November 30, 2008
Financial markets, speculators & feed fundamentals
In the first half of 2008, grain prices skyrocketed to all-time highs. Have fallen by half in just a matter of months, we separate feed's ground-level fundamentals from the recent, volatile unwinding of speculative positions.
An eFeedLink Exclusive Commentary
by Eric J. BROOKS
Oil, wheat drag down corn
What a difference six months makes. Half a year ago, high prices and impending grain shortages were all the rage. Corn, soy and wheat all hit new all time price records, sometimes more than once, between January and July. Driven partly by recent financial panics, feed grain prices have dropped in half in just three months and over the next few weeks, we see even more downward price pressure.
These deflationary pressures however, are, at this time, mostly due to changes external to the region itself. For example, corn market fundamentals within Asia itself are unchanged but this is not the case outside Asia. Dragged down by falling oil prices and declining US petrol demand (of which corn-based ethanol is a component), CBOT corn crashed by more than 50 percent since early July. This in itself did not reflect underlying grain fundamentals within Asia itself.
For example, early 2008's record wheat prices were met with additional acreage planted and favourable growing conditions. The resulting bumper harvests in North America and Europe created a global wheat crop of record proportions. Consequently, with wheat's price crashing and plentiful supplies at hand, farmers across Asia are again substituting as much wheat as possible in their feed rations, thereby further reducing regional demand for corn. All this coincided with falling US ethanol demand, which made more exports hit available just as Asian corn demand slackened.
Slack Chinese demand takes down soy
Deflation has also hit soya beans, which saw early 2008's $15+/bushel record prices fall to the $8.80/bushel range at the time this article was written. However, whereas corn was mostly dragged down by crashing oil prices, market fundamentals account for a much larger proportion of the fall in soya bean prices.
Large soya bean crops in the US and South America coincided with slack feed demand in China, their main export market. In addition, India, though a minor player in global soya beans, also had a bumper year. Powered by a soy crop 10 percent larger than the previous harvest, Indian soy meal exports registered 88-percent growth from 2.66 million tonnes in 2007 to over 5 million tonnes this year.
US corn, soy displaces Indian corn exports, domestic Chinese soy
Interestingly however, it is neither US corn or soy exports which are being hardest hit by this oversupply. Over the last few months, CBOT corn prices have been anywhere from 15 to 20 percent lower than domestic Indian and Chinese corn prices. While both of these countries have extensive barriers against lower cost imported corn, India corn export volumes are set to crash from this year's 3 million tonnes to somewhere between 200,000 and 300,000 tonnes in the fiscal year starting this October. Amit Sachdev, a representative of the US Grains Council in India, stated that, "I don't know to which countries India will be able to sell corn."
Meanwhile, Chinese soymeal prices are weakening as imported US soy is presently significantly cheaper than domestic soy. eFeedLink's Chinese feed industry sources and US shipping ports both report a surge in the number of soy shipments destined for China. Curiously, this is occurring in the year of a record domestic Chinese soya bean crop and slack feed demand. Both market and non-market forces are behind this sudden surge in Chinese soy imports.
On one hand, Chinese soya beans, like corn, is now significantly more expensive than imported soy. Furthermore, imported soy's cost advantage in the Chinese market may, if anything, increase. If Chinese soy stays relatively more expensive, it may find the price gap widening when South American soy hits the market in six months, as it traditionally is lower cost than US soy. With the US dollar having risen strongly against Latin American currencies, South American soy may enjoy an even larger cost advantage than US soy.
In addition, imported soya beans are also being drawn into China due to the fact that it now appears that melamine, far from merely contaminating milk, might be ubiquitous throughout China's feed supply. There are reports from some feed suppliers that their customers in the layer and ruminant industries are starting to request feed derived from imported soy, as it is believed that this minimizes the chances of melamine contaminating meat and dairy products.
Hence, the cost advantage of CBOT corn and soy, when combined with factors unique to large markets such as India or China, is helping sustain their demand in a manner not fully reflected in the current price trend.
Forecast 2009: will prices snap back upwards?
The problematic question however, is anticipating the market's direction going into 2009. Here, we see a witches' brew of strong, yet contradictory market forces at work. On one hand, financial market deflation has drawn down feed grain prices more than is justified by fundamentals, implying a snap back in prices.
On the other hand, serious recessionary conditions appear to be developing in both developed and emerging markets, implying that meat, livestock and feed demand in the latter might be poised to fall. Coinciding with the above are a once-in-a-century deflationary financial contraction. Opposing this looming depression are trillion-dollar attempts at financial reflation, which carry highly inflationary implications. How is such a confusing set of circumstances to be rationally interpreted?
Feed outperforms financials in a deflationary environment
First, we must separate the part of feed grain deflation accounted for by financial panics from that accounted for by underlying fundamentals. One way of doing this is to compare the price change in agribusiness commodities to that of paper-based financials. The graph below clearly indicates that despite their recent price fall, feed grains have maintained their value while financial instruments such as equities have suffered far more serious, protracted declines. Unprecedented financial crashes not withstanding, this implies that feed grains, along with the meat and livestock they sustain, still enjoy strong underlying fundamentals.
According Ned W. Schmidt, publisher of Agri Food Thoughts, much of the decline in feed grain prices was due to a sell-off of hedge fund positions trying to cover their financial obligations, not underlying fundamentals. He believes that grain fundamentals, while strong, rose disproportionately quickly due to excessive commodity speculation by financial industry players. When the financial industry faced liquidity problems in the second half of 2008, these same funds drove feed grain prices below their fundamental price values, where they remain today.
In his Agri Food Thoughts newsletter of November 24, 2008, Schmidt states that feed grain speculation rose, "from about 6 million contracts at the beginning of 2006 to about 8 million contracts in early 2008. With open interest rising by more than a third, prices were pushed above equilibrium." He then notes that driven by the recent financial panic, a quarter of these contracts have now been liquidated. Going into 2009, this leaves open interest (outstanding futures contracts) in US commodity exchanges below their 2006 levels.
Schmidt concludes that having already liquidated a mass of speculative contracts due to financial panic's selling pressure, from here on in, "selling should moderate, pressure on prices should moderate."
Indeed, 2008's economic conditions may eventually serve to make the inevitable rebound in grain prices more nasty than it need be. Thanks to high input costs and falling grain prices, the USDA cut its expected 2008 US cash income for farmers by 10.46 percent; from the $101.3 billion estimated in July to only $90.7 billion as of November 25. While this is still 4 percent higher than 2007's farm income, the USDA states that, "a large increase in the value of crop production is offset by rising production costs for the farm sector."
But the outlook for next year is not as rosy as 2008. Thanks to dropping commodity prices and relatively high production expenses, many US farmers will be nearing the break-even point between profit and loss.
Moreover, this change in returns is already threatening to impact next year's grain harvests. With the decline in corn prices outpacing the fall in production costs, early USDA estimates already forecast a decline in next year's planted acreage for corn. Should today's low prices and high production costs continue to curtail planted grain acreage, it might be difficult to fully meet feed demand within one to two growing seasons.
At that time, without an extraordinary financial accident to disrupt market fundamentals, trillions of dollars in bank bailout money may choose to ignore the moribund financial sector and drift into grain markets, where underlying fundamentals remain strong. The resulting grain price adjustment would then be sudden and hyperinflationary in nature, to say the least.
Have fundamentals changed that much in six months?
In conclusion, six months ago, the mainstream media was filled with alarming reports that global grain inventories were at dangerously low levels. Despite this year's good grain harvests, neither international grain inventories nor the long-term underlying supply-demand imbalances have changed significantly. Nor do we yet have evidence that financial panics have impacted meat or feed demand at ground level in emerging markets.
The only thing we can be certain of is that this year's financial panic removed much speculative selling pressure in the space of just a few short months. Therefore, it is reasonable to believe that when the current climate of financial uncertainty moderates, strong grain fundamentals so visibly evident throughout 2007 and early 2008 should re-assert themselves.
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