Risky Business: Addressing Agriculture Supply Chains

Risky Business: Addressing Agriculture Supply Chains

A study published in 2011 by The Federal Reserve Bank of Kansas City stated:

Strong global food demand and robust biofuels markets have strained the current production capabilities of global agriculture. The prospects of tight global supplies well into the future have spurred booming farm incomes.

The Fed seems to think this is a case of “production capabilities” – farmers aren’t growing enough food. Supplies are inadequate to meet demand because food is fundamentally in short supply. With global agricultural distribution systems growing increasingly complex, the agricultural supply chain is as important a source of risk to farm revenue and food security as are production shortages. Its contribution to future supply shortfalls has significant potential.

“Tight supplies” are not the least bit unusual in agriculture. Yet the agricultural industry is unusual from an economic point of view, due to its risk and return characteristics. In the past, these were generally skewed towards relatively high risk for relatively low reward. A typical farm operation must find a way to manage between many types of risk every harvest season – weather, pests, soil conditions, water quality, labor availability, markets, political, and financial risks just to name a few.  Most operations find economic and financial rewards very often are not commensurate with the risks taken to realize them.

Rewards can be high, to be sure, but they are not as consistently high as the risks are, and rewards tend to be high for only brief periods of time.  This is especially true for farm operators.  In agriculture, it sometimes seems that regression to the mean happens too quickly when prices are good and much too slowly when prices are bad.

The roots of this situation start with supply and demand.  When risks fail to develop, yields are high and prices tend to drop.  When risks manifest themselves, yields are low and prices tend to rise. Political risk in the form of government policy complicates the situation, as do certain types of economic behavior by farmers. The web of government subsidies that has been woven around agricultural production can contribute to the problem, though presumably the subsidies are intended to improve the risk return ratio by transferring risk to the public. The road to hell is paved with good intentions, it is said.

Farmer behavior adds to the complexity. Historically, it is not unusual to find farm operators increasing production when prices are falling, in the misguided belief that an increasingly shrinking margin is better than no margin at all. This was common in the United States during the Great Depression, but it is not unheard of in more modern times.

These factors and more contribute to the wild cycles that characterize agricultural yields and revenues. These cycles help determine the risks to which agriculture is perennially prone. To this list we now must add the modern agricultural supply chain, and the risks to the system between the time production leaves the farm and the time it arrives on the consumer’s plate.

A 2010 study, “Food Waste Within Supply Chains,” published in the Philosophical Transactions B of the Royal Society concluded that, “there is no consensus on the proportion of global food production that is currently lost,” though estimates range between 10% and 50%.  It continues, “the reduction of these losses is recognized as an important component of improved food security.”  In the U.S., the National Institutes of Health reports that 40% of all food produced is wasted post-harvest. This waste was valued at over $180 billion in 2013.

Another study, published in 2011 by The Swedish Institute for Food and Biotechnology, indicates of the 150 million tons of cereal grains wasted in the developed world, about half disappeared between the farm and fork.

Reduction of losses would not be bad for agribusinesses either. Agricultural supply chain risk is real and costly. The question is, what might be done to manage the risk?

The good news is the agricultural sector does not need to reinvent the wheel. Many of the risk management challenges facing agribusinesses up and down the supply chain have been addressed successfully in other industries. The sector needs to learn lessons from these other industries and adopt new strategies for the management of its supply chain and its risks. It is a matter of adapting these lessons to the agribusiness context.

The first necessity is for the sector to recognize the need for strategic change. This requires a cultural change in many instances. This is another story that, in itself, represents a strategic weakness for the industry.

Other industries depend on lengthy and complicated supply chains that add value every step of the way from the production of raw materials to the delivery of a highly processed product to consumers. These industries – as diverse as automotive, energy, and electronics – have forged supply chains characterized by longer term agreements designed to more broadly distribute risks and rewards between the parties making up the chain. These “dedicated supply chains” represent a new business model for the agribusiness industry and would require a fundamental reconsideration of strategy and competitive advantage along the entire length of the chain.

Strategic changes of this magnitude inevitably result in winners and losers, and agribusiness will be no different. In fact, given its existing structure and its inherent reluctance to change, the agricultural industry could experience a more violent shakeout than was experienced by the consumer electronics industry.

The global agricultural supply chain represents significant risk to farm operators, shippers and packers, processors, distributors, and retail food purveyors because the magnitude of losses (even beyond waste) manifested by the existing supply chain is, in all probability, costly and ultimately unsustainable to individual members of the chain. As presently structured, the supply chain can generate more risk (in the form of actual present costs) than is commensurate with the returns it offers.  Imagine its risk return measures if we were to include the present value of future costs of the risks in the system.

About Author

Steven Slezak

Steven is on the faculty at Cal Poly in San Luis Obispo, California, where he teaches finance and strategy. He taught financial management and financial mathematics at the Johns Hopkins University MBA program. He holds a degree in Foreign Service from Georgetown University and an MBA in Finance from JHU.