Chapter 12

In scanning the horizon to look for the best physical commodity investments, food presents itself as one of the underpriced opportunities for the decade ahead. There is probably nothing more basic to our well-being than food. Even back in biblical times, famine was feared. But we have achieved abundance through technology and transportation so that the fears of shortages that Malthus predicted centuries ago have not been visited upon us.

The United States is the world’s biggest exporter of wheat, corn, cotton, and many other food products, which makes agriculture one of America’s great economic strengths. We may depend on others for oil, but others depend on us for food. Even so, agriculture hasn’t yet caught the limelight that the spicy dotcoms did in the 1990s or that the metals and energy have in the 2000s. But agriculture’s rumblings are being felt.

The price of corn tripled from mid-2006 to mid-2008. For soybeans and wheat, the gains were 2.5 times and 2 times, respectively. Prices of most other agricultural commodities have also risen sharply. For investors who made the right moves, big money has already been made in the agricultural markets.

Land dedicated for agriculture has not grown, but yields per acre have steadily increased. For the past several generations, genetic manipulation of plant strains and improved fertilizers and farming techniques have yielded a growing supply of food. The Green Revolution has worked, and worldwide the share of personal income spent on food has declined. Figure 12.1 shows the very long-term history of the relative prices of corn, gold, and oil by developing a ratio where the average price of each was adjusted to 1 for the period of 1875 to 1910. By 2009, the price of corn is 8 times higher and oil is 67 times higher than then. You can see the periods of inflation around wars, and that the general price movements have similar patterns in the long term. The point for corn, and indeed most agricultural products, is that there is some catching up to do. With population growing, and eating more meat (which requires 10 times more grain input per pound consumed), demand for food will be rising. It is my view that even small shortages could create big price rises if there were any disruption in productivity caused by anything from climate change to political instability.

Figure 12.1 Oil and Gold Rose Much More Than Corn over the Last 100 Years

The comparison with oil isn’t arbitrary. Agriculture is closely tied to energy because farming is a gas guzzler. Oil and natural gas are needed to make the fertilizer that feeds the crops, and diesel is needed to run the tractors and other machinery that plant, tend, and harvest them. Then more fuel is needed to bring the crops to market. As energy prices have skyrocketed, so has the cost of farming.

Relative to other goods, food is much cheaper than 75 years ago—even after the recent run-up in prices. For corn to catch up to oil, for example, corn’s price would have to increase by a factor of 8, to $32 per bushel. And that’s on top of its doubling from $2 to $4 over three years, up to 2009.

Grains: Tight Supply Drove Prices Higher Worldwide

Grains tend to trade quietly until a shock hits, most often delivered by nature. But even beyond such shocks, things have been changing. Since about 2001, the world has moved from chronic excess supply—with costly government programs supporting prices and accumulating huge stockpiles—to shortage, with consumption outrunning production and stockpiles shrinking. Figure 12.2 shows how tight the stocks of grains are across the planet. It is made from adding together the world supplies of all the major grain types and showing the stocks as a ratio to the amount of usage.

Not surprisingly, this scarcity has sharply driven up prices of all the grains.

Pricing Model for Grains

I call myself a grain trader, and in so doing, I developed a model for estimating prices, which I will demonstrate. I made big sums of money trading this methodology in 1995-96 during a big rise in grain prices. The market had a big move up in 2008 that I will show validates the model. The model gives a basis for price expectations. Comparing what the model expects and the actual price gives an indication of whether the price should rise or fall from where it is now.

Figure 12.2 Stocks Worldwide of Coarse Grains, Wheat, Soybeans, and Rice Are in Short Supply

SOURCE: USDA.

The approach here is on the long-term fundamentals, to identify situations that should be profitable for months to come. It is based on world supply and demand. Many traders of these highly leveraged futures markets watch with detailed real-time quotes and technical analysis such as moving averages and indicators. I focus on finding the long-term relationships that drive prices, and leave short-term details to others.

The harvesting of U.S. grain crops starts in September each year, so that’s when inventories from the preceding year approach their low points. The nominal harvest date for each particular grain, as cited by the U.S. Department of Agriculture, is a little different, but for each grain the inventory remaining at that date is called the carryout, or ending stock, for the season.

A grain’s scarcity at the end of the crop year can be measured by its usage-to-stocks ratio, which is found by dividing its usage for the season by its worldwide (stocks) carryout. The industry often quotes the stocks-to-usage ratio, much like I used in Figure 12.2. But here I am looking for an indicator that moves up with price. The usage-to-stocks ratio does that. For mathematical reasons, it also correlates with the pressure on price better than the other ratio. When scarcity comes along, the effect on price of small movements in carryout can be large. Using this inverse ratio is what is key to my method.

Figures 12.3 to 12.7 show the comparison of this calculation to price for corn, wheat, rice, and soybeans. In each of them, the grain’s usage-to-stocks ratio, which measures the fluctuating level of scarcity, is shown by the dashed line. Each figure also shows, in the solid line, the grain’s price history. In general, prices have risen and fallen fairly reliably along with the usage-to-stocks ratio. Exceptions to that general rule indicate times when a grain may be underpriced or overpriced. When the dashed line for the usage-to-stocks ratio is above the price, it indicates possible scarcity and a likelihood that the price will move up toward the dashed line. (It was because of such a situation in August 2006 that I predicted a rise in the price of corn. And in May 2007 a rise in wheat.)

Figure 12.3 Corn World Usage to Stocks Justified Higher Price, but No Longer Bullish

SOURCE: USDA.

Figure 12.4 Wheat World Use to Stocks Indicates Price Is High

SOURCE: USDA.

Figure 12.5 Soybean World Use to Stocks Does Not Support High Price

SOURCE: USDA.

Figure 12.6 Rice World Use to Stocks Is Tight, But Price Seems High Enough

SOURCE: USDA.

Except for the ending points (at the right side of each chart, showing figures for the 2009-2010 crop year), the chart lines reflect actual historical data. The ending points reflect forecasts. The forecast for the usage-to-stocks ratio is based on the U.S. Department of Agriculture’s (USDA) monthly estimate of the coming carryout. The price is the latest futures market price for the year. (The USDA’s monthly forecast comes from what is known about existing inventories, rates of consumption, and the size and condition of plantings around the world. The data for these charts are updated in the World Agricultural Supply and Demand Estimate released around the 10th of every month.) The forecast is available on the web here: www.usda.gov/oce/commodity/wasde/index.htm.

The big price jumps we saw in 2008 were predicted by scarcity. Unfortunately, by late 2009, the shortage has been reflected in prices, so the investment opportunity is no longer with us. Corn and rice appear to be in line with the fundamentals; wheat has already had a pullback, but it is still a bit high; and soybeans look overpriced. The disappointing general conclusion is that the sharp up-moves in grains have already occurred. The easy money has already been made.

This model structure can be applied to many of the agricultural commodities, like cotton or other items where the seasonal stocks at the end of the year can be used as good predictors of the price.

There is more detailed analysis that can be developed by looking more closely at monthly data and by looking at countries’—most important, the United States—usage and carryout to refine the analysis. A refinement that could be helpful would be to correct the prices for inflation. The most valuable refinements come from making adjustments to the near-term USDA projections for the current year, as they are the base for the price projection. Money can be made at the margin if we can find factors that will adjust the USDA numbers before they do, such as better weather than expected or a change in policy, like abandoning ethanol subsidies that could bring corn down. I have pushed further to building models that predict what the price should be from regression on the historical numbers using the model described here.

There are many other factors that are added into the revelation of price throughout the growing season. Weekly reports update conditions. Correlations between expected yield and crop conditions can refine the expected size of the crop.

Ethanol

The interrelationship between factors is evidenced in the ethanol situation that was set up to find nonpetroleum sources for automobiles. Ethanol was supposed to meet some of the demand for gasoline. Government subsidies brought new demand to the corn market but didn’t really cut gasoline usage much, because gasoline is a much bigger market. Growth in ethanol production has made carryover feed grain supplies very tight by historical standards. Figure 12.7 shows just how large the ethanol production is compared to feed usage for corn. Ethanol was behind the start of the big jump in corn prices, and one of the reasons I became so bullish on corn in 2006.

Government incentives for the domestic production of ethanol have caused a big increase in the demand for corn, as Figure 12.7 shows.

Figure 12.7 Ethanol Usage Is Approaching the Amount Used for Animal Feed

A closer look at grains markets can be found in the U.S. supply and demand. We’ll usually be trading in U.S. markets, so we can get a better look by using the same method on the data for just the United States and, if you are trading, updating the latest projection with each USDA report on the U.S. supply as opposed to the worldwide supply that was used in Figures 12.2 to 12.6.

Grains are as basic an investment item as I can think of because they are the basis of the food chain and our lives. With prices at one-eighth of competitive commodities compared to 100 years ago, the long-term upside potential is likely. Most grains are fed to animals for our meat. Sometimes meat is called processed grain. So I want to take a little effort to review the situation of meat.

Cattle and Hogs

I point at the meats because their prices are low as of early 2010. In general, meat prices have not kept up with the inflation in other commodities in the last three decades. With a worldwide economic slump, people are not buying the more expensive foods. For the meat producers, when prices fall and costs of grains are high, times become particularly tough as each animal costs more than it can be eventually sold for. The result is that herds are culled by increasing sales of animals just to cut the expenses. And that drives prices even lower. The cattle cycle is about three years long, because it takes that long for breeding and finishing the animals. So after a period of low prices that cuts inventories, we can see the shortages are more likely to occur a few years later because the fewer new calves that were bred mean short supply. The USDA is predicting that the ending stocks of beef in 2009 will be 460 million pounds, which will be the lowest level since 1999. The stocks hit 691 in 2002. Figure 12.8 shows the history of beef stocks.

Cattle traders watch weekly slaughter counts and how many cattle were put on feed getting ready for market, and they look for periods when sales are low, which indicates scarcity of supplies. The model of inventory as applied in the grains does not apply to meat, as it is necessarily sold as soon as it is slaughtered. Grains can be stored for years. The inventory that is watched is the quantity of animals on feed and on ranches. More details of the weight of the animals is helpful in deciding whether they have been fed for a long time or are being shipped off to slaughter early, suggesting smaller supply.

Figure 12.8 Beef Inventories Are Lowest in Years

The situation we are in is clearly one of low prices, and if economic recovery brings prosperity and more demand, one could easily see a significant move in meats.

Conclusion

In this chapter, I focused only on some agricultural products traded on the futures exchanges. They provide the easiest vehicles and biggest markets in which to invest. I suggest some caveats about futures trading because it offers extreme leverage that can wipe out an inexperienced investor.

Everything that touches farming was doing well by mid-2008. The fertilizer industry was booming; shares of potash moved up twentyfold since 2003. Stocks of farm equipment companies, such as John Deere and Caterpillar, moved up. Specialized agribusiness companies like Archer Daniels Midland (grain processor and ethanol producer) and Monsanto (seed supplier) all had their own profit harvest with their stock price up 5 and 10 times, respectively. All dropped into 2009, as crops fared well.

Great as it has been, the prosperity of each of these companies is derivative. It’s fed by rising prices for agricultural commodities, so any position you might take in their stock, long or short, would depend primarily on your assessment of ag prices. So whether you are considering investing in companies tied to agriculture or in the commodities themselves, it all comes down to the question of where, commodity by commodity, the fundamentals of supply/demand are leading us.

Farmland is typically a long-term investment and requires many management decisions, such as finding a land tenant, deciding what to grow, and so on. Agribusiness stocks can be bought and sold easier and have fewer management issues than farmland.

One exchange-traded fund that is large and liquid is the power shares DB agricultural fund. It has a $2 billion market capitalization and trades in volume. It is not exciting, and frankly not the kind of thing that has the laser focus and potential big move of picking a specific agricultural commodity, but it did double during the rise of grains in 2008. It’s now back where it started and would participate in a big rally should one occur.

It is in times like these, when hardly anyone is noticing what is going on in agriculture, that the opportunities for long-term gains can be better than things that are the current focus. Dr. Mark Farber, who is often in the media commenting on the economy, and who spoke at our Casey Research Conference in Denver in the fall of 2009, says that investing in agriculture today will be like investing in the oil sector in 2001-2002. The agricultural area of the globe that can grow food is limited, but the population has grown four times over in that last century. With those basics drivers, agricultural investments are likely do exceptionally well through 2020.

The most fundamental of resources for humanity of food and energy will be solid investments in an era of financial instability. As confidence is lost in the paper money systems, the prices will appear to rise even more in the depreciating dollar they are priced in. And that is the subject of the next two chapters: where investment can be made directly in the demise of the dollar and rising interest rates.