By
Ian
McAbeer
:
You might have recently read about the severe drought that is
affecting the Midwestern United States and the 2012 corn crop. The
drought conditions are reported to be the worst in more than half a
century. Normally I wouldn't write about the subject of corn, or
the weather, being that such topics tend to fall outside the realm
of traditional investment research and analysis. However, there are
so many unique facets to this situation that I consider it to be
worthy of our attention, as it provides insights about
globalization, interconnectedness, unintended consequences,
emerging markets, inflation, resource scarcity, and climate change
-- all subjects that
are
relevant to investment research and analysis.
First the facts
: The United States produces more than one-third of all of the corn
grown in the world, a crop that happens to be the single most
valuable crop grown each year in this country. Presently, about 40%
of our domestic corn crop is used in ethanol production; another
40% is used as animal feed for the worldwide production of
livestock, poultry, and pork, while the remaining 20% is used
primarily in processed food products. Due to the extreme and
exceptional drought conditions across most of the Midwestern United
States (see the Drought Monitor below), it is now expected that
U.S. corn production in 2012 will be
at least
13% lower than last year's crop, making this the worst corn crop in
many years and reducing domestic stockpiles to a bare minimum going
into 2013.
(click image to enlarge)
In just the past few months, as drought conditions have
worsened, the price of corn has risen by about 60% from $5 per
bushel to roughly $8 per bushel. This represents a nearly 400%
increase in the price of corn since the year 2000. As we are about
to see, the worldwide effects of the corn price spike are somewhat
startling and have presented us with some difficult policy
decisions.
Crude Oil/Corn Relationship
: The Renewable Fuel Standard, otherwise known as the biofuel
mandate, is the law overseen by the U.S. Environmental Protection
Agency which requires that 7.5 billion gallons of renewable
biofuels be blended with gasoline in 2012. The vast majority of
this biofuel blend stock comes from corn-based ethanol. Remember,
40% of the entire U.S. corn crop goes into ethanol production.
Given the decline in crop potential for 2012, unless the biofuel
mandate is waived for the current year, it is possible that more
than 50% of all the corn grown in the United States will be
required (conscripted, you might say) for ethanol production,
reducing the amount of corn that would be available for animal feed
and food production.
For the first time ever, we are nearing the point where
more than half
of all the corn grown in the United States will be burned in our
cars, while less than half will be left over for human and animal
consumption. One result of the biofuel mandate and the rapid growth
of the ethanol industry is that the global price for corn is now
inseparably linked to the price of crude oil, the latter of which
has quadrupled in price over the past 10 years or so.
Commodity Interconnection
: As the price of corn goes up, so too go the prices of soybeans
and various other agricultural commodities. Firstly, the same
drought that is affecting corn crops is also affecting other
agricultural crops. Secondly, farmers around the world will react
to the higher price of corn by attempting to plant
more
of it, thereby causing them to plant
less
of other food commodities such as soybeans.
Furthermore, given that corn is the primary feedstock used by
meat producers, any increase in corn prices will ultimately
translate into higher meat prices. According to Tyson Foods, it
takes 2.1 pounds of corn to make 1 pound of chicken, 4.5 pounds of
corn to make 1 pound of pork, and 6.2 pounds of corn to make 1
pound of beef. Of course, cows used for dairy production may also
be fed corn, as well as chickens used in egg production, so you can
see how this same price spike in corn ultimately works its way
through the entire system. Livestock producers, along with various
state and federal lawmakers, have recently petitioned the EPA to
temporarily suspend the biofuel mandate in order to ease the price
pressure stemming from the depleted corn crop, but so far the EPA
has rejected these calls. The bottom line is this: a food price
shock, such as the one we are now experiencing, is really a
multi-commodity shock that ripples throughout the entire food
supply complex and, due to the EPA's mandate, spills over into
energy markets as well.
Globalization
: Just this past week, the director general of the United Nation's
Food and Agriculture Organization said that the U.S. should suspend
its biofuel mandate and allow what remains of the depleted corn
crop to be used for food and feed purposes, rather than being used
to fuel our automobiles. Such a decision would almost certainly
ease global food prices this year and next, but may or may not be
the best choice, depending on one's point of view.
Regardless, it is interesting to see a U.N. official essentially
asking the EPA to exercise its authority and suspend the biofuel
mandate in order to alleviate suffering amongst poor nations. This
demonstrates that we live in a world that is more globally
interconnected then at any other time in history. What we are
witnessing is a domestic fuel policy in the United States, coupled
with a severe weather phenomenon, which is leading to food scarcity
and inflationary pressures across the globe, bringing us to the
next point…
Emerging Market Inflation
: The inflationary impact of rising corn prices will be relatively
muted here in the United States; it is estimated that overall food
prices will rise 2-3% this year and approximately 5% in 2013. The
inflationary impact is muted because U.S. citizens only spend 7-8%
of their income on food. By contrast, citizens in the emerging
markets have a much more subsistence-based lifestyle and generally
spend 25-50% of their income on food. The result is that food price
inflation in the emerging markets tends to be a
much
greater problem, to the point of creating social instability, and
even humanitarian crisis.
You may recall that many of the protests throughout Africa and
the Middle East in 2011 were actually sparked by discontent over
rising food prices. These protests swept through the region and
later morphed into widespread nation-by-nation uprisings known as
the "Arab Spring." Needless to say, politicians in emerging market
countries fear food price inflation and its consequences.
Climate Change
: I won't take a position on the subject of climate change or
global warming because these particular topics tend to foment a
religious-like disagreement between believers and non-believers.
Instead, let me simply state the facts, as I understand them: the
U.S. National Oceanic and Atmospheric Administration (NOAA) has
identified July 2012 as the single hottest month ever recorded in
the United States, with records dating back to 1880.
The exceptional heat and drought conditions in the Midwest led
Fred Below, a plant biologist at the University of Illinois in
Urbana, to recently characterize the situation by saying, "It's
like farming in hell," as recently reported by Bloomberg. The
12-month period ending in July of 2012 was also the hottest
12-month period ever recorded in the United States.
Furthermore, according to NOAA, the month of July 2012 was the
fourth warmest July ever recorded
globally
, as measured across all land and ocean surface temperatures.
Finally, this past July also marked the 329th consecutive month in
which we experienced a global average temperature that was hotter
than the average of the entire 20th century. Now, I am neither a
scientist nor am I a statistician, but I am willing to go out on
limb and speculate that when something happens for 329 consecutive
months in a row, it probably means that there is a firm trend in
place.
Regardless of the root causes of climate change, anthropogenic
or not, we can be reasonably assured that our future will be
warmer, and our weather more volatile, than what we have
experienced in our recent past. I'll leave it at that. Anyone who
disagrees with me can take up their beef with NOAA and the National
Climate Data Center.
So, where does this leave us? What do we do? In the very least,
this leaves us with another example of how complex and
interconnected the world has become. If the U.S. and the EPA choose
to do nothing, then much of the emerging and developing world may
face moderate to severe food shortages and significant food price
inflation later this year and next. We will begin 2013 with even
lower global corn inventories then we have at the moment, thus
creating the potential for a greater problem next year.
Domestically speaking, this would be a bad decision for those in
the livestock industries, as well as for lower income consumers who
are disproportionately affected by rising food prices. Globally,
this would be a bad decision from a humanitarian perspective. What
we effectively have here is a federal government policy that will
require the citizens of the United States to put more than 100
million metric tons of corn into their automobiles this year, while
simultaneously starving millions of people in the developing
world.
What if, on the other hand, the EPA does the opposite and
decides to temporarily suspend the biofuel mandate? Such a decision
would undermine the entire ethanol industry, create enormous
uncertainty for corn farmers and ethanol producers going forward,
and temporarily increase our need for hydrocarbon energy sources.
Depending upon what you believe about the "greenness" of ethanol,
and climate change in general, you might even conclude that a
temporary suspension of the ethanol mandate, coupled with the
commensurate increase in crude oil demand, would simply increase
greenhouse gas emissions further, thereby exacerbating the
long-term problems brought about by climate change itself!
The long-term outlook presents the world with an even greater
dilemma. What we are witnessing here is a rare glimpse into our
collective, global future -- a future of resource scarcity and
interconnectedness that will present us with increasingly difficult
choices. As the world's population grows from 7 billion to 9
billion people over the next few decades, and as emerging markets
seek to achieve higher standards of living for their citizens, and
as the world faces increasing demand for resources, both renewable
and non-renewable, we may be faced with some terribly difficult
choices.
All of this would be true
even in the absence of climate change
, but when we add the climate change factor into the equation, it
becomes apparent that our challenges could become much more
daunting. If climate change does bring about a multi-decade period
of increasing weather volatility, undermining the global food
supply apparatus, then our long-term challenges are magnified and
the potential solutions to such problems are more limited.
Investment Implications
: It is likely that the EPA will do nothing this year and allow the
mandate to continue. What happens in 2013 is impossible to say, but
from a global supply perspective, we'll be going into the year
without much breathing room, so to speak. Therefore, from a
short-term investment perspective, investors' attention should be
tuned in to the emerging markets, watching for signs of rapid food
price inflation and civil unrest. Longer term, the ideas discussed
herein support the notion that investors should have at least a
modest allocation to commodities and resource-related holdings
within their portfolios.
There are numerous ways to play these themes, depending on
whether you are a trader or an investor, and also depending upon
your time frame. So, I'll just provide a variety of short-term and
long-term ideas and offer a few ETFs in each category. Over the
near term (next 6-12 months), it probably makes sense to avoid the
emerging and frontier markets throughout Africa and the Middle
East, where the food price pressures are likely to be the worst. It
probably makes sense to avoid, or even to be short, some of the
fund vehicles such as the SPDR S&P Emerging Middle East &
Africa ETF (
GAF
) or the Market Vectors Africa Index ETF (
AFK
).
Brazil, on the other hand, might fare reasonably well given its
substantial food production capacity, and since this market has
underperformed global equity markets year-to-date, this is probably
the worst market to be short, although not necessarily a good
near-term long position either.
Also, despite all of the comments made in this article, I would
not be inclined to go long the agricultural commodities at this
point. That would have been a great idea three months ago, but the
grain commodities have moved so rapidly in the past few months that
I am not sure the risk/reward trade-offs favors a long position in
the actual commodities at this time. If anything, it might make
more sense to fade the market and be on the short side of these
ETFs, such as the PowerShares DB Agriculture ETF (
DBA
) or the ETFs and ETNs that trade on individual commodities.
Longer term, as I stated, there is a strong case to be made for
the agribusiness companies that will benefit from a continued
global boom in agricultural investment and activity. Some of the
ETFs that hold such companies include the Market Vectors
Agribusiness ETF (
MOO
) and the PowerShares Global Agriculture ETF (
PAGG
). There are also some newer, smaller entrants into this space
including the iShares MSCI Global Agricultural Producers ETF (VEGI)
and the Global X Farming ETF (BARN), which might merit
consideration.
Finally, Brazil might be one of the best emerging markets to own
during a long-term bull market in agriculture, due to the country's
extraordinary production capacity, and vast supply of arable land
and fresh water. Within Brazil lies 14% of all the fresh water on
earth and 11% of all the arable land on earth. Brazil is already
the world's leading producer of numerous food commodities, and is
growing larger every year. There are numerous Brazilian ETFs that
investors can consider for long-term investment, with the iShares
MSCI Brazil Index (EWZ) and the Market Vectors Brazil Small-Cap ETF
(BRF) being the most popular.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is
mentioned in this article.
See also
The Vietnamese Economy May Be A Good Long-Term
Play
on seekingalpha.com