Managing Risk in a High Cost Environment
Farmers are accustomed to managing risk on a daily basis. The array of risk is widespread with Murphy’s Law looking to foil best laid plans at every turn. Commodity prices, cyber security, labor availability, animal health, supply chain management, interest rate volatility, weather and geo-political events all present risks to businesses across industries. It is important to have key people on your team who can help you think about your unique business holistically for when times of challenge arrive.
Impacts of Inflation on Cost of Production & New Construction:
According to the June 30, 2022 swine YTD database that Compeer tracks across our swine portfolio, the average cost of production was just under $90/carcass cwt. For context, this is a 10% increase from 2021 year ended costs which were already inflated 30% over 2020 year ended cost of production of roughly $66/cwt. Corn prices are clearly the primary driver of feed cost increases. We moved from cash corn starting with at $3 to the $6-8 range we’ve seen over the past three years. In the past year, non-commodity feed costs have also risen along with other segments. Inflation has more broadly impacted labor, energy, insurance and facility costs beyond just feed. These areas are likely to be “stickier” than commodity prices, which tend to go up and down with cyclical pricing volatility.
Lumber futures are currently trading closer to $500 vs. the $1,000 +/- peaks we saw during the height of the pandemic. Broader construction costs, however, continue to be significantly higher than levels we saw pre-2020. When you blend the cost of new construction into an existing capital structure, you’ll see a natural upward pressure on repair costs and overall yardage and facility costs.
Unlike in 2008/2009 when we last saw $8 corn before this market cycle, we have been blessed with a positive increase in market hog prices. Fortunately, revenue improvement has exceeded the increase in costs over the past couple of years. The question will be if inflationary supported retail pork prices will support higher lean hog prices paid to the farmer as the pig supply flexes. As of now, good hedging decisions made over the summer will provide support for seasonally lower hog prices through the fall and early winter.
A 10% pull back from a higher starting point is a larger gross reduction in profit margins. Higher prices with elevated “sticky costs” magnify the need for sound risk management strategies. Work with your marketing advisor to transparently communicate your risk profile and your unique financial capacity for risk. Herd health issues, succession planning, marketing decisions, expansion, divorces and natural disasters all impact a business’s working capital and net worth. Remember that your business is not always in the same position to take on risk. Your approach to managing risk should evolve accordingly.
Review your insurance policy before you need it.
Managing ongoing business dynamics is difficult on its own. Natural disasters and acts of God occur regardless of the business’s level of preparedness. Review your insurance coverage levels before an event. As the cost of construction and general inventory values have increased, be sure to revisit your policy to ensure it provides a pathway to replacing facilities and inventory.
If static values have historically been assigned to facilities or inventory asset categories, claim proceeds may or may not be enough to cover replacement as the business returns to normal. Understand how demolition and clean-up costs are covered if a facility is lost. Fuel, labor and equipment costs have increased the cost of cleaning up sites. Be sure to understand how your policy addresses this cost. If a facility is lost, it is good to know if you would need to reconstruct in its current location. Optimal geographic location for certain phases of production have evolved over the years. If you are forced to reconstruct an asset, it is good to have the option of making that assessment at the time of loss.
Business interruption insurance has been critical to many producers in covering the cash flow needs while they return their operations to normal. Review your policy’s time and nominal payout limits because cost of operations have flexed and the duration of re-construction has become extended with supply chain issues.
As inflation has impacted every expense line item within the income statement, so too is true with insurance premiums. This is why I appreciate the opportunity to sit down with producers and their insurance brokers to understand the cost/benefit analysis of higher insurance premiums and the coverage that aligns with each business’s financial capacity to withstand risk. Some producers may elect minimal coverage to save on insurance premiums, but their balance sheet would be negatively affected. Others have minimal margin for error and need enhanced coverage at the cost of current premiums.
Each business is unique and so is your risk profile. Be sure you are comfortable with your risk mitigation plans today.
For more insights from Daryl and the Compeer Swine Team, visit Compeer.com/swine.