By Adam Fleck, CFA and Jeffrey Stafford, CFA
Over the past three years, we've seen corn prices nearly double, soybeans climb more than 66%, and wheat jump 50%, as challenging farming conditions in major growing areas like the United States, South America, and Russia have kept farmers from satiating growing consumption. Over the near to medium term, we believe normalizing weather and slowing demand (principally because of lower growth in U.S. corn-based ethanol production) will drive crop prices lower. But looking beyond the next three to five years raises provocative and important questions surrounding farmers' ability to produce at the levels necessary to meet global demand.
We've highlighted five key areas of concern: water availability, soil quality, the abundance of fertilizers, development of seed technology, and potential equipment advancements. We think the world's growing population and increasing demand for high-quality proteins will lead to demand gains and is worth examining as another potential driver of elevated food prices over the long run. We believe the trends suggest the continuing rise of key inputs into the agricultural complex, and firms with economic moats should benefit in particular.
Plenty of Reserves for Potash and Phosphate Fertilizers
Are we in danger of running out of potash and phosphate fertilizers anytime soon? The short answer is no. Reserves are ample and production capacity is set to expand for both fertilizers as demand grows. While we have many decades' worth of potash and phosphate in the ground, production capacity expansions need to keep pace with demand growth to prevent fertilizer prices from skyrocketing. Could fertilizer become so expensive that farmers in developing regions aren't able to buy essential crop nutrients, thus damaging global yields, tightening food supply, and driving up food prices to a point that limits GDP growth? In the medium term, we don't think so.
Brownfield projects already under way should match, if not exceed, demand growth for potash over the next decade or so, limiting price growth. We forecast that brownfield potash capacity will grow at about a 5% compound annual rate through 2017, compared with our approximately 3% per year growth forecast for potash demand over the same period. Thus, even without a boost from new greenfield expansion projects, we think supply will grow faster than demand. Over the longer term, potash prices may have to rise to provide incentive for more capital-intensive greenfield projects, but we believe a few greenfield projects are economically viable at or near current potash price levels.
We think the phosphate markets will loosen with the ramp-up of a new production operation in Saudi Arabia and expansions in Morocco, but capacity expansion growth will probably be slower in phosphate than potash; however, we also think demand growth will be slightly slower for phosphate compared with potash, given current global application rates. We expect the bulk of phosphate expansion will come from the Middle East. Producers with North American assets are increasingly looking abroad to secure phosphate rock sources.
In the long term, Morocco, which controls an outsize amount of worldwide phosphate rock reserves, is the wild card. If Morocco were unable to increase production to meet the needs of a growing global population, the phosphate market could get very tight in the long run and lead to runaway prices. On the other hand, if Morocco ramps up its production share to meet its reserve potential, it could have a huge influence on setting prices for phosphate rock and could price some poorer farmers out of the market.
Morocco is still years away from matching its phosphate rock production capabilities to its reserve prowess. In addition to new supply providing relief to a tight phosphate market, we think price declines in the supplementary inputs--mostly ammonia--needed to make phosphate fertilizers out of phosphate rock will put some downward pressure on phosphate prices over the next couple of years. In our view, the key to success in the phosphate industry is access to low-cost phosphate rock, as high-cost nonintegrated producers typically serve to set a price floor for phosphate fertilizers. Companies we cover with access to vertically integrated rock include Mosaic (MOS), PotashCorp (POT), and CF Industries (CF).
According the U.S. Geological Survey, the world has 372 years of phosphate rock and 255 years of potash reserves available at current production levels. However, annual mine production should expand in coming years to feed a growing and richer population. If we assume 3% annual growth in production, reserve life contracts to about 80 years for phosphate and roughly 70 years for potash. We think that 3% annual growth in fertilizer consumption for the next 70-plus years, coupled with no upward revisions to proven reserves, is very unlikely. Thus, we see the 75-year reserve life range for phosphate and potash as an extreme worst-case scenario, with reserves likely to last for more than 100 years.
While we're not close to running out of minable potash and phosphate, it's important to note the geographic distribution of reserves for the two fertilizers. For phosphate, 70% of reserves are in Morocco and the Western Sahara, with another 8% of worldwide reserves in Iraq. With such a large share of reserves, Morocco is in a position to wield serious clout in the world phosphate markets. It already accounted for 14% of mine production in 2011, compared with 38% from China and 15% from the U.S. Morocco has 1,850 years of reserve life at current production levels, compared with about 50 years for both China and the U.S.
While Morocco's King Mohammed VI was largely able to avoid the tumult of the Arab Spring, we think geopolitical uncertainty is something to watch as it relates to phosphate. Social conditions have improved under Mohammed, but Morocco's citizenry is struggling with the same type of economic issues that ignited uprisings in Tunisia and Egypt. Further, the Western Sahara, which holds a portion of Morocco's best phosphate reserves, has been a disputed territory since 1975, when Spanish colonization ended and Moroccans began scuffling with the native Sahrawi. The region is currently under Moroccan control, with the king's government using a military presence to ensure phosphate operations are not disrupted by separatists.
Potash reserves are also extremely concentrated, with 46% in Canada and 35% in Russia. Potash production is spread out a little more evenly; Canada accounted for about 30% of production in 2011, with Russia second at 20% and Belarus third at 15%. We think the highly concentrated assets are a positive for long-term investors in potash and phosphate companies. With the majority of potash production owned by a handful of players, companies tend to operate in an oligopolistic fashion, making rational decisions to benefit the entire industry.
Further, as Morocco's piece of the phosphate rock market grows, the country is likely to do what it can to keep prices of phosphate favorable, similar to the current situation in potash. It's not hard to envision political unrest in Morocco driving up global phosphate fertilizer prices at some point down the road. Also, we think Morocco has the potential to build a quasi-monopoly in phosphate even more potent than the current oligopoly in the potash industry, giving the country significant pricing power.
While this could be a very bad situation for poor countries buying food and fertilizer, the phosphate assets of PotashCorp, Mosaic, and CF Industries would be worth more. However, because of Morocco's uncertain position, we have more confidence in long-term oligopoly support for potash prices compared with phosphate.
In our opinion, Potash Corporation of Saskatchewan is the most attractive idea for investors looking to play the super long-term trends in potash and phosphate fertilizers created by the need to feed more people. The company has access to potash assets at the low end of the cost curve--the main reason we award it a wide economic moat. The wide moat is further supported by the company's continual investments in higher production capacity and its low-cost position.
PotashCorp has a blueprint to increase its capacity by 7.5 million metric tons by 2013, outpacing its peers. The company has a record of bringing in projects on schedule and on budget, and we believe it is capable of undertaking these brownfield expansions successfully. However, investors should not buy fertilizer stocks expecting that potash and phosphate prices will march upward unabated. Near- and medium-term supply and demand dynamics could make for a bumpy ride.
Shale Gas Has Improved Cost Position of North American Nitrogen Fertilizer Producers
Nitrogen fertilizers, such as ammonia and urea, are produced from natural gas and air. Thus, the availability and price of natural gas will determine the ultra-long-term prospects for the world's ability to produce enough nitrogen fertilizers. According to BP, world proven natural gas reserves are sufficient to meet only 64 years of production at current levels.
However, reserve figures can be volatile and new technology or higher gas prices can quickly make additional natural gas deposits economically recoverable. So, we take the 64-year estimate with a large grain of salt, especially since the number does not include unproved reserves. According to the Energy Information Administration, at the rate of current consumption the U.S. has enough gas to last about 92 years when unproved resources are added to proved reserves. Still, these estimates don't account for future production increases based on demand growth.
With many decades of reserves, we're not in danger of running out of the natural gas needed for nitrogen fertilizer production soon, but, along with phosphate and potash, this is another super-long-term problem for humanity. In our opinion, the long-term winners in nitrogen fertilizer production will have access to the cheapest natural gas. Given the fluctuations in gas prices by region over the years, it's hard to peg one specific source as the low-cost area. However, recent development of shale deposits in North America has markedly improved the near- to medium-term prospects of domestic nitrogen producers such as CF Industries. Still, over the long run, we think natural gas prices will rise in North America.
We Have Enough Water, but Accessibility Is a Critical Concern
Water is essential for survival, especially in agriculture. We've seen the devastation that can occur during periods of extreme drought, although most U.S. citizens are relatively well off in terms of water availability even during dry periods. There is still enough grain to feed our population, our livestock, and our ethanol plants, even though prices at the grocery store tick up a bit.
In emerging markets, however, a shortage of corn, soybeans, wheat, or rice can lead to massive food inflation and resulting geopolitical struggles. Our medium-term projections assume that the most important growing parts of the world--primarily the U.S., Europe, Russia, China, and South America--will retain adequate access to water for both artificial irrigation and natural hydration of key crops. Beyond the next five years, however, it's important to ask: What if we run out of water?
We withdraw upward of 4,000 cubic kilometers of freshwater annually, whereas the total yearly volume of renewable freshwater runoff from rivers is closer to 42,000 cubic kilometers; there is another roughly 11 million cubic kilometers of freshwater in nonrenewable ground and surface water and another 24 million frozen in glaciers. In addition, many of the ways we use water are renewable, with an ability to recycle water back into the system. Still, a 1996 study led by Sandra Postel estimates that we already appropriate nearly 50% of all renewable and accessible freshwater flows every year. Because of this, we think it's important to examine potential ways to reduce the growth of water withdrawals.
Agriculture is globally the largest user of freshwater (roughly 65%-70% annually). A U.N. study noted that this end market is one of the least efficient, as only 40% of water withdrawn for irrigation actually reaches crops (with the rest lost to evaporation, consumption by other plants in the area, or ground seepage), although much of the water "lost" in this calculation finds its way back to underground aquifers or is later used in urban or industrial activities. Proper maintenance of irrigation systems could probably improve this metric, but this ratio is unlikely to change materially due to the physics of flood-based irrigation.
However, we have seen gains through technological improvement. In the U.S., for example, a move toward sprinkler systems rather than flooding techniques over the past several decades reduced the application rate of irrigated water to 2.35 acre-feet per acre in 2005 from 3.55 acre-feet per acre in 1950, per the USGS. We believe additional gains are possible, though not without additional costs. For instance, a continued move toward sprinklers, drip systems, and other micro-irrigation techniques could lead to faster depletion of underground aquifers and increased energy needs. A study by APCO Worldwide estimates that such an irrigation system can cost a farmer as much as 60% of his or her annual income, with payback periods longer than three years.
Other changes in technique could also alleviate water challenges, including increased storage to offset difficult seasonal patterns, improved irrigation equipment maintenance, and desalination. Of these technologies, we think desalination could offer the best solution for very long-term water concerns, although it is still too expensive to provide a near-term solution.
Only about 1% of total freshwater consumed globally is produced by desalination, and although the cost per cubic meter has come down by half over the past 20 years (to roughly $1), it is still about 10 times the cost of traditional water. Moreover, as much as half of this cost stems from the electricity generation necessary to process saltwater, which in some cases (particularly Australia, which relies heavily on coal power) could contribute further to issues such as global warming and pollution. Nonetheless, the U.N. estimates that nearly two thirds of the world's population could face water shortages by 2025, which should motivate firms to invest heavily in this area.
Pollution is another major concern in the global water system. One of the more controversial sources of this issue stems from hydraulic fracturing, or fracking, for natural gas in the Marcellus Shale. A recent study by Stony Brook University suggests that the risk of contaminated wastewater from the technique in this location is "several orders of magnitude larger" than other water pollution pathways. While the report's authors outline nitrogen-based or liquefied petroleum gas fracturing methods as potential alternatives, these would be higher-cost options.
We think the marginal cost of water is likely to rise at an accelerating pace. We have enough water; it's just going to cost more to access it. This is probably going to lead to continued investment in solutions such as water storage, desalination, and better irrigation systems, with growth likely outpacing global GDP. In particular, we think companies like wide-moat General Electric (GE), narrow-moat Siemens (SI) and Deere (DE), and Lindsay could enjoy outsize demand gains as a result.
Two other factors are worth mention. The first is a downside risk: weather. Many would agree that we're facing a warming climate, and whether this is manmade or not doesn't change its potential to have devastating effects on the world's water sources. While it may not substantially affect the total sum of water available for human consumption, climate change could alter individual regions' accessibility and seasonal flows, leading to new issues such as flooding, droughts, and increased costs.
The second is more positive: Earlier this year, scientists discovered a large underground source of freshwater 300 meters below Namibia and believe additional such sources may exist. While there is still a great deal of effort that must take place to access this water, not to mention the potential geopolitical issues that could arise should some of the water cross countries' borders, we think continued discoveries and improved technology will prevent long-term global shortages.
China Already Enjoys a Better Diet, but Other Emerging Nations Could Improve
One of the key tenets of many long-term demand forecasts is that a rising middle class globally will consume a greater amount of meat, which consumes an increasing quantity of feedstock (mostly grains such as corn or soybeans), leading to rising demand ahead of population increases. While we agree that we'll see rising food demand, stemming primarily from increasing populations, we believe upside for China's per capita caloric intake is probably limited. The country's protein intake is already in line with Japan's and Korea's on a per-person basis, and its per capita calories consumed already surpasses Japan. The country also consumes a similar amount of meat as a percentage of total consumed proteins compared with Japan and Korea, primarily because of a sizable amount of pork consumption.
We think China's daily protein consumption from meat could increase, given continued middle-class development and a demand for higher food quality, but we doubt it will ever reach the level seen in the U.S., given cultural differences. Although this higher meat consumption will have a positive effect on crop demand because of the multiplier effect of calorie consumption via pork, beef, and chicken versus rice or corn alone, we expect demand growth at a low-single-digit rate (slightly ahead of population growth) compared with the 4% corn and 10% soybean compound annual growth rates over the past 10 years.
The story for Brazil is similar. The country has increased its per capita calorie count 13% since 1990 (compared with 16% for China) and its protein intake 24% (versus China's 33%). Brazil now consumes more calories per person daily than Sweden, South Korea, South Africa, the Netherlands, and any other neighboring South American country.
Over the next few decades, however, we see several opportunities for outsize growth in frontier markets such as Africa, the rest of Southeast Asia, and the Middle East. Many large countries in these regions--such as Nigeria, Indonesia, and Pakistan--remain below the median calorie and protein intake, and wealth creation and increasing demand for higher-quality food in these regions could help to mitigate the effects of slowing Chinese and Brazilian demand.
We also think continued economic development in India could offer upside to demand, although the country's per capita calorie intake growth has substantially trailed both China and Brazil (up just 3% since 1990, trailing even the U.S.' 7% gain). But as the country's economy continues to grow, the extremely low rate of meat consumption (even considering cultural differences) versus other developing nations should allow protein consumption to climb at a rapid clip.
One area that garners a great deal of debate is China's imports of farmed commodities. The country's soybean imports have climbed to nearly 60 million tonnes from just 4 million in 1998; this figure has increased to almost a fourth of global production (up from about 2% in 1998) and nearly two thirds of worldwide exports (up from around 9%). China is not a major corn importer at just 5.5 million tonnes last year, or 0.6% of global production, but this amount has increased from minimal imports just a few years ago. We don't think China's corn imports are about to take off, however. First, we think the country's corn yield has room to increase, whereas soybean yields have stagnated. Second, Chinese farmers have continued to add corn acreage over the past decade (up 45% since 2000), compared with reduced soybean harvested area (down about 18%), suggesting a continued commitment to increasing corn production at the expense of soybean growing.
Although we foresee slowing demand growth from an expanding middle class, we nonetheless expect positive movements that will benefit all major players across the global agricultural complex. Still, we view those companies with economic moats--such as Deere, Monsanto (MON), and PotashCorp (POT)--as the strongest of the potential winners.
Leaders Have the Best Chance at Developing Breakthrough Seed Technologies
With the global population climbing and arable land basically set and even declining, farmers will have to grow more food on less land. Crop yields have risen relatively steadily over the past several decades, but it's not clear if productivity gains will be able to keep up with population growth, not to mention potential gains in food consumption per capita.
Advances in biotechnology have been trumpeted by Monsanto (MON) and other seed producers as an avenue to increase agricultural productivity beyond its current limits. In our opinion, Monsanto has demonstrated the best ability to produce seeds that outyield competitors. This is one of the reasons we give the company a wide economic moat rating; with Monsanto's portfolio of patented traits forming the basis. In addition to its proprietary seed companies using the traits developed by Monsanto, the firm also licenses traits for use by others.
This strategy has led to dominant market share, with Monsanto enjoying premium pricing for its patented traits. Monsanto uses the cash flows generated from its current product lineup to invest in research and development for next-generation offerings. It consistently pours 10% of sales into research and development each year. Further, the company owns an industry-leading germplasm and global breeding operation that is difficult to replicate. In our opinion, DuPont (DD) is running in second place in the global seed technology race, but it is a formidable rival to Monsanto, illustrated by our narrow moat rating.
One possible game-changing development is worth mentioning. Until now, the yield gains provided by biotechnology have mainly been attributable to limiting outside pressures. For example, biotech seeds can currently stop rootworms from damaging crops and harming yield, but they struggle to actually make a corn plant produce bigger kernels. Scientists are now taking the next step to actual yield improvement instead of just yield protection.
The most notable example is the effort to improve the photosynthesis efficiency of plants such as wheat and rice to the level of more-efficient plants like corn and sugar cane. Some have suggested this could increase the productivity of wheat and rice by more than 50%. We're not about to put odds on this outcome, but the sheer magnitude of the potential yield gain for crops as important as wheat and rice makes it worth noting.
Increased Mechanization a Key Global Trend
Although the use of farm equipment in developing-market growing areas still sharply trails the U.S. and Europe, we expect continued mechanization increases that should help to boost yields and alleviate supply issues. These investments can be costly, but they present a substantially long-term positive market for farm equipment manufacturers such as Deere, AGCO (AGCO), and CNH Global (CNH). These companies dominate the global market and compete based on customer satisfaction, relationships, and technological innovation. Over the past decade, innovations in GPS, precision agricultural techniques, telematics, and technologies have helped to increase yield for key crops such as corn, soybeans, wheat, and rice in both developing and emerging economies.
Equipment adoption has helped to push up yields in key crops in China, but there is still room for improvement. The country's mechanization level is about 52% today, up from about 42% in 2007. The government's five-year plan targets 60%, primarily through increased machinery usage in rice paddy farming, supported by subsidies and plans for continued land consolidation. Similarly, Russia and the former Soviet Union farm about as much land as the U.S., but with far lower mechanization levels because of a lack of available financing.
In addition, Russia implemented a tariff on imported farm equipment in 2008, leading to sharp declines in tractor volume. However, sales in the region have exploded over the past few years as major U.S. manufacturers have set up joint ventures, local manufacturing facilities, and financing options. Russia is also set to reduce import tariffs through 2016, which could further open this critical market.
The Indian market is similarly undermechanized as a result of smaller farm sizes and lower-powered machines, but is also the largest tractor sales region globally (by volume) and has enjoyed solid growth periods in the past. In Brazil, where government financing programs require local manufacturing, AGCO, Deere, and CNH again dominate the tractor and combine harvester market and have seen total volume of these two product lines jump threefold since 2005.
The farming industry has also rapidly improved its technological offerings. In developed markets, GPS packages, autosteer, and other precision agricultural techniques help planting, fertilizer application, and harvesting, and these packages have made their way to areas like India and China (albeit to a lesser degree). We expect continued adoption in emerging regions, which should help to alleviate pressures on fertilizer, water usage, and other inputs because of more-precise application practices.
Of course, these investments will probably also increase the long-term cost of farming. Machinery operating and ownership costs can run more than half of total crop production costs, according to Kansas State University, and although these machines typically pay back over time, there is a large up-front capital cost. Structural impediments also could prevent full-scale global mechanization at levels similar to North America, such as the smaller average farms in India and mountainous farming regions in China.
More-stringent engine emission standards will probably add to farmers' expenses. In the U.S. and Europe, a steady move downward in allowed particulate matter and nitrogen oxide has led to increased costs for machinery original-equipment manufacturers and resulting price increases on farmers. As these standards are instituted in emerging economies like Brazil and China, we expect continued above-normal price hikes. Nonetheless, these practices could help to alleviate potential weather challenges.
Although we believe the short- and medium-term periods for farm equipment manufacturers will prove sharply cyclical based on prevailing commodity prices, we think the long-run trajectory is solidly positive. Beyond the equipment OEMs, we expect firms such as narrow-moat engine manufacturer Cummins (CMI) and GPS provider Trimble to enjoy solid end markets.
Farming Techniques Need to Be Modified to Slow Soil Loss
Soil erosion may not get much press, but it's a legitimate long-term problem for humanity. Each year, soil is eroding at a much higher rate than it can be replenished by natural processes--the weathering of rocks and decay of organic matter. A 2006 Cornell University study estimates that soil is eroding 10-40 times faster than it can be formed, with the U.S. on the low end of the estimate and China and India on the high end. The Cornell study also points to other research stating that Iowa has lost 50% of its fertile topsoil to erosion in the past 150 years because of farming.
Potential solutions include planting cover crops between regular commercial plantings and moving to no-till practices, as plowing crop land loosens soils and speeds erosion from rain and wind. Farmers till soil for a number of reasons, including loosening the top layer to facilitate planting, killing weeds, and mixing organic matter evenly through the soil. About 30%-40% of U.S. crop land is farmed using no-till operations, according to the U.S. Department of Agriculture.
No-till operations and a reduction in the amount of tilling per year allow the soil to retain more organic matter, which could also reduce the need for additional potash, phosphate, and nitrogen fertilizers added to the soil. For example, cover crops like clover and alfalfa can trap nitrogen and store it in the soil, reducing the need for commercial nitrogen fertilizer. For corn, cotton, soybeans, and rice, the USDA estimates that the portion of cropland using no-till practices increased at a median rate of roughly 1.5 percentage points per year from 2000 to 2007. With no-till agriculture a growing trend (at least in the U.S.), we see this as a long-term headwind for fertilizer producers.
However, soil erosion is a very slow, deliberate process, and the negative effects are not yet apparent enough to facilitate a rapid shift to no-till agriculture worldwide. Thus, we're not expecting a big shift in fertilizer application rates caused by a massive transition to no-till practices over the medium term.
No-till farming presents both a positive and negative for farm equipment manufacturers. The downside is probably obvious: A lack of tillage leads to reduced sales of implements used in the practice. As a result, most no-till farmers are also able to use lower-powered machines, given the high-horsepower required to tow plowing equipment. However, there are upsides that should offset this issue. Because of the large amount of crop residue left in the field following harvest, farmers avoiding tillage need upgraded seed drills (which are typically more expensive) and tractor tires (to avoid compacting the soil and to replace because of damage from the residue).
Demand a Margin of Safety Before Investing
Over the short and medium term, we expect continued cyclicality among the companies we've discussed. Looking out past the next decade, however, we envision secular tailwinds based on the aforementioned factors. We caution that many of these issues will probably manifest themselves in fits and starts, and in some cases may not be as strong as perceived in popular opinion.
As a result, we continue to recommend investing only with a sizable margin of safety. Still, because of the likely upward long-run trend in this end market--we will continue to need increasing amounts of food as the global population grows--we believe companies with economic moats and strong balance sheets present particular opportunities during downturns in the industry.