Keeping Up with Ag Credit Risks

One of my commercial lending buddies had an interesting side hobby.  He set up giant fireworks displays for communities and commercial use.  He was part of a larger team that you would see the incredible results over displays on July 4th. 

He did take his job seriously and detested telling people that he set up fireworks.  He preferred the term “pyrotechnic engineer”.  He had a tennis ball yellow shirt that had on the front, “Pyrotechnic Engineer”.  The back read, “If you see me running, you’d better keep up!”

Today in our agricultural market, there are several credit risks that we must keep up with.  They are as dangerous as the man streaking by you in the yellow t-shirt and if not managed, could result in the detonation of your producer or serious explosive damage to your institution.

One of the most dangerous areas is international trade.  Today, 20% of our farm income is driven by exports.  As the U.S. seeks to obtain fairer trade deals, we tend to expose one area where we are a net exporter, agricultural products.  NAFTA represents 28% of the entire world economy and many people who have money.  We have $20 billion of exports to Canada.  Mexico has $18 billion of exports last year in a country that has 47% of its population under 25 years old.  China is another key ag trading partner with $30 billion in potential. 

In each case, we should expect volatility, possibly extreme at times as new talk of tariffs and trade deals are announced.  It is important for the lender to preform sensitivity analysis on their ag and commercial loans to see how far prices may fall and keep the farm above water. 

The next roman candle of risk is with the oil and energy markets.  The 9/11 tragedy set in motion the wheels of the U.S. becoming more energy independent.  This began a drive toward more efficiency, exploring new energy sources, and a growth in alternative energy as well.  Today the U.S. is the number one energy producer in the world.  Canada ranks #6 and Mexico is eighth.  We also sense trends on the horizon to move away from the internal combustion engine and to electric vehicles.  This move will cause areas that have rare earth metals used in batteries, such as Central Africa, to become the new Saudi Arabia.

In agriculture, nearly 80% of all production expenses are impacted by energy.  Every recession since the 1960s has started off with a spike in oil prices.  This risk may be a bit muted now as we have seen a sharp increase in oil prices since 2016 and yet we do not see a huge increase at the gas pump.  Oil price increases may not create the negative impact it used to as we are now able to export oil.

The U.S. economy is another risk.  We are currently in an expansion that is over 100 months and is nearing the all-time record in length.  At some time, we would begin to expect a correction and the Fed is certainly concerned with possible inflation, low unemployment, strong consumer sentiment, and the overall strong growth in the economy.  Some major factors impacting this are the renewed enthusiasm in business with the recent Trump cuts in taxes and governmental regulation.  People are more hopeful today overall.  This leads people to feeling better about themselves financially and this leads to more consumer spending. 

The strong economy leads to a strong dollar and add in trade issues, leads to low commodity prices.  Also watch future rate hikes that are based upon more urban and costal economies, but do not look fully at the impact of the rural producer.  As I write today, Prime is at 5%.  This is 1.25% higher than what it was just 18 months ago.  Consensus is that rates will go up another 50-75 bps this year. 

The average of Prime is at 6.5%.  If Prime just goes to the average from where we are today, operating lines will cost 30% more in interest than they do today and about 73% more than what they did 18 months ago.  This may be disastrous for a producer who is at best marginally profitable.  The guy in the yellow shirt is streaking by financial institutions who fail to recognize the impact that increasing rates have on their balance sheet as their net interest margin will be sorely compressed.

The final keg of TNT to be careful of is land values.  Years ago, I heard an examiner, of all folks stated, “if you have the dirt, you can’t get hurt.”  Clearly today, this complacent attitude toward land prices is like ignoring a lit fuse.  Land prices have historically showed resilience.  We are seeing a trend that land valuation will be more based upon productivity, availability of water and minerals, technological compatibility, and the impact of organic, local, and natural markets.  Other factors are the increasing aging of the producer and lack of generational transition, availability of affordable operating and equipment financing, and cyclical downturn in land prices, which may occur.

As you lend to farmers and ranchers today, the yellow man is racing by you.  The question is how can you keep up? Closing your eyes as you feel the breeze after he runs past is not a viable option.