The drought that impacted much of the United States this summer has had varying impacts on both crop and livestock producers across the U.S. and in the Eighth District. For crop producers, particularly producers of corn and soybeans, the reduction in crop yields has led to a spike in commodity prices. However, government-backed crop insurance programs provide many of these producers—and their lenders—with an important safeguard against the yield reductions from this drought. As a result, the impact of the drought on crop producers appears to be somewhat tempered.

Livestock producers, on the other hand, generally do not benefit from these same insurance safeguards. Facing a spike in their input costs, as feed costs rose and as pastureland conditions deteriorated, livestock producers have had to make more immediate choices. Some have chosen to cull their herds at temporarily depressed prices. Those who chose to maintain the size of their herds until input costs decline have taken a calculated risk that conditions will improve. This risk, however, could lead to even more severe losses for these producers and, perhaps, their lenders.

Unfortunately, rains that blanketed much of the country in September occurred too late to have any material impact on this year's crop yields, feed costs or pastureland conditions. Weather conditions in the months ahead will serve as a strong indicator for how crop and livestock producers will fare in the spring.

Mild Winter and Early Planting

At the beginning of the year, agriculture conditions suggested that 2012 would be a strong year for the industry. Farm incomes had been strong for most of the past decade, and a mild winter facilitated early planting. The winter wheat crop yield was strong. The United States Department of Agriculture (USDA) predicted in spring 2012 that corn yields would be around 166 bushels per acre?a record for corn producers. Given this prediction, many expected corn inventories to grow significantly, putting downward pressure on prices. In fact, as late as June 2012, corn was priced in the mid-$5 range per bushel, well off 2011 prices.

The Drought Hits

Unfortunately, summer weather conditions did not cooperate. The critical pollination periods for corn and soybeans are generally late June and late July, respectively. But in 2012, excessive heat and dryness was the prevalent weather pattern across most District states, with rain shortfalls reaching 15 inches in some areas. The benefits of a mild winter and early planting were lost. In severely struck areas, many farmers resorted to cutting crops for silage. This weather pattern largely continued through August when the residual rains from Hurricane Isaac provided District states with needed moisture.

Crop Forecasts Are Significantly Revised

By early July, many analysts and academic institutions began revising their forecasts for the agricultural sector. For example, the USDA revised its corn yield forecast down 26 percent to 123 bushels per acre. Other institutions, such as the University of Missouri's Food and Agricultural Policy Research Institute, updated their forecasts in August to factor in the impact of the drought.[1]

The University of Missouri's revised long-term baseline forecast now reflects the following for the agriculture sector:

• Corn prices are now expected to average $8.10 per bushel for the crop harvested in 2012, exceeding last year's record by about 30 percent. This is expected to result in steep reductions in corn domestic use, exports and carryover stocks.
• Soybean prices are now expected to average $16.27 per bushel, up from about $13 per bushel this spring and about 30 percent above last year's record. This is expected to result in sharply reduced levels of soybean crush and exports.
• These higher prices for corn and soybeans are expected to elevate prices for other grains and oilseeds. For example, wheat prices are expected to increase to $8.42 per bushel, in spite of record 2012 U.S. wheat yields.
• Ethanol production is now expected to decline by 10 percent for the 2012/13 corn-marketing year. Higher ethanol prices are expected to result in sharply reduced ethanol exports and increased imports, but domestic ethanol consumption is expected to decline by just 2 percent.
• The increase in feed prices is expected to result in reduced production of meat and milk, pushing up prices for those products. Consumer food prices are expected to increase by more than 4 percent in 2013.
• High prices are expected to keep 2013 corn acreages near its 2012 peak, and soybean and wheat acreage are both expected to increase as well. Cotton acreage, however, is expected to decline in 2013 because of weak cotton returns relative to returns of other competing crops.

The University of Missouri is also concerned that if its forecasts materialize and more acreage is planted to compensate for this year's losses, a return to more normal weather and growing conditions in 2013 could result in a sharp reduction in crop prices because of excess supply.

Crop Production in Eighth District States

Among the 655 community banks[2] headquartered in the Eighth District, 147 of them are considered agricultural banks.[3]

To begin to assess the impact of the drought on agriculture producers in these states and on their lending institutions, we compared yield estimates for several key crops as of September 2012 with actual 2011 yields as reported by the USDA. In general, agriculture producers in the seven states that make up the District harvest more soybeans than corn. Unfortunately, the drought's biggest impact appears to be on corn and soybean production. The charts at the bottom of this article highlight the estimated changes in yield for four key crops produced in the seven states. These estimates come from the USDA's September 2012 Crop Production report.

The Importance of Crop Insurance

Despite the drought's impact on the corn and soybean crops, the impact on farmers and on their lenders is expected to be mitigated by the use of crop insurance. The USDA's Risk Management Agency (RMA), created in 1996, manages the Federal Crop Insurance Corp. (FCIC), which was founded in 1938. Since 1998, private insurance companies reinsured by FCIC have sold and serviced all Multiple Peril Crop Insurance (MPCI) authorized under the Federal Crop Insurance Act. A contract of insurance exists between insured farmers and their commercial insurance providers. Premium rates and insurance terms and conditions are established or approved by FCIC. Reinsurance agreements exist between FCIC and the commercial insurance providers.

Crop insurance program highlights include:

• MPCI covers against loss from many weather conditions including drought, excess moisture, hail, wind, frost, tornado, lightning and flood, as well as other conditions, such as insect infestation, disease, fire and earthquake.
• Private crop insurance companies are fully backed by the federal government. Private insurers are stress-tested to verify they have financial reserves adequate to meet 400 percent of the potential loss on their crop insurance book of business. On July 1, 2012, all 16 AIPs (approved insurance providers) passed this stress test.
• The service delivery side of the program is handled by each private company but overseen by the USDA's RMA, which sets the rates that can be charged and determines which crops can be insured. Private firms are obligated to sell insurance to every eligible farmer who requests it and retains a portion of the risk.
• The USDA subsidizes the crop insurance premium, thus encouraging more farmers to purchase MPCI. The goal is to reduce producers' dependency on federal crop disaster payments when natural disasters occur.
• Agricultural lenders frequently will require highly leveraged borrowers to carry crop insurance and obtain an assignment to the crop insurance proceeds.
• Crop insurance is increasingly viewed as providing the cornerstone for active risk management programs for all types of borrowers.

Impact on Livestock Production in Eighth District States

While crop insurance may help many crop producers partially offset losses caused by various perils, a more material impact could be felt by livestock producers who are forced to pay sharply higher feed bills as a result of the drought.

According to the University of Missouri, higher feed costs affect animal products differently. Figure 1 below summarizes the dramatic increase in feed costs by animal in dollars per pound. The blue bar represents current conditions, with corn at $8 per bushel, soybean meal at $550 per ton and hay at $200 per ton. The gray bar represents more “normal” input prices, with corn at $5 per bushel, soybean meal at $300 per ton and hay at $150 per ton. Under current conditions, pork producers appear to have experienced the sharpest increase in feed costs. According to the University of Missouri, if these price levels persist in 2013, feed expenses could rise to three times the 1990-2004 average and more than 70 percent above the 2007-2010 average.

Increased feed prices will force livestock producers to adjust to the changed economics in their industry. For example, some producers may choose to partially (or even fully) liquidate their herds as prices escalate. Higher livestock production costs will also be felt by consumers as the market seeks equilibrium. Typically, 15 to 20 percent of total food costs are driven by agriculture commodity prices, so total food inflation will not grow at the same rate as commodity prices. However, agriculture products with relatively less processing, such as protein, tend to have a higher rate of price pass-through to consumers. Consequently, meat and dairy products have higher correlations between farm prices and consumer food prices than fruits and vegetables do.

Impact on Agriculture Bank Performance

Ultimately, it will be important to determine how the 2012 drought could impact the performance of the 147 agriculture banks headquartered in the Eighth District. Given that banking performance data are reported only on a quarterly basis, it will be important to track agriculture bank performance over the next few quarters to truly begin to ascertain the impact?which the most recent data do highlight going into the summer drought. Agriculture banks with less than $10 billion in total assets appear well-positioned to handle some of the stresses in the agriculture sector. For example, through the second quarter of 2012, agriculture banks exhibited high profitability (as measured by return on assets) and strong asset quality (as measured by nonperforming loans and other real estate owned to total loans and other real estate loans). Year-over-year performance of District agriculture banks and their national peers has also been remarkably consistent. This suggests that most agriculture banks, on average, have an appropriate financial buffer to withstand the impacts of the drought this year. (See Table 1 above.)

Similar to the situation for agriculture banks, recent years of strong farm income will likely provide many farm operators with an appropriate financial buffer to withstand the impacts of the drought. Bankers with good risk management practices are positioned to identify problems by identifying the level of crop insurance in place and ensuring that files contain appropriate documentation. It would not be surprising to see some ancillary businesses, such as equipment dealers, experience near-term sales declines because of a more cautionary spending approach on the part of farmers. Given the rise in feed costs, lenders with high exposure to livestock production may encounter greater challenges over the next few months.

Summary of the Drought's Impact

Despite historic drought conditions, crop producers and lenders in Eighth District states appear likely to exit the year in satisfactory financial condition. Additionally, crop producers in some states have actually been able to maintain their yields throughout the drought and may even experience a windfall as a result given record-high prices, particularly for corn and soybeans. Since the majority of crop producers also have crop insurance, it appears likely that many crop producers will be able to offset a portion of any lost revenue.

The situation is somewhat different for livestock producers, as higher feed costs and the loss of hay from destroyed pastureland are impacting their cost of doing business. Some producers have already culled their herds in response to these higher input costs, which will likely increase the prices paid by consumers. Even if drought conditions ease by the next growing season, decisions made today, particularly in regard to herd size, may have a more lasting effect. Ultimately, the impact on agriculture banks will become more apparent over the next few months as drought insurance claims are submitted and final payments determined.

Endnotes

1. www.fapri.missouri.edu/outreach/publications/2012/FAPRI_MU_Report_06_12.pdf [back to text]
2. Community banks are defined as those having $10 billion or less in total assets. [back to text]
3. These are community banks with agriculture real estate and production loans making up 25 percent or more of total loans. [back to text]