In risk management, everything you do should be based on reasonable expectations.
Even if you’re the gambling type, you should only be making gambles in which you know the odds you’re playing with.
That applies to short-term situations, like the kinds of prices your crops or livestock will likely fetch a few months from now. You don’t just guess. You look at where things are at now, consider the factors that could affect them and figure out what range of reasonable possibilities you’re facing.
It’s more of a challenge for medium-term situations because the longer the time horizon the greater the chance that factors will change — and change more dramatically. That could apply to machinery purchases and various types of leases that are paid off over a number of years. Multi-year obligations are assumed and then the vagaries of weather and demand strike: sometimes good, sometimes bad.
The risk increases exponentially for long-term situations with lots of debt because the variables could change in ways almost nobody would expect. That’s the situation with land purchases, which rely upon a reasonable assessment of the long-term profit potential of a particular piece of farmland.
How the heck can you come up with reasonable expectations about the value of farmland that will take 20 years to pay off? In that amount of time there’s a strong likelihood for a radical change in both the markets and the climate. There’s time for a commodity boom, like 2006-13, to come and go. There’s also time for a commodity slump, like 1960-72 or 1983-2001, to develop.
There’s plenty of time for multi-year droughts to come, like Saskatchewan’s late-1980s experience. (That also occurred during a long-term low-price cycle.) And there’s time for unusually stable weather, like some argue that the U.S. Midwest has experienced since the 1990s.
A long period of losses and marginal returns, like the 1980s and 1990s for most of Western Canada and the U.S. Midwest, leaves land prices suppressed and relatively “cheap.” But who wants it if you can’t work it for a profit and nobody else wants it?
An extended period of good profits and crops, like 2006-13, sees land prices soar. Who doesn’t want to own a profit-making resource that can always be sold without a problem?
The other day I was tweeting about a farm management expert’s view that farmers were often paying too much for land, and also paying more in rent than can be justified by reasonable expectations of future profitability.
A couple of farmers who tweeted replies perfectly summed up the challenge of valuing a long-term debt obligation and asset against today’s reasonable expectations.
“Anything bought today at today’s prices is a big burden without lots of other land paid off or bought cheap,” said one.
“There hasn’t been a bad land purchase for 30 years, though,” said the other.
Right there are two guys thinking about the central problem facing farmers when they look at long-term debt taken on for an asset whose value will be based on volatile market prices and climate.
I have no wisdom to add here. Farmers who have to buy land will always be caught between the unpredictability of both short-term and long-term market and weather patterns and the utter predictability and inexorable pressure of debt payments and financial risk.
It’s easy to get short-term reasonable expectations right. It’s more a challenge with medium-term expectations.
But for long-term expectations, it’s much more of a gamble than anybody wants to admit.