A financial services company senior executive, representing nearly $600 million in their pork production loan portfolio, recognizes that producers face some unconventional challenges. Their response may determine whether they survive.
Pork producers well remember the price crisis that defined the year 1998, says Mark Greenwood, AgStar Financial Services, Mankato, MN. But they may not realize that a fundamental shift occurred in the pork industry that year.
Up until 1998, recent live cash hog prices averaged $46/cwt. Since then, prices have averaged $40-41/cwt. In a mid-September address at the Leman Swine Conference in St. Paul, MN, Greenwood predicted hog prices would not improve for the next five years. He foresees hogs selling for $39-42/cwt.
There are two major factors that have prompted this fundamental shift in the industry's pricing structure since 1998: vertical integration and the growth of larger operations.
Between 1974 and 1998, a number of producers got in and out of the hog business with the cyclical rise and fall of production. That has given way to the birth of vertical integration, which now stands at 20% of the industry. The big three are Smithfield Foods, Premium Standard Farms and Seaboard Farms. These production systems were joined in the last 5-6 years by a core group of 20,000-sow operations.
“These large operations have staying power, so we are going to have a much more steady supply in the industry for a consistent period of time,” stresses Greenwood. He projects that vertical integration will climb to 35% of the industry in the next three years.
A third reason for tighter margins is the growth of packer agreements. Only about 15% of hogs are purchased on the spot market, further limiting price discovery, he notes.
Hog Financing Tightens
Many hog operations have been financed with low-capital infusion (below 30% capital), remarks Greenwood. Those days are over, he says, and here's why:
There is no room for error in today's hog business. But problems still occur. Many of AgStar's loan customers have broken with porcine reproductive and respiratory syndrome (PRRS) and have had production problems with low capital. Lenders won't provide additional capital in these cases, he emphasizes. A PRRS break on a 2,500-sow unit will cost at least $500,000 in lost production, based on $10/pig and production of 50,000 pigs/year. Every loss of $500,000 equates to a drop in equity of 8%, says Greenwood.
There is more market uncertainty with live hog prices in the past five years, ranging from $8/cwt. to $55/cwt. This uncertainty makes established lenders much more cautious.
Packers are less willing to provide contracts to ensure profitability. Contracts today offer less certainty of repayment capacity on loans.
Cost of Production Squeeze
The average cost to produce pork today is about $41/cwt. with current feed prices (corn at $2.25/bu. and soybean meal at $180/ton), notes Greenwood. There is a 10% segment of the industry producing pork for under $38/cwt. (Figure 1).
By 2006, if feed prices remain stable, the number of producers raising hogs for under $38/cwt. will more than double, he predicts. Few producers will be operating near breakeven costs of $42-44/cwt. (Figure 2).
If feed prices remain constant, the cost structure of the pork industry will continue to tighten by 2010 (Figure 3). Greenwood projects just a $2/cwt. difference between 80% of the marketplace.
Above all, pork producers will need to cut their cost of production to be better than the average if they want to survive.
When figuring cost of production, producers must be sure to add in all costs including depreciation, debt service and also general and administrative expenses, says Greenwood. Smaller producers must include family living expenses.
Another key to survival is to establish adequate working capital. This has been tough to maintain the past two years, he admits. For producers who own facilities, working capital should be $250-300/sow. For producers who don't own facilities, double that figure.
If those numbers aren't achievable:
Try to refinance to increase working capital. Many barns have less than five years left to repay, and current interest rates make it a good time to refinance debt.
Restructure any debt on sows to pay off in less than three years. Include this in cost of production calculations. “Many times, we see sows listed on the operating notes as current debt. Pushing this down to intermediate term debt improves the working capital equation,” points out Greenwood. And with hog prices profitable now, pay down debt instead of adding sows.
Market proactively. Don't just rely on contracts. Use all forms of marketing to compete. “Producers will have to procure inputs, use forward contracts, utilize the Chicago Mercantile Exchange and take advantage of profits when they arise,” he suggests.
Greenwood says there will be two forms of contracts in the future. One will be a cost-of-production contract for a small segment who want to sell hogs for a margin over costs. The second contract will be integrated between producer, processor and food distributor to price products up the food chain.
Control production. Maybe most importantly, producers need to reduce sow numbers. Start by lopping off the bottom 10% of production that are under-achievers, states Greenwood. And forget about expansion. If you need to grow, do so through acquisition.
Unless the industry reduces the nation's breeding herd from 5.9 million sows to 5 million sows, producers are in for long periods of low prices, he warns.
Define an exit strategy. If you don't believe that you can compete, plan to exit now when prices are relatively high, rather than when they are low.
Greenwood concludes, “There are six keys to survival: staying power, integration or coordination, top management, good production skills, low-cost production and adequate equity.”