Cycles are a fact of life in the agricultural commodities business as the markets fluctuate from periods of oversupply and low prices to periods of undersupply and high prices. Most people perceive these sizeable fluctuations in the various markets as risky and yet if you analyze agriculture, you will find that the industry as a whole generates very steady and consistent returns with very little volatility. In the face of headline-grabbing fluctuations in commodity prices and weather extremes, this does not make sense to most people, but that is because, as a whole, those production and price fluctuations generally have a compensating effect elsewhere in agriculture.
There are a large number of factors that contribute to this phenomenon, but the two biggest ones we will discuss in this article are the diversity of commodities produced and the short-term nature of agricultural commodity cycles. In agriculture, cycles ebb and flow over short time horizons (typically 4 years or less) and with a lot of different commodities produced, and with markets for that production all over the world, the randomness of millions of market factors converging almost always ends up near average. This unusual dynamic is caused by the wide disparity of price correlations between the thousands of commodities that are consumed every day.
Let’s start with a very simple example to help illustrate this point. Hard Red Spring Wheat is the most common crop grown in Western Canada, with 7.88 million hectares seeded in 2023. Red Spring Wheat is mostly used for premium bread products and as a blend wheat for bread flour in countries that cannot produce high enough quality wheat domestically. This better-quality Canadian wheat is mixed with domestic wheat to produce the desired quality for bread flour. The market for this grain is completely different than Durum Wheat, which is the second most commonly grown wheat in Canada, and is almost exclusively used as an ingredient to make pasta. These two nearly identical commodities have completely different markets and pricing dynamics. See the price chart below from the last 2 years:
The majority of Durum Wheat producers will also grow Red Spring Wheat as the yield and input requirements are nearly identical. They do this for risk management reasons and as you can see in the chart above, the Durum market at one point in the last two years traded for nearly two times the price of Red Spring. The inverse can also be true at times. When you think about the fact that the two most closely related crops produced in the country offer a significant diversification opportunity, you can see the tip of the iceberg when it comes to the diversification opportunities available in this sector.
Let's examine another relationship in the agricultural commodities market. Pulse crops are commonly grown in the brown soil zone regions of western Canada alongside Durum Wheat, which is the most common rotation crop in the region. Pulse crops are typically consumed as a low-cost protein source in developing countries in the Middle East and South Asia. The Durum grown in rotation is pasta wheat which is exported worldwide but mostly consumed in developed countries and countries bordering the Mediterranean. Farms in this region would also likely grow at least some canola which is a commodity vegetable oil that ends up in deep fryers worldwide. When you think about it, a small farm in Saskatchewan has a diversity of markets that spans the globe. This kind of market, and product diversification would be hard to find in most other types of businesses that generate similar dollar amounts in sales to a typical western Canadian grain farm.
Let’s take this even further. Few people realize that agriculture is the largest consumer of agricultural produce. To be specific, the livestock sector consumes more grain products by weight than people do. This creates a very distinct negative correlation between the performance of the livestock sector and the grain sector. Farmers have taken advantage of this diversification for decades prior to the prevalence of government support programs for agriculture. As late as the 1970s, the vast majority of farms would have been mixed farms with both crop and livestock production. This has gone away in recent years, but this risk management tool is still available to investors in the agriculture sector. Simply put, if grain is expensive, grain farmers do well and livestock farmers do less well because their feed costs are high. If grain is less expensive, grain farmers don’t do as well, but the profit margins of livestock farmers improve.
One last thing: there are a large number of niche markets in agriculture that get very little, if any, attention from the mainstream. Glengarry has looked at a good number of these loans and they include products like ginseng sold in the Asian herbal supplements market, local farm direct meat and vegetable businesses all over the country, hemp seed, goat’s milk for baby formula, greenhouse opportunities, and a lot more. All of these markets are nearly completely uncorrelated with each other and even uncorrelated to other farm produce types from farms right next door. Each of these markets has its own cycles and supply and demand dynamics that drive prices and profit margins.
Allowing the Natural Diversity in Agriculture to Protect Your Investment
Our portfolio management approach always assumes that some of our borrowers will experience challenges while others are enjoying bumper years. As of Q3 2023, Glengarry’s loan book has a lot of concentration in grain and oilseed production which has worked out very well for us in the last two years. The grain industry has moved into a cyclical high, where a combination of very high prices and drier-biased weather has led to good and valuable harvests for most of our borrowers. We have seen repayments from this group of borrowers and significant improvements in their balance sheets, as they are able to migrate back to the mainstream banking system.
However, we would like to take a moment to explain how all of these now top-performing borrowers got onto our books in the first place. Take a look at this fall harvest weather map from 2016:
Wheat prices were near decade-long lows in 2016 and that fall ended in one of the worst and wettest harvests in decades. The grain quality was terrible and combined with low prices, the result was losses across the grain industry. It typically takes 2-3 bad years plus a year or two of delay for a farmer to get pushed out of a bank, so by 2020 or 2021, many grain farmers were finding it difficult to access bank financing and they turned to the private market to meet their needs, which is where Glengarry came into the picture. Today these clients generally have good balance sheets and are making their way back to conventional lending.
Cattle producers, however, had one of their best years ever that year. Feed prices were low to start with, and dropped further, as Western Canada was awash in feed grains. Pastures also perform well in really wet conditions and feed of all types was everywhere and cheap. This is in extreme contrast to the plight of cattle producers in recent years, who have suffered very badly during the pandemic as the main meat processing plants in western Canada had to shut down due to orders from Alberta Health. This led to a no-bid situation for cattle in 2020 where cattle producers couldn’t find anyone willing to purchase their finished cattle for several months. Producers reduced herd size, leading to a predictable shortage of beef cattle by 2023 and very high prices for meat today. We are presently increasing our exposure to cattle farming, partly because they need us right now, and partly because we know that well-run cattle farming operations are heading into very good times and most will be bankable in 2024 or 2025.
The grain versus cattle example above is one clear illustration of how Glengarry manages risks in the different sectors in which we lend, but by no means does it stop there. We were on the right side of the grain and oilseed cycle, and we expect that we are now getting onto the right side of the beef cattle cycle. We are focused on the right combinations of negative correlation and uncorrelation in our loan exposure, which, along with a rigorous approach to other underwriting standards, should help to keep our loan book performing well.