The Ag Industry: Another Credit Crisis Casualty?

Includes: ADM, BG, DBA, DE, EWZ, MON, POT
by: Jimmy Lathrop

I came across this article in the Wall Street Journal last week which revealed another casualty of the credit crisis. The core finding of this article is reprinted below, in its entirety:

In the past several years, amid surging global demand for grain, farmers plowed up land at a feverish pace to plant soybeans, and roads were carved into the countryside to move the goods. Climbing grain prices through the first half of 2008 accelerated the growth.

Now, growers are finding it harder to get loans sufficient to cover the rising costs of fertilizer, pesticides and seed. For those borrowings, growers rely heavily on a handful of multinational grain companies, including Archer-Daniels-Midland Co., Bunge Ltd. and Cargill Inc.

Unlike in the U.S., where farmers depend on loans from private banks and the government, Brazilian farmers get as much as 40% of their financing from agriculture companies. That could drop to as low as 25% this year, according to M.V. Pratini de Moraes, a former Brazil agriculture secretary.

As the volatile commodities market and the global financial crisis have increased the risk and expense of doing business in Brazil, big grain companies are reining in lending.

"Every company is trying to secure as much cash as it can [to withstand] the longer-term effects of the credit crisis," says Stefano Rettore, general manager at CHS Brazil, a major grain-trading company. "That's leaving less cash available to finance Brazilian agriculture."

The squeeze is expected to contribute to a 2% drop in Brazilian soybean production for the 2008-2009 crop year, according to the U.S. Agriculture Department. Steve Cachia, a commodities analyst at Brazilian consultancy Cerealpar, says next year's crop could be smaller than this year's if credit continues to tighten.

That explains a lot of the problems with EWZ, we think to ourselves after reading this article. What does that tell us about the hurdles facing the physical commodities market in 2009?

Let's think about the state of the Western farming industry as shaped by Deere (NYSE:DE), Monsanto (NYSE:MON), Potash Corp. (NYSE:POT), Archer Daniels Midland (NYSE:ADM), Bunge (NYSE:BG) and, to a lesser extent, Dow Chemicals (NYSE:DOW). If you are holding a bushel of soybeans in your warehouse, it probably came from a big farm which depends on highly specialized farm equipment for tillage, seeding, cultivation, fertilization and livestock control. The seeds were genetically bred to resist the weeds and insects which were raiding the local crops at the moment. The crop was given insecticide, fungicide, micronutrients and tested for PH levels to maximize yield.

This is all without mentioning your normal risks associated with a harvest which is achieving high yields in a flood or drought environment with temperature fluctuations. We're talking thin or non-existent margins when things are operating normally.

This past summer, worldwide investors had the pleasant experience of witnessing the prop desks of every trading institution with a five thousand dollar margin account driving up the price of every commodity, in anticipation of an emerging market growth spurt fueled in part by . . . easy credit.

And with that, the removal of the last two words of the previous statement, there has been a significant change of circumstances from last summer to today.

On the futures and equity market end of things, the prop trading desks of the investment banks, hedge funds and institutional investors have yanked their fingers off the hot stove of a volatile commodities markets. These are players who would never take physical delivery and got burned when the market reversed itself. Even the successful players were forced to get out of long winning positions in order to meet margin calls on other losing bets.

But on the actual producer end of the market - and to their suppliers - the reversal of prices has been horrible on business. If we can assume that farm subsidies will kick in, the Western farmer will not plant and will instead collect a check from their government. This means no more upgrading farm equipment, fertilizer, insecticide, et cetera, for at least this growing season. You can turn on any program on RFD TV and you can see that if you are an overleveraged farmer, the cost of producing wheat outweighs the current market prices. Which means, if you are a supplier of the farming industry through equipment, chemicals, seed technology or fertilizer, you are looking at a dismal Western market forecast. This is exacerbated by the market shakeout, but it is still fundamentally poor.

This is the core issue between Europe's farmers and advocates to fight to prevent genetically modified seeds into the EU. Many biologists and agricultural professionals agreed that Darwinian adaptation eventually overcomes the marginal benefits that GM and advanced pesticides have on crop development. If you utilize native seeds with native predators, you can use your own seed banks to create pest resistant crops, but once you get hooked on some good old Monsanto seed products, you will never be able to go back to the old ways because the fragile ecosystem will never recover from the alien invasion of a new seed or a flame-thrower insecticide like Round Up.

Now, with credit drying up, farmers who can't afford to stay ahead of Darwin's inexorable march are turning to their accountants to get the subsidy from their goverment. The farmers who fought against genetically modified products can be proud that they were on the right side of history, but low prices of wheat, corn, soybeans and rice affect every farmer regardless of their ideological bent.

Your average large farming enterprise dependent on seed resistant products can't draw water from their own well at this point of the year. By clearing acreage used for livestock to make way for the flash-in-the-pan cash crops of this summer, they are short natural fertilizer. By introducing credit into the cycle of farming, the freezing of credit has frozen the farms. The farms are made whole by injection of farming subsidies, which will carry farms into the next year. The don't need to have credit extended to them by banks or their suppliers, they can always collect a subsidy and let their fields lay fallow.

The survival of the farm suppliers to weather a domestic downturn will be to embrace the emerging markets instead of turning away from them, because the emerging market nations will not subsidize their farmers to the level where they will not grow. They will fill in the capacity left by domestic producers in this bear price market.

The last item to take from the article is to reflect on the matter of easy credit expanding agricultural markets. I mean, let's be frank here: not all credit is evil. If you were going to short an agricultural ETF in the short to medium term, you could easily say that market distortions are weighing on all classes of physical commodities in the near term. But that would be a little simplistic and obvious. A more sophisticated approach would argue that the physical commodities market is experiencing a contraction from overcapacity, but price levels will not rise as the decrease of supply of products driven by Western farmers will be offset by the natural loosening of credit to the emerging market producers keeping output steady.

Where's the optimism in that? Well, in pure economic theory, supply and demand should even out creating a true price, but we know that the usual market manipulation, trade protectionism, leveraged speculation and natural catastrophes can create many opportunities to take advantage of market imbalances in the medium term.

Disclosure: no positions

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