Mar 17, 2010

The Fundamentals Of The Wheat Market

Over the next decade agriculture may be the most profitable industry for two key reasons. The supply-demand dynamics, which I will discuss in the following paragraphs with data from 1997-2007 and the fact food prices will rise much faster than the inflation tsunami headed our way. In particular I will focus on Wheat in this issue followed by Corn, Cotton & Sugar over the course of the next month. Wheat could very likely be the best performing agricultural commodity this decade. Not only are the fundamentals strong but it also looks to be the cheapest and the best value at the current $4.80/bushel (give or take) spot price. Before analyzing the data, look at the diagram below, illustrating the rising input costs farmers are incurring to harvest their crop. This is because inflation (despite whatever the media says) has caused the price of such things as PP&E, Transportation  and energy to rise. 

  

Comparing 2008 to 2004, we see a stark contrast in the costs of production, which increased substantially in just a four year period. This measurement does not take into account the inflation that has and is still being created on an unprecedented level. A higher percentage of farmers were expected to cover their costs, but only because the market price of wheat has gone up. This forecast showed wheat should become profitable for farmers in 2008 relative to 2004 despite rising input costs as the market price of wheat increased by a greater percentage (exceeding $10.00/bushel at its peak).
Let’s face it, costs will soon start to rise again and rise much faster than the aforementioned 3-4 year period. To think that wheat is only about $1.40/bushel higher now than in 2004 shows a huge disconnect at current market prices. Even in the projected 2008 forecast regarding costs per bushel (which was below what it actually was) showed that 50% of farmers had costs of approx $4.00 bushel. Adding in all the other costs with distributing, SG&A among other things, the all in costs were likely higher. The Producer Price Index has already gone positive, an annualized rate of 4.6% in February, meaning the price of wheat is likely headed higher within the next 18 months because producers need to pass the cost onto the consumer,  In order to remain profitable. Of course measures could be taken to help solve or lessen the severity of rising food prices, but more and more inflation is being created every day with no signs of it slowing down as well as a depletion in ending world stocks of wheat (Previous years stockpile -CY World Production – CY World Production). The following tables of data clearly illustrate many trends that are bullish for the price of wheat.
Mkt year
1/
World production (million bushels)
U.S. production (million bushels)
U.S. share (percent)
World exports (million bushels)
U.S.
exports (million bushels)
World ending stocks (million bushels)
1997
22,413.957
2,481.450
11.07
3,836.521
1,040.398
7,212.570
1998
21,687.828
2,547.331
11.75
3,721.550
1,045.726
7,635.968
1999
21,559.188
2,295.563
10.65
4,168.537
1,086.512
7,699.277
2000
21,417.872
2,228.175
10.40
3,728.531
1,062.040
7,618.294
2001
21,424.449
1,947.453
9.09
3,884.692
962.318
7,465.440
2002
20,866.018
1,605.884
7.70
3,885.353
850.213
6,122.825
2003
20,358.330
2,344.432
11.52
3,992.314
1,158.309
4,848.847
2004
22,991.421
2,156.782
9.38
4,102.435
1,065.898
5,520.412
2005
22,778.639
2,103.320
9.23
4,283.839
1,002.773
5,418.779
2006
21,888.302
1,808.415
8.26
4,100.782
908.488
4,688.277
2007
22,430.418
2,051.071
9.14
4,306.473
1,262.624
4,448.524

For Simplicity sake, we will look at and analyze every column separately. I was only able to find high quality data up to 2007; partly due to the fact many sources had forecasts for the last two years as opposed to hard numbers. But this is immaterial for our purpose as I will just talk about the trends that have and will continue to persist.
·         World Production has remained fairly stagnant while consumption has been increasing. The rest of the world has made up for U.S decline in wheat production, (SEE: increase in world exports).
·         The U.S has lost nearly 2% of market share in a 10 year period which may sound negligible, but due to the size of the grain market, it is rather substantial.
·         Ending World Stocks have trended lower starting in 2000, which is likely to continue over the long run, with intermittent years of higher ending wheat stocks as seen in 1998, 1999 and 2004. Although I don’t have the empirical data on hand, I would say 2008 and 2009 may have seen slight increases due to farmers attempting to take advantage of the high wheat prices in the first three quarters of 2008. This also had an effect on 2009 as farmers may have increased the size of their harvest after witnessing a period of high wheat prices. Additionally many costs such as energy decline enormously, reducing transportation costs, processing costs,etc




Note: The first data table measured bushels of wheat, the following uses metric tons
Mkt year
1/
Area harvested (million hectares)
Yield
(metric tons per hectare)
Production (million metric tons)
 Feed use 2/ (million metric tons)
Domestic disappearance (million metric tons)
Exports 2/ (million metric tons)
Ending stocks (million metric tons)
1998
225.390
2.62
590.246
103.649
578.723
101.284
207.817
1999
215.666
2.72
586.745
98.923
585.022
113.449
209.540
2000
217.895
2.68
582.899
104.422
585.103
101.474
207.336
2001
215.205
2.71
583.078
107.606
587.238
105.724
203.176
2002
214.473
2.65
567.880
111.855
604.420
105.742
166.636
2003
209.611
2.64
554.063
96.298
588.735
108.653
131.964
2004
217.336
2.88
625.724
105.370
607.447
111.650
150.241
2005
219.262
2.83
619.933
110.935
622.699
116.587
147.475
2006
212.213
2.81
595.702
105.877
615.583
111.605
127.594
2007
218.010
2.80
610.456
96.317
616.981
117.203
121.069
2008/2009 Hard Data Unavailable

Again we can identify more supply-demand disconnects in the chart above. The area harvested is more or less the same it was over the previous nine years, which may be due in part to the increase in productivity through the development of better fertilizers or any crop protection agent. Although it isn’t as obvious looking at the crop yield measured over 1998-2007. But looking at the Yield over 10 year intervals we can see the advancements made in crop protection help mask some of the underlying fundamental problems:
·         Yield 1960 – 1.15
·         Yield 1970 – 1.48
·         Yield 1980 – 1.84
·         Yield 1990 – 2.54*
Of course this only for Wheat, as many other agricultural goods which have superior crop protection/fertilizers i.e Potash (more on the implications of that later) have much higher yields which are increasing at faster rates. While the yield has been incrementally creeping up over the years, it is not enough to make up for the rather stagnant production and increasing consumption. As of 2007 ending wheat stocks hit a 26 year low, which will continue to fluctuate up and down each year, but with the same trend intact. Even domestic consumption has been increasing at the same time as exports have been decreasing. In other words, the worldwide consumption of these grains is growing and will likely accelerate in the emerging countries due to increasing standards of living in China and Brazil for example.



So How To Play Wheat?
For most investors, buying an ETF is the easiest way the agriculture market as a whole or if one has access to trade on other exchanges ( which everyone should), you can buy leveraged ETF’s on individual commodities that track the spot price or that purchase futures contracts. This is superior in my opinion because most ETF’s traded here have the whole complex grouped together, while agriculture ETF’s on say the LSE specialize in individual products, allowing one to weight a basket of commodities how they see fit.
The much more profitable way is buying individual futures contracts, which typically have 5000:1 leverage and no cash outlay. But those who aren’t familiar or can’t hedge themselves properly should stay away. Any investor should at least look into mini-futures which typically are 1/5 of a regular futures contract (depending on the product). Let’s take wheat for example: Buying a mini wheat future out to Dec 2011’ costs about 5.40/bushel (which means if wheat went to $0, the max loss in $5,400). I mention this to point because it may be at least worth looking into, due to significantly reduced downside potential relative to a regular future contract which an investor would instead incur a $27,000 loss if wheat went to $0.
Finally the equity side: This is much harder to profit from but if your pick right it could be one of the best ways. I only own two wheat companies and have fairly little capital invested in them. If you’re interested in buying equities to play wheat, my best advice would be to look at Viterra (which bought out my favorite wheat company last year: ABB Grain in Australia). This acquisition reduces the risk of a bad harvest as they have operations in Canada and Australia. This also allows them to sell wheat to the western world and in Asia. The second is another Australian company, Graincorp, which is also worth taking a look at. But I think, however, the best money will be made in crop protection companies such as those who produce potash, slow release fertilizer, etc. I happen to like Potash , Migao (MGO.TSX) , China BlueChem (my favorite but traded on the Hong Kong stock exchange) and Hangfeng Evergreen. But there are numerous companies out there which may be far better than the ones listed above, so finding a good company in this industry may be easier than I make it out be. There are always the Monsanto’s of course, but the big winners will be much smaller.
Conclusion : I think wheat will be one of the best investments for the next 5-8 years, due to the enormous role it plays in everyone’s daily life,  strong fundamentals , depressed price which limits the downside and of course inflation coupled with wheat’s strong reaction when it really gets out of hand.
AG Commodities left to cover: Corn, Sugar & Cotton 

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