This post is in partnership with Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania. The article below was originally published at knowledge.wharton.upenn.edu.
The 2012 farming season may be in its waning days, but the consequences of this year’s drought, the worst of its kind in 25 years, are yet to be known.
The U.S. Department of Agriculture estimates that the drought will push retail food prices up by between 3% and 4% in 2013. That’s a higher-than-average number, but only barely: over the last 20 years, average annual increases have been between 2.5% and 3%. Next year, most of the cost increases will be centered on animal products, like eggs, beef and dairy, which were particularly affected by not only this year’s drought but a similar dry spell across cattle farm-heavy stretches of the southwestern United States in 2011.
The life cycle of American agriculture means that most drought-spurred food price increases won’t be seen until the first quarter of 2013. But the drought is already pushing up food prices globally: An August report from the World Bank recorded a 10% increase in global food prices in July compared to a month earlier. The report noted that the jump was due to the drought in the United States as well as a poor farming season in Europe.
“The United States is one of the biggest food producers in the world. This drought is not going to just impact the marketplace here; it’s also going to hit in China, Africa, everywhere,” saysZ. John Zhang, a Wharton professor of marketing. “You can certainly imagine that the impact is going to be a lot bigger in developing countries than in the United States.”
Other effects of the drought are yet to be determined. Consumers will take a hit in the wallet, but that should be relatively short-lived — and short-term food price spikes can easily be absorbed by small changes in consumer behavior. “Normally, consumers have some way to deal with a food price increase,” Zhang notes. “You can substitute for meat in your diet; you can eat a few more vegetables. As when gas prices go up, people will find a way to cope.”
But just how bad the farm industry was hit and how long it will take to shake off the drought’s effects are subjects of much concern in agribusiness circles.
The Drought in Perspective
In the life cycle of the planet, the drought of 2012 is a blip compared to reports of a mega-drought in the 16th century. But to people whose livelihood depends on the right amount of rain falling at the right time, it has been a disaster, says Robert Giegengack, a professor in the University of Pennsylvania’s department of earth and environmental science. “It was a bad drought. It was the worst in the living memory of many farmers,” he says.
Although a lack of rainfall is the main indicator of a drought, officially declaring one is a complicated, technical process. The U.S. Drought Monitor — a joint effort between the Department of Agriculture, the National Oceanic and Atmospheric Administration and the National Drought Mitigation Center at the University of Nebraska-Lincoln — examines multiple indicators when releasing its weekly drought report, and the same factors that add up to a drought in one region of the country may not do so in another. As of mid-October, nearly three-fourths of the contiguous United States was in some degree of drought, according to the Drought Monitor.
Although the farming season is over, the drought is not. Some late-season rain helped replenish groundwater supplies in some areas of the country, but not enough to ensure a prosperous start to the 2013 growing season. “Many parts of the country are still deficient in terms of their total supply of rainwater,” Giegengack notes. “It remains to be seen if enough rain will fall over the fall [season] or winter to replenish those supplies. People are certainly talking about that, but nobody really knows.”
Reducing the Financial Hit
Although corn and soybean yields were down anywhere from 20% to 100% on some farms, according to Mitch Kasper, principal at Midwest Ag Investors in Chicago, many grain farmers will experience a smaller financial hit thanks to crop insurance, which covers about 80% of all the major crop acreage in the United States. For the current year, anyway, “we probably won’t see too many horror stories,” Kasper says.
National decreases in crop yields this year rivaled a major drought that took place in 1988, according to Frayne Olson, a professor of crop economics and risk management at North Dakota State University. Corn yield per acre this year is on track to be down 25% compared to the trend line, which is the same decrease as in 1988. Soybean yields are slightly better, down 14% compared to 18% in 1988.
“One bad year like this year — a lot of farmers can handle that,” Kasper adds. “It’s built into their operating budget. But if you get a few bad years back-to-back, you’ll see some people really feeling the pain.”
Although the nation’s livestock farmers also have access to insurance programs for their herds, the effects of higher feed grain prices and heat stress on their animals are putting a unique strain on their operations. “In the dairy sector, feed costs make up a very large portion of total production costs. It’s very hard for [dairy farmers] to compensate [in] their systems,” Olson says. “It’s going to take the dairy sector a long time to adjust to higher feed prices.”
Ironically, the drought actually lowered beef prices earlier this year as ranchers sent increasing numbers of their animals to slaughter to cut their expenses. That increased the nation’s beef supply and lowered the cost to consumers. But the culling of herds means there are fewer cows going to slaughter now, which will drive up beef prices before the year is over. “We started to see herd reductions a year ago, and that has accelerated this year,” Olson notes.
Meanwhile, ongoing drought-related disaster declarations for 2,500 counties in the U.S. are allowing farmers and ranchers to access federally backed emergency assistance programs to offset operating losses. The USDA is also offering low-interest loans and is offsetting payments for those farmers and ranchers who already have the loans and are located in a drought disaster area.
Farm subsidies — direct payments made by the federal government to farmers of commodity crops to underwrite their costs — are still flowing despite the drought, although those payments are concentrated among the largest farm operations. About 62% of all farms in the country receive no subsidy payments, and just 10% of all subsidy farmers collected 74% of all subsidy payments from 1995 to 2010, according to the Environmental Working Group, a nonprofit research and advocacy organization.
Damage Down the Line
Based on the broadest definition of agribusiness — that is, anything connected with agriculture, including family farms, farm tool manufacturers, seed companies and operators of grain elevators — no one was unscathed by the drought, although the pain was not equally distributed.
Farms producing fewer bushels of corn negatively affect regional grain elevator operations, which are directly tied to the local farming community. Olson says those operations have no opportunity to absorb decreased business through other channels or by luring in new business, so their fortunes are withering along with the corn crops.
Poor crop production also impacts the railroad and trucking companies that are contracted to haul away the grain. Unlike grain elevators, most of those companies don’t solely rely on the farm industry for their livelihoods, however, so the farming losses are mitigated by other contracts. A slow year also won’t rattle heavy equipment manufacturers, even though fewer farmers are likely to buy equipment this year. Kaspar notes that after several robust years for purchasing, a slow season won’t mean major damage to that sector.
Still, the ripple effects can spread well beyond agribusiness, Zhang says. As higher food prices get passed to the consumer, every step in the supply chain will feel the pinch. “At every level, you can imagine some possibility for substitution,” he notes. “Suppliers will suffer a little bit. When food gets into the retail store, [retailers are] going to shave their [profit] margins to lure customers. Consumers may absorb their increased costs by going out to eat less. It’s going to be a shared burden down the line.”
From Suffering Comes Opportunity
Some burgeoning areas of agribusiness could see a bump from this year’s drought — namely, seed companies selling genetically modified grain.
Bioengineering firms have long been on the hunt for a genetic tweak to corn and soybean seeds that would make them more tolerant to low-water conditions. Some of the nation’s largest seed companies, including Syngenta and Monsanto, recently have been pushing the new seeds as the latest and greatest advance in farming.
“I would guess this year would be a good advertisement for [these products],” Kasper says. But given this year’s drought conditions, the price of the genetically modified seed may be on the way up if demand increases. “When it’s raining outside, that’s the worst time to buy flood insurance.”
The traditional seed and fertilizer companies are having a good fall as farmers are beginning to lock in contracts for next year, notes Andrew Schrange, co-owner of Money Crashers Personal Finance, a financial fitness blog. “Surprisingly, agricultural chemical and fertilizer companies are doing quite well this year, as farmers are purchasing supplies early to produce what will hopefully be a banner year in 2013.”
And early indications are pointing toward that banner year, at least according to the corn and soybean futures markets. According to Kasper, those prices are showing strong demand. As farmers are locking in prices for at least some of their 2013 crop, that’s giving hope that even a mediocre year could bring in cash. “If you get an average year next year, but you sell ahead of time now, you’re looking at a profitable business. Farmers are optimistic; they are not scared off by this year. Obviously, if we have another drought, then we’ll see a lot of pain. But even an average year will be good because demand is still extremely high.
“If the futures prices were lower, that would really be discouraging for operators,” he adds. “That’s basically saying the demand for the product isn’t there. But the futures market is telling you that the demand is definitely there.”
Ultimately, however, future success mostly depends on Mother Nature. Going into 2012, no farmer in the world would have predicted anything but a fantastic year, Olson notes. “One of the reasons people got so optimistic about 2012 is that, with the exception of a few areas, most of the growing region had very adequate to good groundwater reserves, and farmers could get into the field early,” he says. “The idea is that if we can get into the ground early and have good soil moisture, we should have a good crop. Going into 2013, we don’t have a soil moisture reserve built up, so it puts a lot of pressure on [whether] rain [will] deliver in a timely fashion.” If that doesn’t happen, “it could take the yield down very quickly.”