CORN STOCKS GROWING

A record 13 billion-bushel corn crop was a welcome sight for U.S. farmers who planted late and fought too cold and wet conditions all spring and too dry conditions in July. But as they say, “be careful what you wish for,” as now the farmer has a record inventory that is trading at prices below cost of production.

The ethanol and poultry industry is beginning to respond to lower prices but cattle, hogs, and even the export market are not writing home to get on the demand list. “The ethanol industry will be strong in 2010” says Rich Nelson, director of research at Allendale, because the industry has turned over facilities through bankruptcy auctions at approximately 30¢ on the dollar. This has lowered overhead and allowed new owners to take advantage of lower-priced corn markets.

Likewise, the poultry industry is just starting to recover from a 4% decline in production. However, not all sectors are recovering. The cattle and hog industries are both in serious financial stress. Liquidation of herds implies production will decline 1.5% and 2.3%, respectively. This cut in animal consuming grain units will make it very difficult to increase feed demand by the 100 million bushels the USDA is currently projecting. Exports are also struggling and are reflecting the fact that livestock sectors worldwide are cutting back. The USDA is projecting a 350 million-bushel increase in exports. Possibly the weak dollar will shift some demand towards U.S. shippers, but it is more likely that the USDA has overestimated demand. In fact, Allendale research suggests demand will need to be revised downward by January, which would cause ending stocks to rise further.

Corn ending inventories will swell to 1.9 billion bushels vs. 1.674 billion last year. This 13% increase in end stocks translates to a comfortable 53.6-day supply of corn in the United States compared to a more normal 50-day supply. With increasing confidence that new hybrid seeds will perform, traders will be reluctant to take prices much higher as these supplies are adequate, and if prices were to rally too much, a demand recovery might not occur.

World supplies of corn have been trimmed due to drought and frost reduced crops in China. In fact, China will consume about 158 million metric tons (mmt) of corn and produce only 150. There has been talk in the industry of how China might become an importer of corn in 2010. We however doubt this, as their end stocks exceeded two billion bushels, 40% more than the United States. A one-year drawdown would only put their end stocks at a more normal level for the industry, and no threat of a shortage would exist unless crop adversity occurred in 2010. Total world end stocks are projected to be around 130 mmt vs. the five-year average of 128 mmt. Thus stocks are down 3.5% from last year but remain 1.5% above normal levels. Further competing for starch demand is a huge inventory of world wheat. Wheat stocks this year will exceed 186 mmt vs. 169 last year and 122 the previous year. Much of the wheat inventory is feed grade and is being discounted by $2.90 per bushel as of early October. This price pressure is sure to restrict enthusiasm for corn buyers (see “Stocking up” ).

Nothing cures low prices like low prices and current wheat prices are well below cost of production. In an informal survey, Allendale brokers found that many Soft Red Winter Wheat producers are taking a pass this year.

Prices for U.S. corn should remain well supported in the $2.85 area via nearby futures, as this represents a level very profitable for most end users, while the producers of corn will likely keep corn in the bin until prices exceed production costs. If December 2010 prices were to rally above $4, the U.S. producer would respond with greater acreage and by selling 2009-2010 inventories to lock in profitable returns. There are also around four million acres that could come out of the USDA Conservation Reserve Program this year if prices rallied above $4.20. Any price outside these ranges would likely be caused by an outside market influence like inflation-based speculative buying or a major weather adversity that is currently not in the cards.

WHEAT CONVERGENCE

Nearby wheat futures at CME Group remain well above cash levels as convergence issues remain unresolved. As CME Group works towards correcting this issue, futures and cash markets likely will return to normal basis levels. Currently cash is $1 to $2.90 below futures depending on various locations. Thus until the convergence debate has concluded, it is hard to say if futures will move down or cash up. But assuming the cash market is the real market, futures look vulnerable. Additionally, as long as the corn crop is competing for starch demand, wheat will have limited potential. Having said that, there is evidence that intended acreage in the United States likely will decline. This might provide support and correct some of the oversupply issues if the acreage response is significant. As of this writing it is too early to tell, but it is safe to say that July wheat will remain below $6. If corn holds in the $2.85 area as we suggested, then wheat should hold in the $3.50 area.

SOYBEAN PUZZLE

Soybean traders are faced with a more complex environment than the corn trader. Domestic soybean yields produced a record crop and ending stocks doubled from the second lowest levels since 1976 to a very comfortable 250 million bushels based on the latest USDA reports. However, Allendale’s research suggests these stocks are not done growing. Last year, Argentina had a severe drought. Combined with an adverse export tax policy, this drought cut their ability to export beans by 56%. This created an opportunity for U.S. exports to fill in the void and the U.S. producers shipped a record 1,280 million bushels, mainly to China. But in the coming year, Argentina will increase production 59% and likely will re-enter the export market aggressively trying to gain back market share. Yet USDA has projected U.S. exports to remain at the record 1,280 million-bushel pace. This is highly unlikely despite strong sales to China and if revised to more realistic levels, end stocks will exceed 300 million bushels and be well above the 10-year average of 263 million bushels (see “Building supply”).

Once the reality of the large U.S. stocks is factored in, the market will then be dealt the news of large South American acres. Following this will be news that the Brazilian and Argentine crops combined could reach 113 mmt (4.1451 billion bushels), or about 30% more than the domestic production. In fact, Brazilian and Argentine ending stocks are expected to hit 35 mmt, or 69% of the world supply and nearly six times more than the U.S. stocks. Total world end stocks are projected at 50 mmt vs. 40 mmt last year and the 10-year average of 42 mmt.

Anything can happen when you are using weather as the assumption in your pricing models. But for now, unless a major adverse weather event significantly changes the current outlook, the adequate supply situation likely will cap any attempts to post a strong rally. This is not to say that the market will not experience an inflation hedge, speculative led rally, a low dollar value-seeking bounce, or a seasonal move to keep bean prices competitive with corn, so that domestic producers will plant beans and not shift all their acres to corn. But if the corn market does not rally, then there will be a natural tendency for producers to opt acres towards beans to cut costs and reduce financial exposure. Thus if the corn market does not show leadership, the bean market could become the dumping ground.

Obviously the fundamentals suggest selling rallies as a means to stay with the trend. Fundamentally, the nearby futures should be sold in the $9.40-$10 range with an initial objective of $8.10.

MEAT MARKET

The meat industry has been slaughtered with two years of red ink and livestock producers have been forced to liquidate herds. The poultry flocks turned foul even before the economic crisis with major producers like Goldkist and Pilgrims Pride either liquidating flocks or filing for re-organization after H1N1 bird flu affected exports. But losses migrated to other meat-related industries. In the South, cattle feeders have been hit with both the financial stress and the perils of a severe drought forcing some cow/calf operators to sell out due to lack of feed or money to buy it. Further north from Kansas to Minnesota, there have been many producers who have voluntarily reduced herds of cattle and hogs to preserve remaining capital while there have been a few reported incidences where banks have sent in semis and taken sows to slaughter to prevent further financial bleeding.

Contrasting the negative sentiment of the grain and oilseed sector is a very optimistic price outlook for the livestock sector. As a result of the previous two years financially forced flock/herd liquidation, poultry broiler production should be -4%, cattle inventories are -1.5%, cattle on feed -1.2% and hog production -2.3%. Even if poultry production recovers in 2010, a net decline in meat production will begin to show up in the second quarter of 2010. And since the financial sector is not ready to finance expansion yet, supplies should remain low, while an economic recovery should shift the demand curve north resulting in an environment where prices will respond.

Over the next 12 months, Nelson expects nearby cattle to build a bottom in the $82 area and eventually move towards the $94 area during the seasonal peak in April 2010 (see “Cattle on call”). Likewise, he sees a low in the hog market around $45 in December and a move towards $76 in 2010 via August futures. Nelson said the livestock markets could go “much higher” if demand returns.

Investors might consider selling puts to build a foundation of ownership without incurring excessive risk. These positions will make money as long as the markets do not plunge below the strike of the put sold.

The major difference between the livestock sector and any other sector that has gone through financially forced supply reductions is that livestock have a life cycle that requires time to rebuild.       

Bill Biedermann is senior vice president of Allendale Inc. He can be reached at
bbiedermann@allendale-inc.com.