Last week President Obama released his proposed budget for FY 2010 and beyond. Since then, there has been much scrambling to figure out what it all means for investors.
The President's stated objective is to get the economy on the road to recovery by emphasizing green technology, health care, education and infrastructure. To do that, President Obama has proposed many changes to the status quo. While there's no convenient chapter heading in the tens of thousands of words in the budget called "Commodities," there will be huge impact on the commodity space, at least in the long term.
In a market often driven more by perception than reality, understanding what everyone else thinks about tomorrow is often at least as important as understanding what's actually happening now.
Here is your primer.
Round 1: Agriculture
Farm subsidies get headlines. In Iowa, they play well. In urban America, they're anathema. And the budget tackles them straight on, with a number of proposals that will directly affect agricultural commodities:
- A phase out of direct payments to farmers with sales revenues over $500,000 a year. The phase-out would happen slowly over the next three years.
- A $250,000 commodity program payment limit (a cap on any kind of direct payments, no matter how big you are).
- A reduction of crop insurance subsidies.
- The elimination of cotton storage credits.
- A decrease in funding of 20% for the Market Access Programs (MAP) - the overseas agriculture marketing programs.
As you might expect, the various agricultural lobbying groups are up in arms about all of these, because these proposals, while complicated, all mean the same thing: less money for farmers (especially BIG farmers).
On the subject of direct payments, the National Wheat Growers Association points out that while only 5% of the farms counted by the USDA have sales over $500,000 they are responsible for 74% of all agricultural sales. They also argue that the direct payments help farmers qualify for the financing they need for operations - equipment, seed and fertilizer. Reuters put it this way:
"Farmers say the direct payments help them maintain credit with local banks as a form of dependable cash flow, and help farmers who lose crops to drought or disease. They are considered trade friendly, non-distorting to price or production, and so small in sum in comparison to other budget items that farmers and their advocates say there is little upside to eliminating them."
For the ag investor, of course, the real question is how this actually hits supply and demand, and thus prices, should all of this get finalized in the 2010 budget?
If direct payments are truly "non-distorting to price or production" then the elimination of the payments should have no impact on commodity prices. Of course, if the programs actually have zero impact on price or production, it bears the question: what they heck good are they doing anyway?
Regardless, if in the long run farmers are unable to get credit for the purchases they need, then inevitably some level of production will suffer, either through smaller harvests of starved crops or due to lower crop plantings. Of course, if that happens, commodity prices will rise and farmers will once again have incentive to plant larger crops.
It comes down to just how pointless you think the subsidies were in the first place. Totally pointless? No impact. Actually relevant? This makes prices go up, long-term.
Net-net: Possibly bad for farmers and consumers; good for commodity investors.
Cotton - A Special Case?
As a non-perishable commodity, cotton is a little different from other ags. Like oil, it can be stashed away for a rainy day. Right now, farmers have the ability to store it in a government-approved facility and borrow money against it. Until now, the government has been footing the bill for this storage by giving farmers "cotton storage credits" The budget proposes to eliminate these credits. If approved, it will suddenly be less profitable to stash a year's cotton crop. The implication is that more cotton could come to the market seasonally (with theoretically less supply off-harvest). This means volatility.
Right now, cotton doesn't trade with any real seasonality. Of course, if cotton prices are already low, farmers may bite the bullet and continue to store their product, borrowing money until it makes financial sense to sell the crop. While the cotton industry may not support this move, it may serve to make the cotton market more transparent, and ultimately, transparency is always good for investors.
Energy plays a large, headline-grabbing role in Obama's budget - from raising money through various tax and fee changes, to investment in renewables. Most importantly, Obama proposes to raise $31.5 billion in revenues from the energy sector over the next ten years. Here are some of the places that money will come from:
- Levy excise taxes on Gulf of Mexico oil and gas
- Repeal manufacturing tax credit for oil and gas manufacturers
- Disallow expensing of intangible drilling costs
- Disallow the deduction for tertiary injectants
- Discontinue the ultra-deepwater oil and gas research and development program
- Institute a fee on non-producing leases for government resources (use it or lose it)
Some of the proposed changes (be they repeals of existing tax deductions or the implementation of new taxes) may be unfamiliar to investors not focused on the nitty-gritty ins and outs of the oil and gas business. For instance, the budget proposes the repeal of the manufacturer's tax deduction for oil and gas companies - those tax deductions were created with the passage of the American Jobs Creation Act of 2004 and are available to all sorts of different industries. As you can imagine, the oil and gas manufacturers are not too pleased with the idea of losing this deduction (though the companies themselves aren't commenting on the budget publicly... yet). The National Petrochemical and Refiners Association President Charles T. Drevna put it this way,
"Repealing Section 199 manufacturing credits would only weaken, not strengthen, our nation's energy security by stifling both the will and ability to increase domestic oil and gas production."
(For those interested in reading the actual section 199 of the tax code, go wild.)
The NPRA goes on to argue that the tax deduction is for all U.S. manufacturers and that oil and gas companies would be singled out unfairly. They go on to claim that the tax deduction encourages needed investment in refining capacity and domestic refining.
"The Section 199 deduction promotes much-needed investment in domestic energy infrastructure, encouraging refining capacity expansions and domestic oil and gas production. With demand for gasoline continuing to grow each year, U.S. refining capacity is already significantly strained despite multi-billion dollar reinvestments by the industry to expand it. Under normal economic circumstances, most refineries operate at more than 90 percent capacity throughout the year (except during maintenance season), which is significantly higher than the normal industrial average of about 75-80 percent of capacity."
Let's follow the logic here: if the tax deduction is repealed, will oil and gas companies stop expanding their facilities? Possibly, at least until demand for gasoline reaches the point where the supply is so constrained that the price is high enough to trigger capital investment in expanding capacity. Will those costs be passed to consumers? Of course. Ultimately, the market bears all costs. That's what keeps demand in check. So while reasonable people can disagree on whether it's good or bad to remove these kinds of deductions, it's axiomatic that it will eventually lead to higher prices.
Oil For Nothing?
Apparently, some oil companies benefited from a loophole in the leases they signed back in the late 1990's for oil rights in the Gulf of Mexico -- the government left the royalty price triggers out of the contracts. So some companies are paying royalties, and some aren't. Those that aren't would be hit with a 13% excise tax. Those royalties are expected to be worth $5.28 billion over the 10 years covered by the budget. $2.27 billion of would be collected between 2011, when the new royalties would start, and 2014.
The application of this excise tax may have production implications because - like most of these revenue-generating ideas - it effectively raises production costs. How the companies handle it remains to be seen, but as we've seen in the past, if the price of oil rises enough companies will pump out as much as they can, no matter what the excise tax is.
Funding the Green Machine
"To finally spark the creation of a clean energy economy, we will make the investments in the next three years to double our Nation's renewable energy capacity."
- President Obama, A Era of New Responsibility, Renewing America's Promise, pg. 2
Ah, the green stuff. This is the area of the budget that is the most inspiring and headline-grabbing, while simultaneously being the most vague. More is said in sweeping statements rather than specific plans. For example, under the proposed budget, the Department of the Interior would have $50 million to promote renewable energy projects on Federal lands and waters. But unlike the excruciatingly detailed tax repeals other industries are facing, right now, there's really no detail on what kinds of projects these might be.
Other examples from the Department of Energy include vague proclamations like this:
"The budget supports loan guarantees for innovative energy technologies including renewable energy projects, transmissions projects and carbon sequestration projects that avoid, reduce or sequester air pollutants and greenhouse gases while simultaneously creating green jobs and contributing to long term economic growth and international competitiveness."
The technologies mentioned in the budget include solar, biomass, geothermal, wind and low-carbon emission coal power. But there are no specific projects outlined or dollar amounts given. Corn ethanol, one area where the government has made a lot of proclamations over the last decade, is conspicuously absent from this edition of the budget. Given the way the corn ethanol industry has risen and fallen, even the government may be shy to invest.
The alternative energy industry is understandably excited about the idea of increased attention and investment. But where is the money going to come from? The budget proposes to fund much of this green energy agenda with $15 billion a year, beginning in 2012, from the auction of green house gas emission credits. That $15 billion is only a fraction of the annual $78.7 billion that would actually be generated from the auction in 2012; the rest would be returned as a tax cut. By 2019, the budget projects that revenue generated by the emission credits will reach $83 billion.
Regardless of whether you agree or disagree with the politics, what does this mean for you as a commodity investor, assuming it passes in its current form? While there is no way to bottle and trade the sun or wind, there is the opportunity to invest in the companies that make the widgets that go into solar panels or wind turbines, or deliver the watts. The trick is it to figure out which companies are poised to take advantage of the federal loan guarantees and turn government money into a home run: A very different game from true commodities investing.
While some are accusing the Obama budget of overly optimistic projections, calling into question the assumption that the economy will shrink by just 1.2% in 2009 and then grow by 3.2% in 2010, others are quick to defend it. Fed Chairman Ben Bernanke said:
"It's true the administration's forecast is a little more optimistic that the Fed and [Congressional Budget Office's] forecasts. It's important to understand that these forecasts are not precise. Although they are on the optimistic side, they are within the range of uncertainty all of us face."
No surprises there. Ultimately, if the budget does indeed succeed in sparking more investment, freeing up the credit market and setting the economy on its way to recovery, there will be effects across the board. Eventually the economy must heat up, and commodities will be among the first to show the effects as demand for scarce resources begins to lift prices.
The question is when.
Ag: Budget opens Farm Bill Wounds, The Hill, 3/3/09 05:43 pm
Green Energy: Obama's Blueprint for a Daring Green Machine, Barrons.com 3/2/09