Hackett Advisors in the News

Ag Fundamentals: Old And New

Published 4/15/2008

We are entering a new world for agriculture fundamentals. Weather and governmental reports on inventory, planting intentions and other traditional measures of supply and demand used to be the main drivers for agricultural markets, and while they’re still important factors, several new fundamentals have become relevant. If traders want to stay profitable in this new world, they need to pay attention to the shifting dynamics to harvest bigger profits.

The old fundamentals of supply and demand are measured by U.S. Department of Agriculture (USDA) reports (see “Supply and demand”). Many analysts give the greatest weight to the stocks-to-use ratio for grain markets, which is calculated by dividing ending stocks for the year by total use. The stocks-to-use ratios give a picture of how tight supplies are, which is the primary measure used to project prices (see “Little left for rainy day”).

However, with more speculative money flowing into agricultural futures markets, supply and demand fundamentals are fading into the background. “If investors simply look at old school supply/demand fundamentals, they are likely going to have a very difficult time making sense of agricultural commodity markets,” says commodities analyst Shawn Hackett. “Prices are being set more by the investment monies today than ever before,” he adds.

Bill Biedermann, senior vice president at Allendale, says “Today, because of the imbalance of the money, the supply and demand in grain inventory is not driving [the ag market]. [Rather], it’s the supply and demand of money chasing contracts.”

A new kind of investor is also putting the old fundamentals on the back burner. Elaine Kub, commodity market analyst for DTN, says that with more speculative interest in the market, “the idea of inflation or the idea of increased demand from Asia may be enough to encourage buying by some event-driven funds, regardless of demonstrated supply and demand, or regardless of supply issues at all.” As far as seasonal fundamentals, she says, “The commercial traders who are experienced with seasonal tendencies don’t have as much market influence in the face of all the new speculative money as they used to.” Biedermann expects speculative money to continue to pour into the agricultural markets until July or August unless there’s a fiscal collapse and a pull out of the market.

Some analysts claim that the speculative money is causing extreme moves and high volatility. Currently, the agricultural market is experiencing weekly ranges equivalent to yearly ranges, according to Biedermann. “We’re seeing major, major firms pull their contracting capabilities. They’re not offering these contracts anymore because they don’t want to be caught in this futures volatility. Right now, the majority of the grain industry has yanked all of its cash contracts. If you’re a farmer, and you want to take advantage of today’s high price of corn for fall delivery, you can’t even sell it. No one will buy it.”

While large speculators have always had the ability to distort market prices, at least temporarily, there is something completely different with newer speculative money in the ag markets that is benchmarked to long-only commodity indexes. Funds benchmarked to the S&P Goldman Sachs Commodity Index (GSCI) and other long-only indexes arguably are not price sensitive. They are long and simply roll long positions based on the index prospectus. Their allocation to corn, wheat or soybeans is significant to the market but not significant to the index itself so huge price movements in these markets have little affect on the underlying index. A spokesperson for Standard and Poor’s Index Services estimates that money benchmarked to the S&P GSCI will grow to about $100 billion in 2008 and that the universe of long-only commodity indexes will grow to $150 billion. That is up from $18 billion to $20 billion for the S&P GSCI and $30 billion total for all long-only commodity indexes in 2003.

Food vs. fuel

Energy policy also has considerable influence over today’s grain markets. Energy policies mandating increases in ethanol from corn and biodiesel from soybeans are increasing demand for each, but government acreage policies are limiting the expansion of crops. “The policies that are driving food and fuel are colliding,” Biedermann says. “We have an energy policy that’s expanding ethanol usage, so we’ve got a huge build-out program, which is driving total demand for corn and affecting total usage for corn. But we’re not expanding acres at all because we have an agricultural policy that’s restrictive on acres.”

In fact with the huge rallies in soybeans and wheat in 2007, analysts expect farmers to pull acres away from corn and plant more wheat and soybeans in 2008 (see “Robbing Peter to pay Paul”).

William Adams, managing director at JKV Global, says that the current energy bill could have a much greater impact on farmers than the U.S. farm bill. “Converting acres to fuel will create some short-term challenges,” Adams says. “A third or more of the U.S. total corn production will go to ethanol. As far as soybeans are concerned, the U.S. will probably relinquish its export market to South America.” He expects increased demand to affect feed corn and soy meal short-term and for the prices to level off over time. But the bottom line is that corn and soybeans can be viewed as energies as well as ags so energy fundamentals have to be calculated into the mix when looking at these markets.

“Cattle has not garnered the trading interest that the grains have experienced, but livestock in general has been affected by the soaring grain prices,” Adams says. And meats are affected as they are competing for the limited supply of grain for feed.

It’s important for traders to keep commodities’ relationships to each other in mind, as the government’s restrictive acreage policy affects the supply and demand balance of agricultural commodities across the board. “All these different agricultural commodity markets are interlinked with each other,” Hackett says. “We do not have enough farmland in the United States to plant all the acreage we need for all the agricultural crops needed. So each year, certain markets will be left with an insufficient supply/demand equation.” He says to “invest in those that are not likely to get what they need.”

The USDA’s Prospective Plantings report lists how many acres farmers intend to plant each growing season, and has repercussions on supply and demand and how the available acreage will be distributed. Adams called this year’s report “one of the most highly anticipated planting intentions reports in recent history.”

“It is very likely that some of the agricultural crops will not receive the acreage they need to maintain a comfortable supply to meet the expected demand. No matter which way you look at it, agricultural markets no longer have a safety net in excess to cover any supply shocks. This means that if either acreage or weather misses the mark, food shortages and record high food inflation could be seen sooner then we think,” Hackett says.

Other key reports include the USDA’s August crop production report, which reflects yields, and the USDA’s monthly World Agricultural Supply and Demand Estimates (WASDE) report, which shows planting intentions worldwide. Like the USDA supply and demand reports, the most important figure in the WASDE reports is the stocks-to-use percentage, which shows actual supply and demand and how tight supplies are. A lower stocks-to-use percentage year to year, for example, signifies tighter supplies due to higher demand. The reports are important for the short-term, but for the long term, keep your eye on additional market factors. “The most influential report we’ll receive [was] the FOMC’s rate cut,” Kub says, adding that the USDA reports “tend to bring out a lot of short-term speculators and volatile movement on the report days, [but] from a long-term perspective it is probably more important to keep track of the trend of the dollar and other commodities — crude oil, especially.” The volatility in ag markets is an opportunity for traders but they must be able to factor in these new fundamentals because there is less room for error.

“Opportunities in the marketplace are enormous this year,” says Biedermann, but he cautions that additional risk management is needed. “In this kind of a market environment, you need to put on slightly more complex covered positions,” Biedermann advises. “Keep your eyes open for a rebalancing in either the policies in energy vs. agriculture vs. fiscal policy, or a balancing trend in the amount of fund money. If you see the market trending more towards balance, then the market itself will become more focused on the fundamentals of supply and demand of grain inventory rather than the supply and demand of money driving the market.”

Ag traders also should keep their eyes on stock market moves and events in China. “Watch for money being lost in the stock market – that will generally spur a flight to liquidity out of commodities. Also be aware of whatever news you can trust out of China. If their economy begins to struggle and their [consumption] stops growing at its current rate, some of commodities’ demand-driven arguments could be washed off,” Kub says.

Adams says that most opinions will be bullish about where prices are headed this year, but when it comes to predicting the future, “Weather, disease, fiscal policies, and international crises all have huge, unpredictable influences on market prices.”

Don’t throw out the old agriculture fundamentals, but expect the new ones to remain dominant for the time being. Biedermann says, “There will be eventually a return to the underlying economics of the actual commodity that we’re trading, but right now, that’s not what we’re trading. We’re trading money.”


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