Farming fundamentals

While the ailing global economy is pressuring industrial commodity prices, the agricultural grains markets have some very different fundamental drivers, some of which appear fairly supportive, finds Pauline McCallion

A fter a five-year bull run, agricultural markets took a nose-dive last year nearly as spectacular as that of the much-talked about drop in oil prices. In the grains markets - among the most liquidly traded agricultural markets - wheat lost 28.15% between July 2008 and the end of the year, corn lost 43.40%, and soybeans 40.29%. The Standard and Poor's (S&P) GSCI Agriculture Index dropped by 28.88% in 2008.

Many of the losses seen in the grains markets were due to the mass exodus of speculators that had inflated prices - however, the global economy also exerted a strong downward pressure as demand, particularly for meat, fell steeply.

While the economy will be a big influence on the outlook for grains markets in 2009, there are also several other factors in play such as the weather, fertilizer prices, demand from the livestock sector and government policy.

The majority of analysts interviewed for this article predict that short-term agricultural prices will remain depressed, but that longer term, demand is likely to pick up again as the economy improves. Even if economic growth remains subdued for the next year, some analysts expect a rise in agricultural prices as soon as the end of this year. They cite weather-related supply problems in Brazil and Argentina, and continued demand, particularly for soybeans, from Asia.

Most analysts expect agricultural prices to reflect fundamentals a lot more closely than they did last year, and do not expect speculators to return to the market for some time. Last year saw a huge loss in liquidity in agricultural markets.

Discussing the drop in open interest numbers for corn between the end of 2007 and the end of 2008 - a fall of 37.3% according to CME Group - Darin Newsom, senior commodities analyst at DTN, says, "What this tells me is that we saw a great deal of money being pulled out of these markets (last year). As we go into 2009, I am not looking for the return of the type of investor money that we have seen over the last few years."

Fundamentals

Physical demand is also expected to remain subdued. The United States Department of Agriculture (USDA) has forecast lower demand for wheat and corn in 2009, although it notes that soybean demand has been buoyed by strong sales and shipments to China.

Some analysts believe that agricultural markets are more insulated from recent economic woes than other commodities due to an inelasticity of demand. "It's very difficult to tell to what degree global growth has an impact on the agricultural sector itself," says Gavin Maguire, director of agricultural risk management firm EHedger. "You have to assume that while people may build fewer rail cars or buildings, or purchase fewer automobiles (during an economic downturn), they are not going to eat any less. So you'd have to think that food demand would be somewhat immune to a global growth downturn."

Others disagree. "There is strong correlation between what the Dow Jones is doing and what the livestock futures market is doing because of the idea that in a weak economy, people don't buy as much beef, and they don't go out to eat as much steak, etc," says Newsom. He believes this could temper any possibility of a rally in livestock in 2009, which in turn would hit demand for grains which are used as a feedstock for cattle and pigs.

Demand for corn is expected to be hit the hardest. Corn's primary use is as an animal feedstock, but feed-quality wheat can be used instead if the economics stack up. Currently there is a surplus of feed-quality wheat available to farmers in Europe, making the substitution economically viable. "When farmers have the opportunity to use something substantially cheaper (than corn), but still with a decent amount of protein, they will take that," notes Maguire. "Right now there is a near-record amount of feed quality wheat on Europe's doorstep, emerging out of the Ukraine and the central independent states."

In the World Agricultural Supply and Demand Estimates (WASDE), released by the USDA on January 12, 2009, it also notes that "low-priced, low-quality wheat from Ukraine" is likely to attract import demand from the EU-27.

Another factor that could contribute to a bearish outlook for grains prices in 2009, according to Maguire, is the recent trimming of livestock herd sizes in the US and other countries due to high input costs. As an obvious source of demand for grains, this will play a part in prices next year.

The rise in corn and soybean prices to all time highs last summer has led to both farmers and feedlot managers trimming their herd sizes. "Now the question is, will that translate into high meat prices and will those high prices snuff out demand from people who are essentially tightening their belts because of the broader economic landscape?" asks Maguire.

Food for fuel

While demand for food is primarily affected by population, which continues to grow despite the recent economic slowdown, the faltering economy will mean there is less demand for crops to be used as alternative fuel sources as industries feel the pinch.

"We could see less demand for commodities for things like corn (a major component of ethanol) and soybean oil because of a slowdown in industrial growth," says Maguire. "That could definitely lean on prices, or at least drag on prices, even though outright food demand may not be all that much impacted."

USDA figures show ethanol takes up a quarter of US corn production, while the US produces more than 40% of the world's corn and provides for more than 60% of global import needs.

Lewis Hagedorn, agricultural commodities analyst at JP Morgan, says: "Ethanol has become the marginal demand driver for corn, and as such the outlook for corn prices has become increasingly focused on the prospects for ethanol demand."

A big factor in this is the blending of ethanol with gasoline. This blending process is required in the US under the Renewable Fuel Standard programme (RFS) which dictates that the amount of renewable fuel blended into gasoline rise from 9 billion gallons in 2008 to 36 billion gallons by 2022. In 2009, refiners, importers and blenders must ensure 10.21% of gasoline is made up of renewable fuel, such as ethanol.

Paul Mazzarulli, director of biofuels markets at Evolution Markets, believes such mandated blending will provide some price support, but adds: "Ethanol is currently trading at a premium to gasoline and as long as that's happening, it's going to reduce any demand for discretionary blending."

The WASDE lowered its January forecast for ethanol corn use in 2008/2009 by 100 million bushels from 3.7 billion to 3.6 billion. It said the revision was due to negative margins seen since December.

While JP Morgan's 2009 Commodities Outlook report agrees that any blending over and above that mandated by law is likely to be limited, this year's RFS increase will also be an important support.

It states: "The level of the RFS mandate has always served as the most important demand guide for the (ethanol) industry; the increase from 9 billion gallons in 2008 to 10.5 billion gallons in 2009 implies a 700 million bushel uptick in corn demand during the 2008/9 crop year (from the 2006/07 demand figure of 82.9 billion bushels)."

Tight supply

Support is also expected to come on the supply side. In a recent webcast on the outlook for commodities in 2009, Frank Holmes, CEO and chief investment officer at mutual fund company U.S. Global Investors, said he was bearish on the short-term outlook for agricultural prices, but added that the long-term picture was brighter, thanks in part to supply constraints.

"The global population boom is not going away and the earth is not getting any bigger," he said. "On the supply side there have been contractions and I do not foresee any huge spikes that could keep prices down."

Global supplies are expected to remain tight. According to the USDA, 2008/09 consumption figures show world corn stocks at just 7.2 weeks of consumption. Plus, the commodities research team at Barclays Capital believes input and fertilizer costs could reach a level again in 2009 that would act as a disincentive to increase plantings.

As Maguire points out, corn is a very input-intensive crop. "While soybeans endow the soil with nutrients, it's a one-way street for corn, it sucks everything up," he says. Therefore, volatile fertilizer prices, as seen in recent months, can affect corn plantings.

Fertilizer prices increased sharply before falling back again during 2008, causing problems for crop producers hoping to access such resources. "Fertilizer prices were not volatile on a day-to-day basis," explains David Franzen, a soil specialist at North Dakota State University, "but they rose for a period and then fell back."

According to the International Centre for Soil Fertility and Agricultural Development (IFDC), the price of urea, the world's most common nitrogen fertilizer, rose from $280 to $405 per ton in 2007, reaching a peak of $815 per ton in August 2008.

However, the price had dropped to $247 per ton by December of last year. The IFDC blamed price rises on high input costs and an imbalance in supply as countries such as China and India clamored for more stocks, and the US, Brazil and Europe looked for fertilizer to produce biofuels.

The demand destruction resulting from this spike caused prices to drop again. Franzen continues: "The big increase in prices meant people were reluctant to buy fertiliser at the end of last year. It was also due in part to concerns about the global economy."

However, prices may well strengthen again this year - although not necessarily to the heights reached in 2008. Franzen explains, "This time of year is traditionally quiet, but producers may buy more fertilizer than usual to make up for buying less last year. As we come into spring, this could strengthen prices."

Trimming demand

These are volatile times for many types of agricultural commodity, with the outlook changing on a monthly basis. The USDA's January WASDE report revised its global wheat production figures for the 2008/09 crop year by -0.16% - a 1.1 million-ton drop from 682 million tons predicted in December 2008. For soybeans, it cut its output forecast by 1.45 million metric tons (mmt), a 0.62% drop from the December 2008 figure of 233.20mmt.

However, corn production cuts in Brazil and Argentina will be more than offset by increases in China, the US, Mexico, Russia and the EU-27, resulting in a 0.65% or 5.1mmt increase from last month's projection of 785.9mmt for 2008/09 production.

Brazilian and Argentine corn production forecasts have been lowered for 2008/09 by the USDA due to drought conditions in both areas. The projection for Brazil is down 2mmt at 51.5mmt from last month, a 12% decrease on figures from a year ago. "The national corn yield was decreased this month due to high temperatures and dryness in southern Brazil," according to its latest world production report. Argentine production forecasts were lowered by 1.5mmt from last month to 16.5mmt - a 21% fall from last year's figures, again due to dry conditions and high temperatures.

"We think weather is going to be a very big component of the agricultural outlook," says Dan Basse, president of AgResource. He singles out the central plains in the US, Argentina, the Yangtze River valley of China and Russia as areas of concern. "Last year we had one of the best growing seasons that we can remember. This year is not starting out with the kind of conditions we would like to see," he warns. "If mother nature throws a curve ball, if you will, at the same time farmers are reducing their plantings and seedings due to the dire (economic) situation in the world, we think the two will team up for an upward movement in grain and meat prices for at least the last half of this year."

Maguire says a "serious production problem" in Brazil and Argentina, such as adverse weather conditions could also push soybean prices higher. "The main worry is that there could be a prolonged dry stretch during the pod-fill stage. Global producers and users would be worried about a lack of rain between now and end of February."

The seeds of price recovery?

Newsom believes the agricultural markets could be fertile ground for finding buying opportunities this year. "There are some opportunities out there in commodities because of the sell-off (that occurred last year). Find a market that has either neutral to bullish supply and demand right now - soybeans would be an example - or a market that could possibly see its demand turn a bit more bullish," he advises.

A more selective approach will be key. "It's not like the last couple of years where you could basically throw a dart and any commodity was going to rally," he adds. "You're going to have to find a market with some support from the fundamentals to see a decent return."

However, Basse believes the agricultural sector will be one of the first in the commodities complex to recover. He foresees continued demand from South East Asian countries such as India, China, Malaysia and Indonesia, and points to China's record soybeans purchases, as well as a build-up of livestock herds, both in poultry and pork.

"We think that China, India, Brazil, and maybe to a lesser degree Russia, will be the lynchpin for some kind of demand recovery in commodities as we look at the last half of the year."