Corn Belt remain dry. In addition to dry soils, increased potential for damaging crop pests following a mild winter and the possibilities for soybean rust add to production risks. These production risks, along with narrowing of profits margins, have producers worried.

The first reaction to a squeeze on profit margins is often, "We have got to cut costs!"

But this is not easy to do and it can sometimes produce disastrous results. What costs can really be cut? Quite often very few can be reduced significantly. It may be possible to reduce a tillage pass or field operation, but many producers are already practicing minimum or no-tillage operations. Shopping around for "deals" on some input prices may provide some savings. Crop rotations to capture nitrogen credits from legumes (most are already doing this anyway) and waiting until spring to apply nitrogen may lower fertilizer cost somewhat. However, cutting back on fertilizer rates or other inputs may seriously risk reducing production and income potential. Increasing soybean acres could reduce total production cost outlays, but will that mean multiple years of soybean production on some fields with increased risk of insect and disease pressures, increased potential for herbicide weed resistance, need to apply P & K fertilizers, or lower yields? Remember, efficient production is lower cost per bushel, not necessarily the lowest cost per acre. It is important to budget alternatives carefully to consider the impact of yields and prices, as well as production costs, on profitability. Cutting costs may not be the answer after all!

Note printed budgets and downloadable budgeting software to assist in this task are available at: http://www.fapri.missouri.edu/farmers_corner/index.asp?current_page=farmers_corner

The key to profitability is producing efficiently, managing risks, and capturing market opportunities to increase revenue. The early projections by market analysts suggest considerable risk of lower prices for 2006 production. In addition to efficient production, it will be essential to plan on managing production and price risks in the coming year.

Current prices offered for new crop futures contracts for corn (December) and soybeans (November), suggest downside risks ranging from $0.50 to $1.35 per bushel for soybean prices and 20 to 45 cents for corn based on early 2006-07 price projections. Although the new crop seasonal price trend is usually higher into early spring, current prices appear to be offering an opportunity to begin pricing new crop production and managing some of the price risks. Spreading forward contract sales throughout the season or using options can be used to take advantage of early prices and reduce the risk of changes in production prospects or market outlook. In spite of the fact that option premiums are expensive, purchasing put options still provide downside price protection against a sizeable portion of potential price risk. More complex option strategies, such as a "fence" (buying a put option and selling a call option) can reduce premium costs and "lock-in" a range of favorable prices. These or a number of other marketing tools (futures hedges, "new generation" cash contracts, etc.), offer a variety of marketing tools to capture price opportunities. Regardless of which selling strategies are chosen, marketing plans are essential to managing price risk with narrow profit margins.

Crop insurance, when coupled with marketing plans, helps manage production and price risk. Although the variety of crop insurance plans available sometimes seems complex and confusing, it is important to consider how each can provide risk protection. The decision on which plan to choose often depends upon a compromise between desired risk protection and the amount of premium. Multi-peril or "Actual Production History" (APH) policies provide limited production protection. Although not a substitute for a marketing plan that is aimed at protecting profits, some of the newer type policies, such as Crop Revenue Coverage (CRC) or Revenue Assurance (RA), include price protection as well as production risk insurance to protect against excessive revenue losses. So far, the February prices for November soybean and December corn futures contracts, which are used to determine minimum price guarantees, are providing prices well above early 2006-07 price projections by most analysts. These crop insurance policies can help reduce risk of revenue loss due to reduced production and provide funds to make up for production shortfalls on forward contracts, providing confidence to proceed with pre-harvest marketing plans aimed at avoiding potential harvest time price lows.

The cost/price outlook with the potential for negative profit margins is discouraging. However, it is important to manage costs for efficient production and be careful to avoid excessive cost cutting that reduces production. While not all production or market factors can be controlled, blending risk management strategies and government price support programs with efficient production practices suggests the potential for profits still exists.