In the AHDB Horizon report, Preparing for change: The characteristics of top performing farms, setting goals and budgeting were identified as a top trait of high performing farmers. In this paper, we look at one approach that can help achieve this – taking a long-term view of prices.
Why is a long-term view on price and profitability important?
Price volatility is part and parcel of commodity markets, especially agricultural markets. Predicting short-term price movements and swings is an impossible task but there are tools and techniques available to help get some perspective in order to make informed business decisions. At the moment, the majority of farm business decisions are dominated by reaction to short-term signals. It is important to monitor spot/short-term prices to manage cash flow but these are not enough to gain an understanding of the profitability of a business.
Fluctuations in the supply and demand balance is a fundamental factor behind price volatility, with production the key variable. Here, we are to a large extent reliant on aspects which are beyond our control, for example the weather. This can lead to short-term supply impacts and price extremes.
So, how should farmers interpret and react to short-term price movements? Also, how do you make plans to put the business on a profitable footing when prices move so quickly?
Farmers often have limited options to enable a quick reaction to short-term price signals, which could help to rebalance the market. By the time new business plans are put in place and fully implemented on the farm, it’s almost inevitable that near-term prices will be different.
A business is, or should be, a long-term concern, so we should be looking at slightly longer-term trends to put prices and profitability in to context. One way of doing this is using rolling averages.
The graph below shows daily nearby Brent crude futures prices since 2000, as well as the three-year and five-year rolling averages, to illustrate how farmers can use price information specific to their own commodities. When prices are averaged over a longer period, price extremes are smoothed out. In the graph, the rolling averages, reflect changes in the market in a smoother fashion than the nearby prices and removes the focus from the short-term volatility. As short term price movements are difficult to respond to in any case, rolling averages provide a better base on which to monitor ongoing performance.
We can also use rolling averages to put spot prices in context. If we focus on crude oil futures from 2010, we see that although the price fell 29% from around $125/barrel to $89/barrel between February and June 2012, it remained near the three-year and five-year rolling averages. In 2018, spot prices climbed above both the three-year and five-year average for the first time since 2014.
For an individual farm business, having a handle on both rolling average costs and price can give a clear indication of profitability and competitiveness over the longer term. In addition, with farmers now able to average profit over five years for tax purposes, the incentive to look at profitability over a five-year period is clearly there.
Taking a five-year view on price and cost makes managing profitability a long-term proposition. However, cash flow remains a short-term item to manage – especially during periods of low prices. So, to be successful, businesses should not be using cash flow as a measure of profitability and need to have separate strategies to manage liquid assets and profitability.
For some, a three-year rolling average can be useful as it can help identify a trend change which may not be noticed when using rolling averages over a longer periods, which smooths out fluctuations to a greater extent. A three-year rolling average essentially provides an early indicator of change and helps to consolidate where we are in terms of the overall commodity cycle.
Whether to use a three-year or five-year average will largely depend on how quickly your business can respond to market signals. For some businesses, especially those where production cycles are shorter, a three-year rolling average may be more relevant and useful than a longer one.
Using rolling averages to see where we are in the commodity cycle
Another useful aspect of rolling averages is they can help identify where we are in the commodity cycle.
Sticking with the example of crude oil, the graph below shows distinct phases in the crude oil commodity cycle since 1996:
Period A – low, stagnant prices (high oil inventories, Asian financial crisis, OPEC introduces price band)
Period B – Rising prices (lower production due to lack of investment, strong Asian demand)
Period C – Sharp drop in prices (2007–08 global financial crisis)
Period D – Rising prices (higher demand, Arab Spring)
Period E – Falling prices (high production versus weak demand)
Period F – Rising prices (production cuts by led by Saudi Arabia and Russia, geopolitical tensions e.g. the US unilaterally exiting nuclear deal with Iran). Prices recently fell below the rolling averages briefly as the US allowed waivers on Iranian oil imports but OPEC and Russia have agreed to cut production and so prices have moved up again.
As we can see from the graph above, there isn’t a fixed set of time for a certain phase within the commodity cycle. For example, the low price period, E, was longer than the previous low price period C. The other point to note is that the rolling averages during period E indicated a longer term downward trend than during period C.
From a business management point of view, the extended downturn in the markets during period E suggested the need to be ‘cash prudent’ in order to see-out the low price period. Those crude oil producers who were farsighted would have built up reserves during the high price periods which could draw on. Now, in period F, although prices are rising, it is probably too early to get carried away.
Cost discipline is vital in a rising as well as a falling market. Tracking rolling averages can provide a forward indication of trends and potential direction change. The three-year average provided a faster indication that the high price period D was running out of steam in late 2013/early 2014. Investing a large amount of the profits reaped over period D in costly infrastructure at that point, for example, may not have been a wise decision. Now, the three-year rolling average appears to indicate an upturn while the five-year rolling average is starting to flatten, rather than continue to decline. This is indicative of a period of higher prices, although it is difficult to say how long this will last.
Taking a long-term view of prices by using rolling averages helps to:
- Smooth out the “noise” from the day-to-day price volatility, providing a clearer picture against which ongoing performance can be monitored
- Identify changes in price trends
- See where prices lie in the commodity cycle and put prices in context
This just one tool to monitor the performance of your business and can help with longer term planning – see AHDB’s Resilience Checklist for more.
Average price charts for wheat futures, ex-farm feed wheat, oilseed rape, potatoes, pigs, cattle, sheep and milk are now easily accessible on the AHDB website.