volume 58 article #1

Risks and Risk Management in an Industrialized Agriculture

Michael D. Boehlje and David A. Lins

Boehlje is a professor in the Department of Agricultural Economics, Purdue University; Lins is a professor in the Department of Agricultural and Consumer Economics, University of Illinois.

Abstract

Dramatic changes are occurring in the agricultural sector—changes which will result in agricultural industries having many of the characteristics of manufacturing industries. These changes are resulting in new and different risks for the industry as well. The purpose of this discussion is to identify some of those risks, how they might be analyzed, and what we find to be some of the more interesting research and educational challenges and opportunities because of the changing risk environment in agriculture.

Key words: industrialization, risk, strategic risk, value at risk, real options, market risk, credit risk.

Article <top>

The agricultural industry, particularly the livestock sectors, is in a period of major change and transition. This transition is commonly referred to as the industrialization of agriculture—the application of modern industrial manufacturing, production, procurement, distribution, and coordination concepts to the food and industrial product chain. Industrialized agriculture is characterized by the following:

Drabenstott and others have documented the movement of various sectors of agriculture from a traditional to an industrialized structure. In the livestock industries, much of the poultry sector moved to this structure during the 1960s and 1970s. The pork industry is currently transitioning from a traditional to an industrialized structure; for example, at the production level, 5% of the total pork supply was produced by the 40 largest producers in 1986, whereas 31% of the supply was produced by the 40 largest in 1996. Dairy is moving more slowly to larger-scale, industrialized operations compared to pork, at least in the Midwest, but the trend is still clear in the western and southern U.S. In beef, the feeding activity moved to an industrialized model during the 1970s and 1980s, but the beef cow sector remains fragmented.

In plant agriculture, processed fruits and vegetables, sugar, potatoes, and similar crops have adopted an industrial production and distribution structure. The commodity sectors (corn, soybeans, cotton, wheat, rice) have remained more traditional in structure. In recent times, however, differentiated products with specific end-use characteristics (such as white food corn, waxy maize, high-oil corn, high-protein wheat, colored cotton, high-amoloyze soybeans, etc.) have been introduced into the market, and the production and distribution systems for many of these differentiated products exhibit the characteristics of the industrial model.

The implications of this industrialization process for the risk in the agricultural industry are profound. What are the new risks that will result? How might we analyze them? Who will bear them? What mechanisms are available to manage them? What are the financing implications? And, in general, what are the important issues that we must emphasize in future research and outreach programs in risk management for the agricultural sector? These implications are the focal point of this discussion. Our purpose is to raise issues, stimulate dialogue, and suggest testable hypotheses—not to provide definite, empirical answers to these important questions.

What Are the Risks? <top>

The risks faced by agriculture have often been classified into such categories as production, marketing, financial, legal, and human risks (Baquet, Hambleton, and Jose). An alternative and possibly more useful taxonomy is to categorize risk as tactical or operational risk and strategic risk. As agriculture becomes more industrialized, strategic risks are likely to become increasingly more important and, as we will note, are typically more difficult to manage.

Tactical or Operational Risks <top>

The traditional risks faced by farm and agribusiness firms can be categorized as business risk and financial risk. Business risk is commonly defined as the inherent uncertainty in the financial performance of the firm independent of the way it is financed. Thus, business risk includes those sources that would be present with 100% equity financing. The major sources in any production period are price, cost, productivity, and production uncertainty; a number of factors may affect this variability over time.

Financial risk or uncertainty is defined as the added variability of net returns to owner’s equity that results from the financial obligation associated with debt financing. This risk results primarily from the use of debt as reflected by leverage; leverage multiplies the potential financial return or loss that will be generated with different levels of operating performance. Furthermore, there are other risks inherent in using debt. Uncertainty associated with the cost and availability of debt is reflected partly in fluctuations in interest rates for loans and partly through nonprice sources. Nonprice sources, a type of institutional uncertainty, include differing loan limits, security requirements, and maturities, depending on the availability of loan funds over time. Thus, financial risk also includes uncertain interest rates and uncertain loan availability.

Strategic Risks <top>

The focus of strategic risk is the sensitivity of the strategic direction and the ultimate value of a company to uncertainties in the business climate. These uncertainties include: (a) political, government policy, macroeconomic, social, and natural contingencies; and (b) industry dynamics involving input markets, product markets, and competitive and technological uncertainties. Tactical or operational risk is easier to manage than strategic risk, in part because information is generally available to measure these risks, and because of the availability of accepted tools and techniques to transfer risk to others, such as insurance and futures markets.

Most strategic risks cannot be managed or transferred through conventional futures or insurance instruments or markets. Strategic risk is multidimensional, so managers cannot assume the simple one-to-one mapping between exposures and hedging or insurance instruments. Creative strategies must be developed to manage strategic risk exposure; approaches include flexibility, adaptability, and diversification.

One of the strategic risks farmers as well as agribusinesses are facing because of the industrialization of agriculture is contractual or relationship risk. The expanding use of contractual agreements and other forms of negotiation-based linkages between the various stages within the agricultural production and distribution system, combined with the decline in impersonal, market-based transactions, results in price risk being replaced by relationship or contractual risk for many businesses. A grower may have a contract that guarantees a price for the crop, but what happens if the processor goes bankrupt? What happens to the contract next year if the processor finds other suppliers in other areas who can satisfy the requirements at a lower price? This risk is not unlike that of losing a landlord or a lender, but losing access to the product market has typically not been a significant risk in commodity-based agriculture.

Another strategic risk that seems to be increasing in recent years is that of compliance or regulatory risk. Farm and agribusiness firms are facing increasing regulation in all aspects of their business transactions. Added to the traditional areas of regulation concerned with transportation, taxation, and labor use are two rapidly growing regulatory areas: food safety and the environment.

The Universe of Risk <top>

When viewed from the broader perspective of both strategic and tactical or operational risks, the total risk that farm and agribusiness firms face is much more complex and more pervasive than is often perceived. In fact, as the agricultural sector increasingly exhibits the characteristics of an industrial model, the types of risks it will face will also change. A taxonomy of the broader dimensions of risk that farm and agribusiness firms will be facing in the future is presented in Table 1. From both an analytical and managerial perspective, a major challenge in the future will be to quantify both the frequency or probability of occurrence and the magnitude of exposure from each of these potential sources of risk.

Table 1. The Universe of Risk: A Taxonomy of Risk Facing Farm and Agribusiness Firms in the Future

 

Managing Risk <top>

Economic theory suggests a tradeoff between risk and returns, i.e., people who accept higher risk should expect higher returns assuming they are operating on the risk-return efficiency frontier. Selecting the appropriate risk-return tradeoff is a critical management decision.

Managers have a variety of mechanisms for managing risk. The method of managing risk depends upon the nature of the risk involved. Four general procedures for managing risk are: (a) avoidance, (b) reduction, (c) assumption/retention, and (d) transfer. A discussion of each follows.

Avoidance is the process of structuring the business so that certain types of risk are nonexistent. For example, in swine production, there are considerable risks associated with farrowing operations including disease, poor genetics, low conception rates, and others. The traditional independent farrow-to-finish hog producer could not avoid these risks, although producers buying feeder pigs and finishing them out could avoid such risks. The problem for the producer buying feeder pigs in the past was that it was difficult to avoid the risks associated with buying feeder pigs from various sources. The quality of the pigs was variable, genetics were mixed, and disease may have been a problem. The movement to integrated production of swine has allowed growers to avoid these types of risks. Swine finish operations producing in an integrated system can largely avoid these risks, although other sources of risk may result and returns may be altered.

Reduction is the process of lowering the risks associated with the business venture. Consider the following example from the crop production side. A grain producer can hire crop scouts to spot disease, chemical imbalances, and pest control problems. This helps reduce the risk of poor yields, but the risk is not eliminated completely. In an industrialized form of agriculture, there are often good opportunities for producers to reduce these risks. Contractors for grain and livestock production, for instance, may supply experts who help the producer reduce production risks through timely advice. Again, this reduction of risk may result in implicit or explicit reductions in returns.

Another common way for producers to reduce risk is to diversify across different enterprises. For example, traditional independent swine producers are often diversified across crop and livestock enterprises. For industrialized agriculture, risk reduction through enterprise diversification is seldom a driving force. Rather, industrialized agriculture often involves specialized production as a means of achieving economies of size in one particular enterprise.

Assumption/retention is the process of retaining or accepting risks that would normally have been borne by some other party. The objective of assuming this increased risk is to maintain control and/or enhance overall profitability. Integrators in both crop and livestock production may retain ownership of products being produced under contract. To illustrate, consider the case of an integrator who contracts with growers to finish hogs. The grower is often responsible for providing the grow-out facilities, for a fixed or minimum guaranteed fee, while the contractor retains ownership of the market hogs. Since the grow-out facilities are not recorded on the balance sheet of the contractor, traditional measures of financial leverage (such as the debt/asset ratio) may not reveal the risks associated with this arrangement. Because the contractor retains ownership of the animals and has a signed contract with the grower, one can think of this arrangement as a pseudo-guarantee by the contractor for the loan taken out by the grower. The integrator is retaining more risk with the expectation of enhanced profits.

Transfers of risk occur when one party lowers his or her risk by shifting that risk to someone else, often for a specified price. There are numerous methods in agricultural production to shift risks in this manner. Common examples include futures and options contracts, crop insurance, and fire and hail insurance. These transfers are accomplished with a known cost, i.e., the cost of insurance, options contracts, or the like.

Risk transfer can also occur in situations in which the "cost" of the transfer is more disguised or vague. For example, grain farmers can transfer price risk through forward contracts. Likewise, a contract producer of vegetables may be able to transfer price risk to the contractor. The monetary and nonmonetary costs of such risk transfer are less clear.

Industrialized agriculture has tended to alter the mechanisms for managing risk. Producers who operate under contract may have better opportunities for yield and price risk avoidance, reduction, and transfer than do traditional independent producers. However, these opportunities may be offset by increases in less traditional risks such as relationship risks and strategic risks. Integrators, on the other hand, have opportunities to assume more risk in the new industrialized forms of agriculture. Of course, higher returns are expected for accepting such risks.

Who Bears the Risk? <top>

Industrialization of agriculture is expected not only to change the kinds and amounts of risk in the industry, but it may also influence who bears those risks. As agriculture moves from a traditional to an industrial model, government policy is simultaneously changing, particularly as it relates to the grain sector. Price and income supports are being dismantled which will reduce the funds available from the public sector to mitigate the financial consequences of lower prices and/or incomes in agriculture. Thus the opportunity to transfer some of the risk from the private sector to the public sector as occurred in the past will likely be reduced. At the same time, new private sector risk management instruments, including yield insurance and crop revenue insurance, are being developed. Changes in public policy and innovations in the risk management markets have the potential to significantly impact the cost of transferring risk as well as affect the ability of various firms within the industry to assume or reduce risk.

As more responsibility for risk absorption and management is transferred from the public to the private sector, it is less clear who in the private sector will eventually bear the risk—the producers who produce the raw materials, the processors who convert those raw materials to consumer goods, the consumers who buy the products, the capital providers (both equity and debt) who finance the industry, or the risk management/service industries who introduce new products and services to the market. But two trends are likely. First, as the public sector’s role in absorbing the risk in agriculture is reduced, more incentives emerge for the private sector to develop increasingly innovative and efficient risk management instruments and markets. And second, private sector providers who perform risk management functions have the potential for higher rewards from efficient and effective risk-bearing than in the past.

Analyzing Risk <top>

There are numerous ways to evaluate and analyze the risks faced by producers and agribusiness firms. These methods vary from highly quantitative techniques such as computing probability distributions, to subjective procedures such as those used in risk scorecard techniques. A discussion of four different procedures for evaluating and analyzing risk is given below; these procedures are not all new, but provide additional opportunities for both analyzing and communicating risk in industrialized agriculture. While this is not a comprehensive list, it does cover the major techniques for evaluating and analyzing risk.

Probability Distribution Techniques <top>

Risk is closely tied to the variability associated with various physical and financial performance measures. Consequently, there has been a long history of measuring risk on the basis of variations in yields, prices, net farm income, and other performance measures. At the most basic level, this involves the measurement of means, standard deviations, coefficients of variation, and cumulative density functions for the various variables of interest. Historical data provide the basis for such measurement of risk. Cumulative probability distribution functions are an effective way to communicate the risk implications of various decisions and events.

Moving beyond the basic measures, various procedures have been used to help select among risky choices. In agricultural economics studies, stochastic dominance has been used extensively to order risky choices (Robison and Barry). In addition, modern portfolio theory (MPT) has been widely used to determine optimal portfolios, including studies that have examined the role of farmland in optimal investment portfolios of institutional investors (Lins, Kowalski, and Hoffman).

Fairly recent advances in computer programs have allowed researchers to more easily incorporate risk into spreadsheet programs. For example, the program "BestFit" allows one to quickly and easily determine the distribution that "best" reflects the distribution from which a historical set of data was drawn. Output from the BestFit model can then be directly inputted into spreadsheet programs such as "@RISK" in Lotus or "Crystal Ball" in Excel. The application of these techniques in agricultural economics is still quite limited, but the approach has been used by Barry, Sherrick, Lins, Banner, Dixon, and Brake; Mazzocco and Laduzinski; and Powell, Brumm, and Massey.

Value at Risk <top>

Closely associated with probability distribution techniques, value at risk (VAR) is a procedure for specifying the minimum amount of money one could expect to lose with a given probability over a specified period of time. The concept has become quite widely accepted in the corporate business world as a mechanism for more effectively communicating the dollar amount of risk associated with a given portfolio position. A 1995 Institutional Investor survey found that 32% of the firms used VAR as a measure of market risk; a survey by the Stern School of Business reported that 60% of pension funds used VAR measures (Linsmeier and Pearson).

The VAR measure has three components. The first is the probability level used to specify the minimum amount of money one could expect to lose. Since the objective is to evaluate an unusual or abnormal loss, this probability is often set quite low; 1%, 2%, and 5% probabilities are the most commonly used. The second component is the length of time over which the loss can occur. This could be a day, week, month, year, or any other relevant time interval. Because the concept is most heavily used in the business world, the time interval is normally 90 days or less. The third component is the actual dollar amount of the potential loss. Consider the scenario of an integrated livestock producer with a total investment of $20 million. This producer might find that the VAR for the firm for one month with a 5% probability level is $200,000. This means that the firm is expected to show a loss of $200,000 or more over a one-month period with a probability of 5%.

The concept of VAR is appealing because it allows one to consider the dollar amount of risk associated with the entire portfolio, or set of business ventures, not just one component of the portfolio. In essence, the focus of VAR is on the loss exposure as measured by the reduced value of a business or business venture that results from unpredictable events. To quantify this risk, one must compute the probability distributions associated with the components of the portfolio. Linsmeier and Pearson have identified three different approaches to measure probability distributions: (a) historical simulations, (b) the variance-covariance approach, and (c) Monte Carlo simulation. They describe the pros and cons of each approach, and their synopsis will not be repeated here. However, they suggest a number of advantages to the Monte Carlo approach— an approach that is quite easily accomplished with the @RISK and Crystal Ball programs noted above.

While VAR has been quite widely accepted in the corporate finance world, it has seen limited use in agriculture. Schnitkey, Miranda, and Irwin have used it to assess the consequences of various grain marketing strategies. As we move toward a more industrialized agriculture that also utilizes corporate finance tools and techniques, firms seem more likely to adapt to and use this risk assessment tool to analyze implications of strategic risk in particular.

Options Theory <top>

Options theory provides a well-recognized conceptual framework for measuring and pricing risk, and it is widely used in financial markets to transfer and price interest rate, foreign exchange rate, commodity price, stock price, and other risks through both organized futures and options exchanges and privately negotiated arrangements such as strips and swaps in the financial markets. More recently, the concepts of options theory have been extended beyond the financial markets to investment decisions in a risky environment—real options (Dixit and Pindyck).

The basic premise of real options theory is that many investments (as well as most strategic decisions) involve risk and uncertainty concerning future payoffs and costs, but they can often be divided into stages and sequenced so that more information is available after the first stage, which will influence the probability as well as the potential size of the expected payoff. In these circumstances, the initial stage investment or commitment is much like buying a call or an option, i.e., the opportunity but not the obligation to make additional investments or commitments at a later stage.

Real options concepts have the potential to be very useful in analysis of strategic risks in particular. In addition to decisions concerning the profitability of capital investments including R&D expenditures, the timing and staging or sequencing of such decisions in an uncertain environment can be best understood as a real options problem. Generally, uncertainty or randomness increases as the time horizon increases, and delaying will decrease uncertainty by allowing new information to become available, by increasing the experience in managing randomness or the development of new technologies or techniques to enhance process control and reduce variability. But there is a cost of delaying, not only in terms of the time value of money, but also in terms of lost market position, first-mover advantage potential, etc. Real options concepts can be used to determine the optimal timing and sequencing of real investments such as land purchases, large-scale new-venture livestock production facilities, or company acquisitions.

Real options theory also may be useful in understanding and evaluating the payoffs and risk of joint ventures and strategic alliances. A number of alliances, joint ventures, and similar vertical linkages have been formed recently in the grain and input supply industries (ADM and Growmark, Pioneer and DuPoint, Monsanto’s acquisition of Holden Seeds and investment in DeKalb, etc.) Licensing and other agreements are increasingly dominating the biotechnology industry. From a strategic positioning perspective, such arrangements compared to acquisitions might be viewed as acquiring an option, or as a preemptive move, yet maintaining flexibility until new information is available. Folta and Miller have applied real options theory to strategic alliances in the biotechnology industry. In similar fashion, real options concepts may be useful in understanding recent developments to form downstream linkages in the grain and oilseeds industries.

Risk Scorecarding <top>

Many of the new risks that are part of industrialized agriculture can only be assessed subjectively or qualitatively; sufficient numerical observations are not available to provide objective assessment of probabilities so as to develop market instruments for risk transfer and allocation or use actuarial techniques to price risk absorption or mitigation. Although objective measurement of risk is preferred to subjective assessments, the increasing relative importance of these subjective risks in agriculture suggests that they cannot be ignored because they cannot be quantified. Until more objective evidence is available to build actuarially sound numerical estimates of risk, a systematic procedure to assess the frequency and consequences of these new risks may be essential. This in fact is the emphasis of recent developments in scorecarding and stress testing.

Risk scorecarding is similar in approach to that of credit scorecarding used by the lending community to assess the credit risk of various customers. The concept is to identify the potential sources of risk for a particular business, to assess the severity of those risks, and to aggregate these scores into an overall risk assessment that then can be compared to a standard which discriminates acceptable from unacceptable risks. Objective, quantifiable measures of risk are preferred, but as in the early days of credit scorecarding, a systematic approach to subjective assessment of risk is facilitated by the systematic scorecarding approach. An illustrative risk assessment scorecard that is structured to assess the individual categories and total risk identified in Table 1 is presented in Figure 1. A research challenge is to develop the necessary measurement and quantification procedures to convert this initial subjective assessment process into one that is more objective, as is currently occurring with credit scorecarding.

The process of stress-testing is often used to determine the severity of the consequences of future events that are uncertain and cannot be predicted probabilistically. In reality, stress-testing is a form of "what if" analysis whereby the severity of the consequences of future uncertain events is measured. Again, Monte Carlo simulation procedures are frequently used in the numerical analysis. With the growing importance and awareness of strategic risk in the agricultural sector, stress-testing will likely become an increasingly more common component of the assessment of future financial performance.

Selected Research <top>

A number of research issues that surface with the industrialization of agriculture have already been identified including the importance of strategic risks, the potential usefulness of value at risk and real options concepts, and the new risks and new ways of managing risk that result from contract production. This discussion will present selected additional issues that in our judgment merit research attention. A challenge in performing research on many of these issues is that of measurement and quantification—we will not spend as much time on how to do the analyses as on what we find to be interesting issues.

Figure 1. Risk Assessment Scorecard

 

Risk and Product Differentiation <top>

The food and industrial use markets for agricultural products are increasingly characterized as segmented or niche markets that can appear and disappear rapidly. Some food distribution channels may require particular quality characteristics which may not be available in predictable quantities in open, spot markets. For many agribusiness firms that are in the food processing and distribution business, the risk of changing consumer preferences or a food safety scare may be a much more critical and important risk to manage than price or availability of raw materials. One reason for a contractual arrangement to source raw materials from a qualified supplier is to reduce price and availability risk as well as food safety risks from contamination, and simultaneously obtain the attributes needed in the final product from the specific-attribute raw material. But as noted earlier, this arrangement may reduce flexibility and introduce relationship risk.

The transformation of a segment of agriculture from a commodity to a differentiated product industry introduces at least three new risks that merit analysis. First, differentiated products are positioned to respond to unique market segments that value the attribute that is differentiated. Assuming this attribute is measurable (which may be a risk in itself since many food attributes, including quality, are difficult to measure), one risk is that consumers’ and end-users’ attitudes and willingness to pay for some attributes may change over time.  For example, consumer attitudes with respect to food additives, biotechnology, and genetically modified organisms (GMOs) do not appear to be stable or predictable across cultures and across time.

Second, alternative techniques to accomplish product differentiation will likely develop over time, and those firms or individuals that can produce the differentiated product will likely increase. Thus, differentiated products are regularly commoditized over time, and initially higher margins are eroded as new competitors appear. The speed of commoditization is also a source of uncertainty.

Finally, differentiated products in the food market, particularly if that product is a branded product, also carry the risk as well as the reward of branding. Brand value can be quickly destroyed by defects or quality lapses, and in the food product markets, food safety is a risk that can quickly destroy brand value.

Risks in Value-Added Investments <top>

Investment in value-added activities by producers is appealing because margins are often perceived to be better in these activities, and more control of the food production-distribution chain can be acquired by involvement in additional activities in the value-adding process. Furthermore, the common perception is that vertical linkages or alliances through ownership or contract production will also reduce quality and quantity risk.

The implications for financial and strategic risk are less clear. If the margins in the value-added activities are negatively correlated with margins in production activities, risks are reduced from a portfolio perspective. However, given that in the long run the same fundamental supply and demand drivers will shape the profitability and margins in the entire production and distribution chain, it is quite possible that these margins are not negatively correlated, but positively correlated, thereby limiting risk reduction potential.

Furthermore, if additional debt capital is acquired in the acquisition of the capital assets to implement the value-added activities, the leverage position may be increased, and thus the financial risk would be greater. And even if the financial leverage of the vertically integrated firm is no different than the aggregated financial leverage of separate firms involved in the same stages of the food chain, the fact that this equity is supplied only by one firm (or a smaller set of equity holders compared to the broader set associated with independent ownership of the stages of the production/distribution system) will typically result in increased absolute risk exposure for those individuals, and thus a redistribution of risk. In essence, the dispersion and/or concentration of financial risk as one moves from independent firms to vertical linkages is a critical issue that merits further analysis.

A further dimension of this issue of changes in risk exposure with producer investments in value-added activities is the potential new risks that may exist or be introduced. These new risks may be in the form of strategic risks such as business partners and partnerships, competitors and competition, distribution and distribution channels, etc., rather than operational risk (price, quality, or quantity). These strategic risks will be encountered by both independent or integrated firms, but the magnitude and complexity of such risks are expected to be larger and more difficult to assess and manage in a more integrated system compared to more fragmented and independent production and distribution systems. Thus, as producers invest in additional activities further down the chain, they would likely face a new and different set of strategic risks than have been encountered in the past.

Financial Performance and Contract Production <top>

Many independent producers have entered into contractual agreements with other businesses in the hog industry. Kliebenstein and Lawrence report that while contract production reduces the level of risk for the producer, risks and returns vary by contract. A key consideration in assessing the economic impact of contracting and other business arrangements on the producer is the interrelationships between the risk aversion (and risk-return tradeoffs) of the producer and the risk attitudes of lenders and the capital markets as reflected by the financing terms and arrangements and credit availability for different business arrangements. Because of their risk-averse nature, lenders are careful in extending credit to businesses that exhibit significant operating risk; they will often extend more credit to those businesses that manage the operating risk through various techniques such as contract production. To transfer operating risk to someone else requires the producer to accept a lower profit margin (since the risk taker must be compensated to accept that risk), and thus a lower return on assets.

The real issue for the producer is how to identify the impact on return on equity of different business arrangements. If the lender allows a producer to borrow additional funds and expand the business, because of the reduced operating risk under contract production, it is possible for the producer to have a higher mean return on equity and a lower variance of return on equity. The higher mean return and lower variance on equity may coincide with the producer receiving a lower mean return on assets. This issue of the implications of the impact of various contracting arrangements on the risk and return to equity capital (not just to assets or total capital as is typical of most analyses of contract production) is critical to understanding the growing opportunities and interest in contract production.

Market Risk and Performance <top>

The industrialization of agriculture is likely to compound the risk and uncertainty related to the effectiveness of markets in providing accurate messages to consumers and suppliers in the food chain concerning prices, quantities, and qualities of products and attributes. With the formation of more tightly aligned food supply chains, it can be argued that messaging is much more precise, timely, and generally more accurate for participants in the chain than might be provided by market forms of coordination. Critical assumptions of this argument are that product attributes are accurately measurable, and that consumer demand for attributes is predictable. A recent study of this phenomenon in the pork industry provides support for this hypothesis, but much additional work in this and other industries is needed (Cloutier).

What about the risk faced by those who are not part of the tightly aligned supply chain—i.e., are not qualified suppliers? Is there more volatility in the prices they receive because of thin markets? Do they have access to a market or are they closed out because only qualified suppliers can participate? Because of the thinness of these markets, are they not only subject to more volatility, but also to more potential for manipulation? Do the prices and other information conveyed by these thin markets provide accurate messages to consumers and suppliers concerning quantities, qualities, cost, and value? If the commodity markets become the "salvage" market for products that do not meet specifications in the qualified supplier system, do they become frequently oversupplied with the prospects of more downside price volatility than upside potential? If those who cannot participate in the qualified supplier systems can only sell in commodity markets and these markets take on the characteristics of a salvage market, do the participants incur more of the risk of more tightly aligned chains that are part of industrialization without the potential of receiving any of the rewards? If markets become sufficiently concentrated that only one or possibly two qualified supplier arrangements are available in a particular locale, how can participants be assured that their share of the risk and rewards of participation are equitable? The fundamental issues of access to information, transaction transparency, equitable sharing of risk and rewards by nonparticipants as well as participants in tightly aligned supply chains, and the risk associated with market access are all important market risk and performance issues that are part of the industrialization of agriculture.

New Risk Management Instruments/Options <top>

As noted earlier, private sector innovation in the risk transfer/mitigation/allocation markets has resulted in a proliferation of new instruments and alternatives. In grain production, futures trading in yield contracts, combined with futures and options on commodity prices, has facilitated the development of a broader set of insurance contracts including crop revenue insurance and revenue assurance. More complex risk management alternatives that combine various forms of crop insurance with traditional forwarding pricing, hedging with futures and/or options, contracting, or similar instruments are being offered. Contract production in livestock production, including pen space, window, or minimum price contracting, is increasingly common in the pork industry in particular. Net income per acre contracting has been used in specialty crop and seed production, and may have potential in commodity production in the wheat and corn industries. More input supply firms are offering performance warranties as part of their product/service package (not just in machinery and equipment, but also in the genetic and chemical industries). And more consulting firms are offering a broader set of risk management/ counseling services. The number of instruments and strategies for managing risk in crop and livestock production is proliferating rapidly, yet we know little about how effective these instruments and arrangements are and under what circumstances they may be useful.

Lending or Credit Risk <top>

The risks involved in lending to industrialized production agriculture are different than those in traditional agricultural lending. If the product produced is a specialized or differentiated product rather than a commodity, the risk of market access may increase.

Differentiated product markets can disappear and/or be flooded by alternative suppliers; the borrower must have a thorough understanding of the market in addition to well-developed marketing and distribution skills to be successful in differentiated product markets. Documenting these potential risks and procedures for assessing and managing them would assist lenders in credit analysis for differentiated product producers. And the growth in differentiated products and contract production may also have important implications for commodity markets and commodity producers. As noted earlier, open-access commodity markets may increasingly become residual markets with growth in contract and differentiated product production. Consequently, those who lend to participants in these markets may be subject to increased price variability with the prospect of more downside price risk than upside potential—i.e., a skewed price distribution.

Many of the integrated, new-venture projects also involve specialized assets. The technology embodied in these specialized assets may be critical to the physical performance and debt servicing capacity of the venture. The wrong technology could be disastrous, both in terms of operating performance and marketability of assets if default occurs. Although the technological risk for integrated, new-venture projects may not be all that different than for traditional loans, the size of the loan, and thus the exposure to a bad technological choice, is likely to be larger. The implications of asset specialization and technological risk on credit risk and collateral management are compelling and important research issues.

New-venture projects are expected to have long lag times during the construction and start-up phase which must be recognized in developing financial projections. It is not unusual for delays to be experienced in construction of hog buildings and other livestock facilities, resulting in little revenue during the first year and an expanded need for operating funds to cover cash flow deficits during the longer-than-expected startup period. It is typical to have the operation running only at 75% to 90% of efficiency and/or capacity during the second year of operation, so cash flow and debt servicing is impeded further. Documenting the magnitude and frequency of these startup problems and the implications for debt servicing would be useful for lenders in assessing credit risk, and in developing loan terms such as deferrals of first-year principal payments on building loans or multi-year operating credit lines to accommodate startup problems.

As a function of the larger scale of operations, industrialized new-venture projects may more frequently encounter regulatory compliance risk. Particularly in integrated livestock production, larger-scale units may be held to higher standards concerning environmental rules and regulations and labor and worker safety rules. Recent violations of environmental regulations, both in the Midwest and Southeast, have resulted not only in significant increased monitoring of compliance, but have made the approval and permitting process in some states more formidable. Thus regulatory concerns may not only increase the delays in current and future construction which will impact cash flows, but they also may increase monitoring and compliance cost as well as the potential risk of shutdown because of noncompliance, which also will impact debt servicing capacity. Documenting these costs and risks would be useful to understanding the credit risks that lenders who serve this segment of agriculture will face.

Increased integration of the food system also has significant implications for lenders. An integrated food system will mean that individual firms may require financing for a broader set of activities, thereby increasing the potential amount of funds needed as well as the types of financing terms and arrangements. If the coordination is accomplished through contracts or strategic alliances, the lender must not only evaluate the internal creditworthiness of the customer, but also the terms and conditions of the contract or alliance to make sure that the overall arrangement is financially sound. Various coordination systems will likely change the asset structure or the cost and revenue characteristics of a firm, and thus require different criteria for credit assessment. For example, out-sourcing of supplies or contract production frequently reduces the current assets and liquidity of the firm since others own the inventory. Therefore, typical measures of liquidity used in credit analysis—such as the current ratio or liquid asset margin—will need to be modified.

Analytical work to document the risk implications of a more integrated, industrialized agriculture would not only be useful in lending decisions and credit analysis, but also in policy discussions concerning both safety and soundness in the financial industry, as it attempts to serve industrialized agriculture, and farm policies and programs to cost-effectively mitigate or manage risk in the agricultural sector.

A Final Comment <top>

Dramatic changes are occurring in the agricultural sector—changes which will result in agricultural industries having many of the characteristics of manufacturing industries. These changes are resulting in new and different risks for the industry as well. The purpose of this discussion has been to identify some of those risks and what we find to be some of the more interesting research and educational challenges and opportunities because of the changing risk environment in agriculture. If we have stimulated you to agree or disagree, to see the issues differently, to show us to be right or wrong—to undertake new research and educational programs to understand and manage these new risks—we will have accomplished our goal.

References <top>

Baquet, A., R. Hambleton, and D. Jose. "Introduction to Risk Management." Risk Management Agency, USDA, Washington, DC, December 1997.

Barry, P.J., B.J. Sherrick, D.A. Lins, D.K. Banner, B.L. Dixon, and J.R. Brake. "Farm Credit System Insurance Risk Simulation Model." Agr. Fin. Rev. 56(1996):68­84.

Cloutier, M. "Economic and Strategic Implications of Coordination Mechanisms in Value Chains: A Nonlinear and Dynamic Synthesis." Unpub. Ph.D. dissertation, Dept. of Agr. Econ., University of Illinois at Urbana-Champaign, 1998.

Dixit, A.K., and R.S. Pindyck. Investment Under Uncertainty. Princeton, NJ: Princeton University Press, 1994.

Drabenstott, M. "Industrialization: Steady Current or Tidal Wave?" Choices (4th Quarter 1994):4­8.

Folta, T.B., and K.D. Miller. "Buyouts and Dissolutions in Biotechnology Partnerships: A Test of Option Theory."  Academy of Management J. (forthcoming, 1999).

Kliebenstein, J.B., and J.D. Lawrence. "Contracting and Vertical Coordination in the United States Pork Industry." Amer. J. Agr. Econ. 77,5(1995): 1213­18.

Lins, DA, A. Kowalski, and C. Hoffman. "Institutional Investment Diversification: Foreign Stocks vs. U.S. Farmland." In Financing Agriculture in a Changing Environment: Macro, Market, Policy, and Management Issues. Proceedings of Regional Research Committee NC-161 meeting, held September 1991. Manhattan, KS: Kansas State University, February 1992.

Linsmeier, T.J., And N.D. Pearson. "Risk Management: An Introduction to Value at Risk." Working Paper, Dept. of Accountancy and Finance, University of Illinois. Online. Available at

http://w3.ag.uiuc.edu/ACE/ofor/wp0496ab.htm [No date.]

Mazzocco, M.A., and S. Laduzinski. "Modeling Stochastic Interest Rates in Financial Institution Budgeting." In Regulatory, Efficiency, and Management Issues Affecting Rural Financial Markets, edited by C.B. Moss, pp. 206­20. Proceedings of Regional Research Committee NC-207 meeting, held in St. Paul, MN, 28­29 September 1992. Pub. No. SP93-22, Food and Resour. Econ. Dept., University of Florida, Gainesville, September 1993.

Powell, T.A., M.C. Brumm, and R.E. Massey. "Economics of Space Allocation for Grower-Finisher Hogs: A Simulation Approach." Rev. Agr. Econ. 15(1993):133­41.

Robison, L.J., And P.J. Barry. The Competitive Firm’s Response to Risk. New York: Macmillan Publishing Co., 1987.

Schnitkey, G.D., M.J. Miranda, and S.H. Irwin. AGRISK. Online. Available at http://www-agecon.ag.ohio-state.edu/agrisk/agrisk.htm

Teach, E. "Microsoft’s Universe of Risk." Chief Financial Officer (CFO) (March 1997):69­71.

 

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