Farmers in Iowa and other regions across the U.S. are deciding if they plan to replant after recent flooding wiped-out entire crops. Not unexpected, prices for the soft agricultural commodities reacted to the news of the flooding with higher prices as traders began worrying about whether supply would be anywhere close to current demand levels. Fortunately, many farmers now take out crop insurance, allowing them to recover at least some of their initial investment (covering up to around 85% of average recent production). Since the floods of 1993, the number of acres of USDA-insured land has more than doubled. This leaves many farmers with a dilemma - take the insurance, or replant. If farmers take the insurance, supply will be down and prices are sure to stay high into the fall, and could potentially go higher. If farmers decide to replant, the potential exists for getting closer to a normal supply-demand balance, and preventing further prices increases.
As reported at the WSJ, the high price of soybeans, currently near $16.23 a bushel for July contracts (see additional WSJ story), is turning out to be too tempting for some farmers. As corn prices rose last year, many farmers switched from planting soybeans to planting corn. Even with the corn crop damage, recent USDA reports showed that farmers had planted 87.3 million acres of corn, compared to the original forecast of 86.0 million. The extra 1.3 million acres of supply caused the price of corn to sell off some this week. Of course, this also means that less soybeans had been planted. A farmers strike in Argentina, a major global supplier, has also put upward pressure on soybean prices. Ironically, the current high prices may actually be the catalysts needed to cause some farmers to forgo crop insurance and take the risk of replanting. For some farmers, even if the soybean yields are below 50% of normal levels, and soybean prices approach $10 a bushel, they can still make enough profit that it is worth taking the risk. But there are risk. In addition to the risk of new weather issues, crops planted this late are also at risk of being damaged from an early frost. Furthermore, corn planted after June 25th, and soybeans after July 10th, receive less coverage from insurers.
So what is an investor to do? Outside of investing directly in soybeans, where the risk of weather and other factors affecting supply and prices levels will still be volatile and somewhat unpredictable, another potential area for investment could be the fertilizer companies. Given the late planting, and issues with land and weather, farmers will no doubt be looking for ways to increase yields. This should help companies such as Potash (POT), Agrium (ARU), and Mosaic (MOS), each of which continues to have the ability to raise fertilizer prices. In addition to fertilizer, farmers will also need to purchase new seed. Companies that could benefit include Monsanto (MON), Dupont (DD), and Syngenta (SYT). If farmers are enticed by the high prices to replant soybeans, each of these companies should benefit. Furthermore, returns from this new round of planting will not be as sensitive to commodity price if there were to be any future crop damaging issues, such as additional harsh weather. Profits from the sale of fertilizer and seed will for the most part have already been made. One caveat to this would be any special offers given by companies working to help farmers replant. The CEO of Monsanto mentioned recently on CNBC that his company will not be charging full price for seed that is replanted as a result of flood damage. This is certainly a nice corporate gesture in a time of loss for farmers, and a time of higher food prices for all.
Rainfall has been over 3 times the normal amount in the Midwest the last few weeks, with more rain on the way. The heavy rains are affecting corn and soybean yields, with just 74% of corn emerged from the ground, and only 32% of soybeans emerged. Farmers are now at a point of needing to make a decision of whether to take the Government subsidized crop insurance and keep the ground idle, or plant and take the risks of lower yields, which could be potentially as low as 75% of normal yield levels. As much as 500,000 to 3 million acres may become idle. Analysts are already cutting corn crop yields by 4 bushels per acre. As ethanol production continues to increase, expect corn prices to rise, with consumers feeling the effects at both the pump and in the grocery store.
Companies to watch that may be impacted include Archer Daniels Midland (ADM) and Bugne (BG). Others that are likely to continue to benefit from rising demand for food commodities include fertilizer companies such as Mosaic (MOS), Potash (POT), and Agrium (AGU), chemical and seed companies such as Dow Chemical (DOW) and Monsanto (MON), and agricultural machinery makers such as Deere (DE). On the direct downside are the users of corn, especially the restaurants and food producers with lower margins and less pricing power, such as Darden (DRI) and Tyson Foods (TSN).
Recently there has been a lot of discussion as to whether the run-up in commodity prices is a bubble or not, or whether there is a fundamental factor at work, primarily a sustainable supply-demand imbalance.
A recent WSJ survey found that 51% of those surveyed said that demand from China and India was the prime factor for high energy prices, with 41% blaming demand for rising food costs. Supply constraints were listed by 20% as causing higher food prices, while 15% felt that supply was resulting in higher energy prices. Only 11% felt that a speculative bubble was in the works.
So what should we take of this? Those surveyed felt that the supply-demand imbalances were the major cause of higher commodity prices, and not speculation. Furthermore, demand is driving the growth and higher prices, and not simply lower supply. This is something often debated, but those surveyed felt differently on average - we have enough for now to go around, people are just demanding more of it. This makes sense to me, given that China and India are continuing to increase their energy needs to grow their economies and increase the standard of living for their citizens. This higher standard of living is putting further pressure on food commodities, no only to consume directly, but also to feed livestock as the demands for protein-based foods increases in these areas of the world. Supply may eventually become more of an issue, but demand appears to be driving prices.
As with any survey of economist and analysts, there were "two-handed" inconsistencies. The same survey group felt on average that the price of crude oil would fall to about $105 by the end of next month, and to about $93 by the end of 2008. Demand is high, supply in check, but prices will fall? Possibly, and this course is the argument surrounding the falling dollar. But this is not what the responses feel. Only 15% believed that currency (i.e., dollar woes) were causing higher energy prices, and only 7% felt they were contributing to higher food prices. This is somewhat surprising given the amount of talk recently about how weakness in the dollar is contributing to the high cost of crude oil, with some estimates showing nearly 50% of recent price increases resulting from the falling dollar. 
In the end, even with the discussions of crude oil prices being too high, and pronouncements of $150-$200 a barrel prices in the next 6-24 months (bringing back images of Internet valuation calls in the late 1990s - where a yearly price target was raised one day, only to see the stock move to that new level a few days later), it is still difficult to foresee a complete collapse of commodity prices, at least a sustained collapse over the long-run. Will there be sell-offs and short-term corrections? Yes. Will there be volatility? Absolutely. Will there be adjustments as the dollar strengthens? Most likely. But will there be a total collapse in demand? It is doubtful. Demand destruction is always a worry, but people will always want to eat, and emerging countries will need energy to continue their growth, just as the United States has in the past, and will continue to in the future.
So as commodity investors, in particular energy investors, what do we do? The safer investments may still be in the "consequence" plays, i.e. the seed and fertilizer companies for the food commodities, and natural gas for the energy plays. The Potashes of the world still have tremendous demand and pricing power. Natural gas, while also having a nice run-up recently, is still trading at a lower BTU multiple than crude oil. Using historical comparisons, natural gas still has room to move to the upside, even with crude oil leveling off. If crude reverses its upward trend, this lower than historical multiple may also cushion the fall of natural gas if crude oil was to begin selling off.
The moves in energy have no doubt been sharp, and the prices do seem high, but this may in fact be the issue that we struggle with when considering investments in commodities. We have not seen $125 crude oil before, and the recent spike does seem over-extended, so it certainly seems scary. Of course, if crude oil was a stock, and the company had the same level of demand, pricing power, growth forecast, future supply issues, and strong technicals, many of the same investors might be jumping into the stock, while at the same time shying away from crude oil. Of course, commodities and stocks are very different animals, and stocks also top and end badly, or at least have large corrections, even for good companies (i.e., Google), but the analogy is not totally lost. The key is to eliminate the emotion as much as possible and examine the fundamentals and technicals for what they are. When they change, they change - and this could happen today, tomorrow, or next year. But when they are in place, they are hard to ignore. Right now they look pretty good.
Tickers: POT, AGU, MOS, MON, UNG
The U.S. Department of Agriculture is estimating that U.S. farmers will plant 8% fewer acres of corn this year. Farmers are shifting to higher-priced soybeans (us 18%) and wheat (up 6%). The journal is reporting that "A smaller corn crop is good news for farmers who could reap $6 a bushel this season, up from around $2 a couple years ago, if prospective corn acreage remains at the forecasted level and if a soggy spring keeps farmers in the Corn Belt out of the fields until later in the season."
In a previous post we mention how rain could caused soybeans to be planned instead of corn since they can be planted later. As such, the long corn, short wheat spread is still in play. As expected in the market, the seed and fertilizer companies are doing well, while those that need corn, such as the food producers, are taking a hit. Ironically, the ethanol companies are also finding margins squeezed as their feed-stock cost increase. Maybe Washington will final see the current folly of putting corn in our tanks, and not in our stomachs.
Agriculture Tickers: MON, POT, MOS, AGU
