Prices are the only thing growing as crops feel the heat

WHILE the UK has spent most of 2012 soaked to the bone, wondering when summer was going to gift us some rays of sunshine, on the other side of the Atlantic – specifically the key growing region in the US Midwest corn belt – they have been experiencing quite the opposite. Wiltingly hot temperatures in excess of 37 degrees Celsius, combined with little rain, have severely reduced the potential yield of crops like corn and soybean. With inventories of soybean and corn historically low, a tight squeeze on the prices of these soft commodities is expected over the coming months. This year’s drought in the US is the worst since 1956 and, with South America and the Black Sea wheat and corn producing regions also suffering, soya and corn crops will likely continue to take a hit.

Wheat and soybean futures markets have undergone a dramatic change since the spring, when excellent planting conditions led many to expect a bumper harvest.

The US Department of Agriculture reinforced this view by estimating that farmers had planted the most acres of corn in the country since the late 1930s. Despite the poor weather, the US expected to bring in a large crop.

But the market has seen a sharp drop in expectations. The June World Agricultural Supply and Demand Estimates (WASDE) report predicted 166 bushels per acre in corn yields. The July figures reduced that to 146 bushels per acre.

And it’s not just the Midwest facing shortages. On Friday, the International Grains Council (IGC) lowered its forecasts for Russia’s 2012-13 wheat output by 8.2 per cent, to 45m metric tons. Production is now expected to fall 20 per cent. While this will still be higher than the 41.5m tons produced in 2010-11, when a fierce drought prompted a ban on exports, it is nonetheless worrying for wheat shorts. The IGC also slashed Russia’s wheat export forecast to 9m tons – 59 per cent lower than its actual 2011-12 exports of 22m tons. Supply worries are also compounded by fears that Russia may impose restrictions on exports again or ban them altogether, as was the case in past grain shortages.

“Seasonal factors have always been a big driver of food prices, particularly in recent years. Floods, droughts and other natural events have seen strong moves up, as well as down, in soft commodity prices,” says Michael Hewson, senior market analyst at CMC Markets. “Case in point, corn prices in the last three weeks have jumped 50 per cent to their highest levels in 10 years, as have soybean meal prices.”

Traders looking to profit from the come-down in wheat, corn and soya expectations should not just limit their focus to the soft commodities futures markets. Volatility in these markets has risen sharply over the last four years (see chart). Though profits are to be made, the high price volatility could catch you out.

Further upstream, rising soft commodity markets make companies involved in machinery, fertiliser and seed protection attractive to those with a long-term view. “In a strong soft commodity environment, the farmer has greater incentive to use the best seeds and maximize fertiliser application,” says James Govan, investment manager of the Baring Global Agriculture Fund. “In addition, we believe that, despite potentially lower crop yields, persistently high soft commodity prices should result in another favourable year for farmer profitability. This bodes well for farm machinery demand, which is highly correlated to farmer incomes.”

The structure of the fertiliser industry – particularly potash – plays into the hands of those who want to stock pick rather than take a position of an agricultural sector as a whole. With few producers in the market place, there is a strong price environment for those wanting to take a position on the likes of PotashCorp.

The upside in corn prices is also having a bearing on the FX market. Half of all of New Zealand’s exports are farming-related commodity products – either corn and soybean themselves or the machinery used in their harvest. As a result, the country stands to benefit from this boost in prices. This month’s New Zealand consumer price index-based inflation figures (CPI) printed below 4 per cent for the fourth month on the bounce – price rises are now at their lowest level since 1999. With this strength in soft commodity prices, the Kiwi dollar is likely to see support going forward.

As recent frenzied trading in the corn futures markets has shown, the soft commodities market can be a volatile place to trade – especially on a short time frame. If the US weather outlook continues to improve, expect corn futures to encounter resistance. But the long-term upwards trend is unlikely to be checked. Traders and investors in it for the long term should focus on soft commodity-dependent markets to harvest strong results.