A Reality Check

The New Zealand Farmers Weekly this week begins a four-part fortnightly series on the New Zealand agricultural scene by Palmerston North-based independent analyst Colin Riden.

Riden describes himself as an analyst capable of and who likes “digging into issues until the core issues rather than the symptoms are understood”.

Originally involved in horticulture, Riden did 15 years of contract systems and data analysis for government, business and research in field such as genetics, supply systems and traceability.

“In recent times, I have been working with agricultural production economics and resource allocation optimisation models.”

His concerns about NZ’s agricultural industry are:

  • It’s working off a poor information base.
  • It undervalues information as a resource and as a source of power in supply chains.
  • Agriculture has to a large extent disengaged from the rest of NZ society and much of the world.

This week Riden identifies what he believes are sloppy attitudes to using information, gaps in understanding and knowledge and a lack of analysis.

His second article will cover trends in technology, policy and economics which have resulted in the agriculture we have today. He will also pose questions about where they will take rural NZ in the future.

The third article will cover the intellectual underpinnings essential to keeping NZ agriculture competitive and last article will specifically analyse Fonterra’s performance.

I have struggled, particularly during the past 18 months, to understand some of the economically perverse things going on in New Zealand agriculture. I know others have been trying to understand these behaviours. Many farmers seem bewildered. From what is in the media, confusion in the broader agricultural community also seems apparent.

I get the impression people want to discuss what is going on, but lack information or insight. This leads to the recycling of the same limited range of ideas. I believe the amount of sound information available is inadequate for effective decision-making and poor use is sometimes made of what information is available. Inconvenient information is often simply ignored. For example, Treasury last year produced a paper on the role of research and development in productivity growth in NZ from 1927-2001.

My take of the paper was:
Returns on NZ research and development tend to be considerably lower than in many countries.
Private investment in research and development has returns several times higher than public investment.
Returns on extension services were negative, but only sometimes significantly so.
Specifically, Treasury found in almost all cases there was no identifiable benefit for agriculture from the NZ public investment in research and development.

I have no doubt lots of valuable publicly funded research and development work has been done in agriculture. But it’s also very likely real problems somewhere else are dragging the average effect of research and development investment on productivity down to a point where it can’t be identified. My interpretation of the report suggests there are fundamental questions to be answered.

AgResearch claims the paper supports its view it is providing a 17% return on investment. I am not aware of this selective view being challenged. The lack of questioning, analysis or follow-up of a research paper with significant implications for NZ agriculture could be because:
1. It wasn’t widely read.
2. The research and implications weren’t understood.
3. No independent analysis was done.
4. Leaders thought it unimportant.

NZ’s agriculture industry often has an unquestioning attitude to information that fits well with what it wants to hear. An example of this is the spin around the idea of a “golden age of agriculture”. There is good news, but a “golden age” appears to be the dreamed-of result of compounding a range of best-case scenarios in reality unlikely to all line up together.

The above figure is in real 2007 dollars. On this basis the projected increase in MS payouts for 2008 are not as marked as those that actually occurred in 2001 and 2002. In 2001 milk solids payout increased 27% but accompanied by a 10% increase in production costs.

Some farmers aren’t getting too carried away by the hype - they are intuitively aware of issues in agriculture and have been through swings in commodity prices before. But many others in the community are - from rural commentators to the Reserve Bank to potential investors. This could be based on poor information, or an unquestioning willingness to believe people often with something to sell.

I believe these attitudes result from and are symptoms of, deeper issues. Above all, it points to large gaps in the information, knowledge and ideas required by most of those presently involved in agriculture to make sensible decisions on investment, production, research or policy.

A primary reason for confusion is farming has been moving from creating wealth from farming to generating it from capital gains. The agribusiness community makes no bones about this. Comparisons between the two forms of profit favour capital gains in ratios that in recent times have been more than five to one. There are serious issues around this ratio, including its sustainability, but having the major part of profit coming from capital gains certainly adds to confusion and uncertainty over decision-making.

Marginal issue must be recognised
A second and undoubtedly less well-known contribution to confusion is ignorance of the nature of the basic production function for pastoral farms. The following diagram is a simplified production function for the average Waikato dairy farm based on its costs for 2006, sourced from a paper The Marginal Cow.

The exact costs aren’t that relevant - it is the shape of the function which may surprise many dairy farmers. The graph uses marginal costs - essentially the cost of the last cow’s additional production. Profit is maximised where marginal cost equals marginal revenue - MC=MR. On a NZ dairy farm, the milksolids payout will be a reasonable proxy for marginal revenue.

Over a handful of cows in the transition zone, the return on each cow shifts from about $350 positive to negative $400. Each additional cow will only make a few dollars difference in average costs per cow - unlikely enough to be noticed.

The shape of this production function will be common to most types of pastoral farming as production increases through the transition to using purchased supplements. While the shape is common, the position and slopes of the lines will vary for every farm (dairy farms will depend on factors such as their dry-matter production, the climate, cow replacement rates and genetics).

For at least two generations, NZ farmers increased their production by moving to the right along the marginal cow positive line. By sometime during the 1990s many had increased production to a point where they were producing around the transition zone.
By 2006, the average Waikato dairy farm was producing in the early part of marginal cow negative zone.

No dairy farmer is going to increase production if he or she knows doing so is going to cost more than $7/kg MS. But I doubt many farmers have thought about the difference between average and marginal costs, or have much idea of their marginal costs. Many won’t know what their farms’ production functions look like and few will know accurately whether they are operating marginal cow positive or marginal cow negative. This confusion will extend well beyond the farm gate.

Wherein lies the competitive advantage of pastoral farming? From where many farmers are operating in relation to their marginal costs of production there appears to be a significant management or knowledge gap worth possibly a few hundred million dollars in dairy industry profits. At this point, the lack of an identifiable contribution from public investment in research and development found by Treasury strikes a chord.

There is little acceptance purchased supplements are expensive. In the Waikato under 2006 conditions, their use will not be profitable until prices exceed $7/kg MS for an average farm. This leaves me with serious questions over the level of understanding we have of the systems we are working in – at international, industry or farm level.

Production obsession is no longer effective
I am concerned we have failed to recognise the production-focused model and average-cost approach we have followed for about a century is causing confusion, leading to overproduction, costing profit and is no longer effective.

Much of this can be explained as created by a combination of sloppy attitudes, poor analysis, poor information or little leadership, but I think there is more to it than that. Agriculture may also be guilty of disengaging - both from the rest of NZ and from international experience.

Agriculture has a symbiotic relationship with the rest of NZ which needs to work, but isn’t working very well at the moment. Agriculture is struggling to even communicate information within its own industry.

Agriculture needs a major lift in thinking, much greater openness, innovation, much-improved management information and a broader range of ideas - some of which will have to come from outside the industry and NZ.

Changes to agriculture are required and the whole country has an interest in those changes. Sustainability of agriculture is crucial, but depends as much on engaging the rest of NZ as the agricultural community.

Capital gains aside, farming is working - just - for those presently farming. But it’s unlikely to do so for future generations if the status quo is maintained. The attitude and culture of NZ’s agriculture industry needs to change.

The Treasury paper is available at: http://www.treasury.govt.nz/workingpapers/2006/twp06-01.pdf