HardAssetsInvestor

Written by HardAssetsInvestor.com  |

May 09, 2007

Quick Marge! Short Obesity!

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Here’s the newest buzzword for you: agflation. It’s the idea that rising prices for food commodities will be inflationary to the economy.

• Is it true?
• Will the ethanol boom push up the price of chicken?
• How “trivial” is a 50% increase in prices?

With over 3500 uses for corn, corn is everywhere, including places you'd never thing of. Oh, of course it's in the food we eat: from our chips to our soda to our package of pre-cut lettuce. It's in the crayons the kids draw on the walls with, the gypsum boards that make up those walls, and the wallpaper we cover them with. (More uses? How about a corn based earth friendly deicer for our roads?)

Given that modern day life is just bursting with corn, how will the ethanol boom affect the rest of our lives? Is the demand for ethanol going to increase our cost of living? Or will the supply keep up and keep things on an even keel?

According To The Experts ...

The most obvious inflationary aspect of any ethanol boom would be a rising price for food. But if you listen to the National Association of Corn Growers (NACG), the ethanol boom isn't going to impact the price of food in any substantial way. In a NACG-funded study, investigators considered three scenarios:
• Corn prices fall from the $4.00/bushel levels of today back down towards the more traditional $2.75 - $3.00 per bushel range.
• Corn prices drop and then hold at $3.00 to $3.50 per bushel; and,
• Corn prices remain high in the $3.50 - $4.00 range.

In the first scenario, the NACG states that would be little or no impact on consumer food prices. The second scenario might result in slight increases for certain food items, but that “would likely be unnoticeable to the consumer.” Only when the price per bushel stays in the $3.50 - $4.00 do they find that “consumers could experience a minor increase in retail prices for some grocery items,” though they propose that it would be “trivial.”

Can that possibly be right? Won’t the price of corn flow straight through to the end-users … that is, all of us munching on Coco-Pops in our morning breakfast?

Well, it’s not so certain. Cash corn prices are up nearly double since January 2006, but according to the Bureau of Labor Statistics (BLS), the prices for most meat, dairy and other common products haven't budged. Maybe we can have our ethanol and eat it too…

According To The Other Experts ...

Maybe, you’re thinking, that the NACG isn’t exactly the most impartial judge. Maybe the good old US Department of Agriculture would have a different idea.

Well, they do: in the self-same study, the NACG cites a USDA quote saying, “Consumer prices for red meats, poultry and eggs [will] exceed the general inflation rate in 2008-10 as the livestock sector adjusts to higher feed costs due to the expansion in corn-based ethanol production. As a result, overall retail food prices [may] rise faster than the general inflation rate in those years.”

So, which is it? No impact? A “trivial” impact? Or a doubling of our grocery bills?

Here is a look at the USDA’s numbers. Looking ahead to 2009, if we peg corn at $3.50 (the middle scenario for the NACG), the USDA predicts a 40 cent difference in pork shop price (roughly a 10% increase), a 52 cent difference in the price of a gallon of milk (15% increase) and 24 cent increase (20%) in the price of eggs.

Trivial? A recent report from the UDSA stated that there has been almost a 48 percent rise in the price of wholesale eggs due to higher cost of corn and soybean meal.

Where's The Beef?

The biggest food-based impact of corn, paradoxically, will be felt in the meat business … since meat is really just a pricey way to convert corn into protein.

So, if you're a meat ranger, how do (or can) you respond when the feed gets a wee bit pricey? The first order of business is to stop feeding the cows grain. Pasture and range grazing isn't only cheaper, it can also be a marketing advantage. As long as Mother Nature cooperates, there is a little room to change the animals’ diets: just keep them in pasture longer and spend less time “finishing them off” in the feed lots.

And if feed prices get really high? Meat producers can respond by sending lower weight animals to slaughter and/or decreasing their herds or flocks, thereby tightening the supply and sending up the price of meat.

In sum, there is some wiggle room before the price of lean hogs and cattle gets too crazy, but it's a classic tipping point problem: once feed prices cross an unknown threshold level (one that will be different for each rancher), they'll simply scale back their production to a level they can support.

When that happens, it could get ugly.

Grains' Response
There are two relief valves to the short-term pressure on corn supply: wiggle room in the demand side, and wiggle room on the supply side.

With limited farmland, the supply slack isn’t huge. We all saw the massive jump in corn plantings this year, but it’s not so easy. Much of the reported increase came from marginal farmland – you know, that odd piece of land on the fringes; the land the farmers don't bother to plant when prices are lower because it has lower crop yields and/or it is more labor intensive. The rest comes from other crops. Farmers can seasonally play a “robbing Peter to pay Paul” game, hoping they get ahead of their neighbors and harvest while prices stay high, or harvest enough to make good on their futures contracts. More corn means less of something else: in this case soybeans (11 percent lower), cotton (down 20 percent) and wheat (7 percent decline).

Where Do We Go From Here?

What does it all mean? Perhaps something as simple as lower supplies and somewhat higher prices.

Nowhere in the market is Economics 101 more cleanly demonstrated than in the current battle for corn. Corn has made a shift: it's not only a food crop; it is now an energy crop. This change in dynamic introduces new aspects of volatility unfamiliar to grain producers. And as wheat and soybeans are also available as ethanol ingredients, the way we, as market players look at grain as a classification, not just a product, is changing, and the market will be changing accordingly.

This new volatility creates opportunity. The changes occurring in soft commodities right now --- a change from food to energy --- is no Tulip bubble; there has been a fundamental shift and an opening of a major new market. Assuming that oil prices remain high,

Investors who maintain a focus on the big picture stand to do very well. Put in the simplest of terms, demand has shifted, and is shifting, from petroleum to grain.

So here's all you have to figure out:

• Is the price of oil likely to drop because of the increase in ethanol? (Our guess? Not so much.)
• Is the price of grain, writ large, likely to set at a higher equilibrium point for a given level of supply? Almost by definition.
• Will supply adequately (or excessively) compensate for the new demand?

That last one is the sticky wicket. There’s just no way to gauge where the supply/demand will balance out; that’s the one you have to decide.