How a Depleted Corn Supply Could Wreak Havoc on Agriculture Stocks

By Tom Clancy Disastrous weather has put this year's crop report in question, and could affect fertilizer stocks, crop insurance, and more. “Soldiers of corn, lend me your ears!” --El Seed in The Tick The Ag trade consists of 4 parts: 1) Seeds

• Monsanto MON
• DuPont DD

2) Fertilizers

• CF Industries CF
• Mosaic MOS
• Agrium AGU

3) Grain Processors

• Archer Daniels Midland ADM
• Bunge BG
• Corn Products International CPO

4) The food companies that buy the feed, oil, and starch Some of the reporting on the trading in this sector has been missing important analysis, so I want to take a minute to break down the crop reports and what it may mean for the different segments of the agriculture complex. In a few days the USDA will release its June acreage report, which is typically viewed as the “final” reading ahead of the crop, but I want to caution Minyans to take this report with a grain of salt. This survey of farmers was conducted on June 1 while flood and tornado damage was still being assessed, and before much of the planting had begun. In other words, while farmers are typically much further along in planting, this year many did not have the answer to the questions about what they were going to plant and on how many acres. (To read an infographic on Groupon from the Minyanville Staff, click here.) The most recent data point on food supply came two weeks ago when the USDA released its World Agriculture Supply & Demand Estimates, which indicated there could be problems with the corn crop this summer. Interestingly, the report began with a disclaimer from the USDA that these are just “projections” and could differ from actual results, an indication of just how difficult it is to project the crop this year. However, the nuances of this report indicate that while corn prices should move higher into December, it may mean weak profits for most of the Agriculture complex. The two major points I extracted from that report are that the estimated planted corn acreage in the US was reduced from 92.2 million acres (in March) to 90.7 million acres, and harvested acres were reduced by about 2 million to 83.2 million acres. These numbers are probably the ceiling on this year's crop and will probably be revised lower as we move through the summer, because yields are asymmetrical (meaning that not every stalk planted will yield as expected). The second data point of interest was that the Soybean numbers did not change much from the March crop report, indicating that farmers not planting corn are collecting insurance payments rather than shifting crops. Industry insiders have noted that even some of the best farmers, who have never taken an insurance payment, are doing so this year because of the physical and emotional damage left in the wake of the disasters. While the corn crop should come in weaker than initially expected, an overall crop of more than 13 billion bushels would be both a record and 6% higher than last year's total. The problem is that the ethanol mandate -- a 50% increase in the EPA ethanol blending allowance for gasoline (from 10% to 15%) -- and the fact that ethanol lowers the price of a gallon of gas by a few pennies means ethanol will consume about 40% of this year's corn crop. So with stockpiles already low, ethanol economics are poised to dramatically shift the demand equation at a time when supply may be constrained even further. Industry consultants have told me supplies are so tight that we have already begun feeding animals with wheat, and it is possible that we run out of corn this year, something that has never happened before. We have to destroy demand to bring this into balance, and it will likely be the small ethanol producers, which are the first to shut down. Ethanol can't be hedged by selling it forward, so the corn is purchased on the spot market. If they can't find the corn they will have to shut down. (To read why Greece's austerity plan will kill democratic capitalism, click here.) With regard to farmers collecting “prevented planting payments” or crop insurance payouts, the wet weather, tornadoes, and flooding has caused less than ideal conditions and prevented many farmers from getting their crop in the ground. As a result those fields are left unplanted. We do not yet have a reading on the extent to which this will impair the crop, but USDA estimates that corn production costs consist of fertilizer (38%), seeds (27%), chemicals (11%), and other, so any impact will be felt throughout the supply chain. First, crop insurance companies will probably have record payouts this year. I don't know which insurance companies are exposed here, other than recalling that ACE Limited ACE purchased a crop insurer last year, but if you own insurance company stock, look through the 10-K again to see if they are exposed. Second, when an insurance payment is made, the farmer returns the seeds and then doesn't buy the fertilizer they otherwise would have put on the crop. Corn requires phosphate, potassium, and nitrogen to grow. The phosphates and potassium are already in the ground and while they must be present, adding additional fertilizer does not necessarily improve yields. Nitrogen, on the other hand, sits on the surface and incremental applications may improve crop quality. One school of thought has nitrogen fertilizers selling like wildfire this summer, as any farmer with a crop will ensure they produce as much as they can at these prices. The other side of that coin is that an unplanted field isn't purchasing any nitrogen until next year. Both are correct, but we don't yet know how the balance between canceled orders and over orders plays out for the nitrogen companies. Overall, fertilizer pricing has been extremely accommodative and industry contacts noted that, “if corn reaches $7 or $8 per bushel, you can't price fertilizer high enough to make the economics unattractive.” Third, the fact that the corn crop will be large and in allocation (if demand rises, supply processors must allocate what they have among their customers) indicates that the grain processors should be making good use of installed infrastructure, resulting in solid profits. However, if drought conditions destroy more than 10% of the crop it will negatively impact their asset utilization, and what happens on their hedging/grain trading desks remains a wildcard. As the food companies report earnings over the next few days, I will be listening closely to see if price increases are gaining traction, because there will be no relief from corn into 2012. Many of these pricing actions were taken in recent quarters, with the expectation that lower priced inventories and initial discounting would be worked through providing a potential upside to second half earnings expectations. If the higher prices cause consumers to trade down instead, it would mean margin compression continues through year end. Either way, it doesn't look like the consumer will see any relief at the checkout in the near future. (To read Marty Kulas's firsthand account of the protests in Budapest, click here.) The unique dynamics caused by ethanol mandates and unusual weather conditions during the planting season could pressure corn prices higher through the Brazilian crop in December. In addition, any extended dry period would put additional pressure on an already tight supply situation. The acreage report we get next week will be less reliable than these reports typically are, and commodity prices will more likely be dictated by weather patterns over the next 6 to 8 weeks. While the Greece drama distracted us from the deteriorating economic conditions in the US, the Drought Monitor could provide just as much excitement in July. Think before trading the agriculture complex, as nuances suggest that higher corn prices may not result in the windfall profits some are expecting. To read the rest, head on over to Minyanville.