VERSACE: Drought has commodity prices sizzling

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ANALYSIS/OPINION:

Is it hot out there?

More like, it’s been hot out there over the past several weeks, particularly in the Midwest. The result is shaping up to look like the worst drought in the U.S. in nearly 50 years, and that means lower-than-expected yields in corn, soybeans and several other commodity crops.

According to the U.S. Department of Agriculture (USDA), close to 88 percent of the corn crop and 77 percent of the soybean crop has been affected by the drought. Lower-yielding crops means there is less to go around, and that means prices for corn, soybeans and other commodities have been on a tear.

Corn is now selling for around $8 a bushel, up significantly from just a month ago, and soybeans are at a near-record price of $17 per bushel, compared with $13 just eight weeks ago. This rise prompted the USDA to revise up its food-price forecast with poultry and beef prices being hit the hardest.

The USDA’s revised figures show the consumer price indexes for chicken and turkey would rise 3.5 percent to 4.5 percent later this year, with beef prices expected to climb 4 percent to 5 percent over the coming year.

The National Oceanic and Atmospheric Administration’s outlook for August through October, which predicts continuing dry conditions in the Midwest even as more than two-thirds of the U.S. are now enduring drought conditions. Not good for corn and soybean crops.

The potential corn-supply problem is compounded by two things. First, the USDA reported that corn stockpiles as of June 1 fell 48 percent from March 1 to 3.15 billion bushels, the lowest level since 2004. Second, the demand for corn continues to grow owing to a combination of exports, livestock feed and ethanol production, according to the National Corn Growers Association.

While those are three key drivers of corn, the reality is that corn is a key ingredient in cereal, peanut butter, snack foods and soft drinks and is utilized in more than 4,200 different uses. That means higher input costs for those products that count corn as a key ingredient. An example of this occurred this week when PepsiCo Inc. reported its second-quarter earnings results that showed its margins and profits are being squeezed by higher costs for corn and other ingredients used to manufacture, package and ship the company’s products.

PepsiCo and other companies facing these rising input costs have sought to pass along these increases to consumers by raising prices. Last October, PepsiCo announced it would raise prices on some Gatorade sports drinks and Frito-Lay snacks to help offset higher commodity costs. That was in addition to price increases PepsiCo put in place during the third quarter of last year. Sounds like we can expect more of the same in the coming months from food and beverage companies.

With consumers facing higher food prices in the coming months — yes, that means that inflation is alive and well, Federal Reserve Chairman Ben S. Bernanke, thank you very much — how can they use the stock market to help ease the pain?

First and foremost, let’s be sure to avoid any additional pain and that means letting go of the shares in those companies that are going to get hit hard by rising corn and soybean prices.

Pork, beef and poultry industries come to mind, and the key question will be whether companies such as Pilgrim’s Pride Corp., Smithfield Foods Inc., Hormel Foods Corp. and Archer Daniels Midland Co. can offset rising costs with price increases. If they can’t, or can only do so to a limited degree, that is likely to spell trouble for margins and earnings in the back half of 2012 and into 2013.

As for the who benefits from this drought-induced pain, there are a few categories to look at.

First are the fertilizer stocks, such as Potash Corp., Mosaic Co., Agrium Inc, and CF Industries, to name a few. Another sector is agricultural-equipment companies, such as Deere & Co., AGCO Corp. and CNH Global, because farmers buy and/or replace equipment when flush with cash. While the harvested acreage may fall, it looks as it the corn-price increase will more than offset that drop, particularly given low corn stockpiles.

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About the Author
Chris Versace

Chris Versace

Chris Versace, the “Thematic Investor,” is the director of research at Think 20/20, an independent equity research and corporate access firm located in the Washington, D.C. area. Before Think 20/20, Mr. Versace was the portfolio manager of Agile Capital Management (ACM), a thematically driven alternative investment fund. The groundwork for ACM was laid during Mr. Versace’s tenure as senior vice president of equity ...

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