Economic and Policy Update

Economic & Policy Update www.euni.de

February 24, 2016

Swift Expansion of the Beef Herd Continues

Volume 16, Issue 2

As always, USDA’s January 1 cattle inventory estimates provided much data for discussion.

Continued good weather and historically strong calf prices for much of the year led to further herd expansion. The headliner was a 3.5% increase in the number of beef cows in the US, which exceeded most expectations. Part of the reason for the increase was a downward revision to the 2015 estimate by a little more than 1%, so the total number of cows is not that different from expectations. But, it does mean that the cow herd is growing at a very rapid pace and that we are likely to see over 3% more calves moving through markets during 2016.

Edited by Will Snell & Phyllis Mattox

Swift Expansion of the Beef Herd Continues - Kenny Burdine Flexible Cash Leases - Greg Halich Burley Tobacco Costs and Returns: Pre vs Post-Buyout - Will Snell

Anytime we are in an expansion phase, heifer retention is also of particular interest.

Heifers being held for beef replacements were up a little more than 3%, which suggests expansion should continue in 2016. It is also worth noting that a slightly larger share of those heifers are expected to calve in 2016, as compared to 2015. As we have discussed previously, reduced cow slaughter was the major driver during 2014 and 2015. While cow slaughter was extremely low during the last two years, it is likely to pick up in 2016. Once this happens, heifer development will be driving future changes in beef cow numbers and the pace of expansion will slow.

Turning our attention closer to home, Kentucky beef cow numbers were up 2.4%, but this was also after a downward reduction in the 2015 estimate. This puts Kentucky beef cow numbers at an estimated 1.021 million cows, which is not that different from the original 2015 estimate. Interestingly for KY, our beef heifer retention estimate was up by 20,000 head, which is about +14%. Another way to put the 20,000 heifer increase into perspective is by considering that this would represent 2% of Kentucky’s beef cow herd. The sharp drop in prices from summer to winter may have been part of the reason for this increase.

While there is no way to know how much this happened, I do know there were some stocker operators who chose to breed heifers, rather than sell them as feeder this fall.

The USDA report is summarized in the table below and the full report can be accessed at: http://usda.mannlib.cornell.edu/usda/current/Catt/Catt-01-29-2016.pdf USDA January 1, 2016 Cattle Inventory Report

Precision Conservation Management Program Announced - Jerry Pierce

Source: NASS, USDA 2016 as % of 2015

2015 (1,000 hd) 89,143.0

2016 (1,000 hd) 91,988.0

38,609.0

39,646.2

103

29,302.1 9,306.9

30,330.8 9,315.4

104 100

Heifers 500 Pounds and Over For Beef Cow Replacement For Milk Cow Replacement Other Heifers

19,261.2 6,086.4 4,710.4 8,464.4

19,822.3 6,285.2 4,824.0 8,713.1

103 103 102 103

Steers 500 Pounds and Over Bulls 500 Pounds and Over Calves Under 500 Pounds

15,629.5 2,109.4 13,533.9

16,320.4 2,142.4 14,056.7

104 102 104

Cattle on Feed

13,025.0

13,177.0

101

Total Cattle and Calves Cows and Heifers That Have Calved Beef Cows Milk Cows

2014 Calf Crop

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33,552.0

2015 34,301.7

103

2015 as % of 2014 102

Kenny Burdine, kburdine@uky.edu Educational programs of Kentucky Cooperative Extension serve all people regardless of race, color, age, sex, religion, disability, or national origin.

UNIVERSITY OF KENTUCKY, KENTUCKY STATE UNIVERSITY, U.S. DEPARTMENT OF AGRICULTURE, AND KENTUCKY COUNTIES, COOPERATING

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Flexible Cash Leases Last month the article “The Blinking Game,” http://www.uky.edu/Ag/AgEcon/pubs/extbluesheet16-0116.pdf (page 4) pointed out that the projected drop in prices for row-crops combined with the steep increase in cash rents in recent years has created the perfect storm for negative profitability in the grain sector. Flexible cash leases were mentioned as one possible method to help reduce rents during times of low profitability. This article goes into the details of flexible cash leases and provides strategies on how they can be used to reduce the financial risk due to continued low commodity prices.

What is a Flex Lease? A flexible cash lease, also called a flex lease, is a lease that varies from year to year based on grain prices and farm yields, much like a crop-share does. In fact, some flex leases are almost identical to crop-shares in terms of the final rent the landowner receives, with the caveat that most flex leases will have a rent floor, or base that will be the lowest that the rent can be. Crop-shares have no such floor. Another distinction is that most flex leases are officially considered cash leases for tax purposes. Both of these provisions are appealing for many landowners that would not consider a crop-share.

Much like a crop-share, a flex lease will pay out higher rents when prices/yields are high, and pay out lower rents when prices/yields are low. This reduces the risk exposure to farmers during stretches of low commodity prices. The tradeoff of course, is that you will have to give up some of the upside profit potential during the good years. But with the current environment of low commodity prices, having effective protection against high land rents when grain revenue is low can be an extremely valuable for risk management tool.

Examples of Flex Leases: There are theoretically an infinite number of ways you could set up a flex lease. Some flex leases are based on just price and some just on yield. My preference is one based on total revenue (price and yield).

Assuming we want a flex lease based on total revenue, the two most common types have a base rent plus a bonus rent component. The base rent is essentially the lowest rent that would be paid out, and the bonus rent is dependent on total revenue.

Flex Lease Type 1: Bonus Above Revenue Trigger - A revenue trigger is set such that if actual revenue goes above the trigger for a particular crop, a bonus is paid in addition to the base rent. The percent of the revenue above the revenue trigger going to the landowner also needs to be specified. For example, assume the revenue trigger for corn is $550/acre and the percent of revenue going to the landowner above that trigger is 35%. The base rent is $150/acre. Here is what the final rent would be in the following scenarios: 1) $4/bu at 125 bu/acre: Total revenue is $500 so no bonus is paid. Final rent = $150 2) $4/bu at 150 bu/acre: Total revenue is $600 so a bonus is paid. Bonus = .35 x ($600 – $500) = $35. Final rent = $150 + $35 = $185 3) $3.50/bu at 175 bu/acre: Total revenue is $612.50 so a bonus is paid. Bonus = .35 x ($612.50 – $500) = $39. Final rent = $150 + $39 = $189 4) $4/bu at 175 bu/acre: Total revenue is $700 so a bonus is paid. Bonus = .35 x ($700 – $500) = $70. Final rent = $150 + $70 = $220 Flex Lease Type 2: Revenue Percentage - With this type of lease the landowner gets a specified percentage of the crop value or the base rent, whichever is greater. For example, assume the percentage the landowner gets is 35%, and the base rent is $150/acre. Here is what the final rent would be in the same scenarios: 1) $4/bu at 125 bu/acre: Total revenue is $500. Final rent = $500 x .35 = $175 2) $4/bu at 150 bu/acre: Total revenue is $600. Final rent = $600 x .35 = $210 3) $3.50/bu at 175 bu/acre: Total revenue is $612.50. Final rent = $612.50 x .35 = $214 4) $4/bu at 175 bu/acre: Total revenue is $700. Final rent = $700 x .35 = $245 5) $3.50/bu at 120 bu/acre: Total revenue is $420. Final rent = $420 x .35 = $147, but since the base rent is greater the final rent is $150.

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Notice that by using the same base rent and the same percentage, the revenue percentage flex lease had higher final rent payments in each of the first four scenarios. This does not mean a farmer would not prefer this type, but that you need to adjust the base rent and/or percentage between the two flex lease types to make them more comparable. Regardless of which of the two lease type you choose to use, you will need to find a base rent and percentage that work for both the farmer and landowner.

Also, the revenue trigger and revenue percentage that works for corn will not necessarily work for soybeans.

Typically, the revenue trigger for corn will be higher, and the revenue percentage will be lower compared to soybeans. You will need to work through many possible combinations to find one that work for a particular farm.

Which Flex Lease Type is Recommended? The revenue percentage flex lease is simpler to understand and thus more appealing for most individuals. However, the bonus above revenue trigger can do a better job tailoring it to a specific farmer/landowner situation. It can also do a better job at keeping rents at appropriate levels over a wider range of prices/yields. Unfortunately, it will take more time getting a landowner to understand this type of lease.

Farmer Concerns about Flex Leases: One of the biggest concerns I have heard regarding flex leases is that if the base lease is set too high, the farmer does not get much benefit when prices/yields are low, but still has to pay higher rents when prices/yields are high. This is a valid concern. If a landowner is not willing to have a low enough base rent when prices/yields are low, than it would not make sense for a farmer to give up upside profit potential when prices/yields are high. However, many landowners will understand this tradeoff and these are the ones where there is potential for a flex lease to work. Again, the key is to find one that both parties are satisfied with compared to a cash lease.

Part of this concern may also be that farmers feel that landowners will get a higher rent (over multiple years) with a flex lease than they would with a cash lease. Unfortunately, this reasoning misses the point. Landowners should, on average, get a higher rental rate with a flex lease as they are taking on part of the risk that would otherwise be borne by the farmer. As the old economic axiom states: The greater the risk, the greater the reward.

New Flex Lease Calculator: Finding a flex lease with the appropriate provisions that both parties feel is fair can be potentially difficult and confusing. Both the farmer and landowner will want to work through various price and yield scenarios to see what rents would be in each situation, and will want to see how changes in base rent, revenue trigger, and revenue percentage going to the landowner will affect these rents.

A tool that can help in this process is a Flex Lease Budget from the University of Kentucky Extension that evaluates the two main types of flex leases detailed in the previous examples. The user enters the type of lease they wish to evaluate, the base rent, revenue trigger (for the first lease type) and the percentage above the base rent going to the landowner. They then enter expected grain prices and yields. Tables are then generated showing what the flex rent would be for various scenarios showing changes in both price and yield from those expectations. Using these tables, the both parties can easily see what the rent would be for various price-yield combinations for a specific flex lease, and help determine if that particular lease will work for them. If it doesn’t work, the users can change the flex lease parameters to try to find one that will. The budget allows various acreage combinations of corn, full-season soybeans, and wheat-soybean double-crop. This budget will be available at the following site (it is currently in the final review process): http://www.uky.edu/Ag/AgEcon/halich_greg_rowcropbudgets.php Other Helpful Resources for Flex Leases: There are a number of useful publications on flex leases from other states. The best ones are summarized below.

Iowa Publications on Flex Leases: Flexible Farm Lease Arrangements http://www.extension.iastate.edu/agdm/wholefarm/pdf/c2-21.pdf Summarizes types of flex leases and discusses advantages and disadvantages Flexible Cash Rent Examples http://www.extension.iastate.edu/agdm/wholefarm/pdf/c2-22.pdf Shows examples of flex leases

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Northcentral Farm Mgt Lease Site: Fixed and Flexible Cash Leases for Your Farm http://www.aglease101.org/DocLib/docs/NCFMEC-01.pdf Good template to actually write a lease Fixed and Flexible Cash Leases for Your Farm – Short Form http://aglease101.org/DocLib/docs/NCFMEC-01A.pdf Shortened version of previous link Summary: Flexible cash leases will not work with all landowners but there is potential to use this tool in many situations. The key is to find flex lease terms that work for both parties: one where the farmer has adequate protection when prices/yields are low, and also where the landowner feels they are justly compensated when prices/yields are high for accepting a lower base lease compared to a cash lease.

The examples shown here should be in no way thought of as appropriate for a specific situation. They are just examples. Cash rents vary considerably depending on soil productivity, access, competition for land, etc., and flexible cash leases will also vary considerably depending on these and other factors such as how much risk the landowner is willing to accept. There are an infinite number of ways that a flexible cash lease can be set up.

Imagination is the key to a flexible cash lease that both the tenant and landowner are happy with. Using the Flex Lease Calculator can help make this process easier. For help structuring flex leases and other questions regarding their implementation, contact the author at the email/phone number below.

Greg Halich, greg.halich@uky.edu Greg Halich is an Associate Extension Professor in Farm Management Economics for both grain and cattle production. He also raises corn and soybeans in southern Woodford County and uses a flexible cash lease on his rented ground. He can be reached by email or at 859-257-8841.

Our Land-Grant Values The University of Kentucky College of Agriculture, Food and Environment was founded as, and remains a landgrant institution, committed to improving the quality of life for Kentuckians. Our research, teaching, and extension programs are part of a national system that maintains a statewide presence and links local, state, and global issues. Agriculture, food, and environmental systems are key components of Kentucky's economic future, and the college is playing a prominent role in those areas with its programs.

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Burley Tobacco Costs and Returns: Pre vs Post-Buyout In the midst of a turbulent outlook for the KY farm economy, tobacco growers, as well as a few tobacco companies, have been inquiring about current burley tobacco production costs and returns. Unlike grains, where input parameters (excluding land rent) are fairly consistent across farming operations, many tobacco budget parameters (labor hours, H-2A vs domestic labor wages, big vs small bale, yields, fully depreciated vs relatively new equipment/infrastructure, contract vs auction sales) do vary considerably among growers. As a result it is really a challenge to come up with a precise estimate of the cost and returns on a “typical” tobacco operation.

Consequently we have always encouraged individual growers to develop their own budget analysis to match their particular operation. Let’s first look at some historical trends on prices, yields, costs and returns before we provide some estimates for the 2016 burley crop.

Prices: USDA has not released their official average price for the 2015 U.S. burley crop, but it will likely be near the 2014 average of $1.94/lb. Despite ample global supplies entering the 2015 season, along with slumping global blended cigarette sales, a strengthening U.S. dollar and crop quality concerns, prices for the 2015 burley crop held up fairly well in response to relatively strong U.S. cigarette sales, an improved U.S. burley trade balance, and quality/quantity concerns over the 2016 South American and African burley crops related to El Niño weather patterns. Recent U.S. burley grower prices in the $1.95 to $2.00/lb range result in actual (nominal) prices returning to pre-buyout levels, but real (inflation adjusted) prices have declined by more than 20% relative to 2004.

Yields: While other crops/livestock enterprises have achieved steady improvements in yields/ rates of gain over time to help offset declining real prices, burley tobacco trend yields have remained relatively flat. Average yields were expected to show some improvement during the post-buyout era with the exit of marginal managers and lower yielding land which could not survive in a more competitive marketing environment. Along with some weather and disease challenges, burley yield gains have likely been hampered during the post-buyout era by the movement to larger scale of production units (reducing management intensity), a change in the labor supply away from family labor, production incentives by the companies which reward certain grades, and abuse of the federal crop insurance program.

Costs: According to USDA input cost indices, fertilizer prices have increased 107% since the passage of the buyout, while chemical prices are 28% higher. While changes in fertilizer and chemical prices receive attention, these two input groups account for a relatively small share of burley production expenses. Tobacco costs and returns are driven primarily by changes in yields, labor efficiency, and wage rates. Labor efficiency for most growers has improved over time with the adoption of labor-reducing practices, (e.g., purchasing transplants, bale package, housing design/practices) but most burley farmers are still using approximately 150 to 200 labor hours per acre. Tobacco budgets clearly reveal that labor accounts for 50% or greater of the cash expenses associated with burley production. The Kentucky H-2A wage rate increased from $10.28/hour in 2015 to $10.85/hour for 2016 and is 42% higher since the passage of the tobacco buyout. Accounting for transportation, housing, utilities, worker compensation insurance, fees and other expenses associated with H-2A labor, the total wage rate for H-2A guest worker program in 2016 is likely in the neighborhood of $13.00 to $14.00/hour.

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Net Returns: Prior to the end of the federal tobacco program in 2004, USDA would annually update tobacco cost of production as a variable in determining the average price support level. However beginning in 2005, USDA suspended calculating tobacco costs and returns. The table below summarizes the pre-buyout USDA burley costs and returns reports from the 2003 and 2004 crops and projected estimates for 2016 from University of Kentucky and University of Tennessee burley budgets. The UK budget assumes a higher yield (2,200 lbs vs 2,100 lbs for the UT budget) but also higher hired wage rates ($12.50/hour vs $10.00/hour for the UT budget) to conservatively reflect the wage rate of an increasingly used H-2A labor force. In this analysis, we only consider “cash� costs, excluding the value of quota (for pre-buyout calculations), land costs and operator labor expenses. The analysis reveals that net cash returns have declined from more than $1.00/lb in 2003 and 2004 (using actual average yields below 2,000 lbs/acre) to an anticipated 40 cents/lb for the 2016 crop (using average yields of 2,100 to 2,200 lbs/acre). This represents the cash left over to compensate the operator for use of his own labor, management and land. Accounting for these inputs, results in both budgets leaving virtually no cash remaining to encourage infrastructure investment for future crops or to encourage younger farmers to replace an aging tobacco grower base.

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Price ($/lb) Average Yield Gross Value of Production ($/acre) Total Variable Cash Expenses ($/acre) Total Fixed Cash Expenses ($/acre) Net Cash Returns 4/ ($/acre) Net Cash Returns 4/ ($/lb)

2003 1/ 5 PAGE $1.98 1,920 $3,801 $1,389 $350 $2,062 $1.07

2004 1/ $1.99 1,945 $3,863 $1,485 $356 $2,021 $1.04

2016 UK 2/ $2.00 2,200 $4,400 $3,032 $500 $866 $0.39

2016 UT 3/ $2.00 2,100 $4,200 $2,806 $502 $892 $0.42

1/ Tobacco Production Costs and Returns ERS/USDA, August 2006, http://www.ers.usda.gov/media/861710/tbs26001.pdf 2/ Data from 2016 UK Burley Budget, forthcoming 3/ Data from 2016 UT Burley Budget, http://economics.ag.utk.edu/budgets/2016/Tobacco/BurleyTobaccoBudget2016.pdf 4/ Excludes land, quota, and unpaid (operator) labor/management costs

Will Snell, Steve Isaacs, Laura Powers, and Bob Pearce

Will Snell, wsnell@uky.edu

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Precision PrecisionConservation ConservationManagement ManagementProgram ProgramAnnounced Announced Recently Robert Bonnie, U.S. Under Secretary for Natural Resources and Environment, announced $5.3 million in funding for the Precision Conservation Management (PCM) program. USDA calls PCM “an innovative service program designed to apply hard-nosed financial farm business planning with precision conservation technology to provide a blueprint for conservation decision-making.” The program should be available to Kentucky farmers in the fall of 2017.

The Precision Conservation Management program was developed by 30 farm-interest groups in Kentucky, Illinois, and Iowa. Kentucky groups include the Kentucky Corn Growers Association and the Kentucky Farm Business Management (KFBM) program. These groups operate PCM to achieve four main priorities: 1. Promote conservation by providing an informed assessment of financial risks & benefits.

2. Encourage participation by providing data entry and other services for participating farmers.

3. Provide aggregate data for agronomic and economic analysis of conservation practices.

4. Improve productivity, water quality, soil health, and avoid the need for more regulation.

The mission of PCM is to use farmer data to serve farmers’ interests with specific emphasis on conservation adoption. The program seeks to integrate conservation and farm management.

PCM will play a critical role in addressing the vital questions farmers have when considering a new conservation practice: “What are the risks associated with this practice and how will it financially impact me, my family, and our farm?” KFBM will provide the financial impact analysis of conservation practices to help answer those questions.

How will it work? Upon enrolling in PCM, KFBM will help cooperators create a field-by-field inventory of detailed agronomic management practices. The data will be kept by a secure third-party entity. Participating farmers will receive a privately-funded incentive to develop a plan assessing their farms’ sustainability and natural resource concerns. Based on the assessment plan, PCM specialists will help the farmer work through Natural Resources Conservation Service (NRCS) programs with a long-term goal of Conservation Stewardship Program (CSP) readiness.

KFBM’s Extension Economists and staff will continue to help farmers to evaluate CSP for their farm and enter updated data as needed. Specialists will also work with participants to evaluate the financial impacts of conservation services on whole-farm profitability on a continuing basis. Financial impacts include profit and loss, financing, and income tax liability.

“We’re partnering with KFBM, the Kentucky Corn Growers, and others, and using farmers’ own data to help them efficiently, effectively, and profitably improve water quality and soil health,” says Laura Gentry, Illinois Corn Growers Association director of water quality research and adjunct professor in Natural Resources and Environmental Sciences at U of I. “PCM was designed to help farmers make good, financially based, conservation decisions. As part of that goal, PCM will assist farmers with participating in NRCS programs and will demonstrate the good stewardship decisions farmers are making to protect our soil and water resources.”

Jerry S. Pierce, Jr., jerry.pierce@uky.edu

University of Kentucky Department of Agricultural Economics 315 Charles E. Barnhart Bldg. Lexington, KY 40546-0276 Phone: 859-257-7288 Fax: 859-257-7290 http://www.uky.edu/Ag/AgEcon/extbluesheet.php

Economic & Policy Update View all issues online at http://www.uky.edu/Ag/AgEcon/extbluesheet.php Educational programs of Kentucky Cooperative Extension serve all people regardless of race, color, age, sex, religion, disability, or national origin.

UNIVERSITY OF KENTUCKY, KENTUCKY STATE UNIVERSITY, U.S. DEPARTMENT OF AGRICULTURE, & KENTJCKY COUNTIES, COOPERATING.