Tom Fernandes: Going Long on Agriculture

Includes: DBC, GCC, GSG, RJA
by: Hard Assets Investor

By Lara Crigger

With China canceling U.S. soybean shipments, and national corn and wheat stockpiles hitting all-time highs, the fundamentals are looking dicey in the ag markets right now. But there are still opportunities to be found, says Tom Fernandes, director of operations for GreenHaven, LLC.

An expert in commodity futures, Fernandes is the founder of the Grain Service Corporation and the manager of operations for the GreenHaven Continuous Commodity Index Fund (NYSE Arca: GCC), an equally weighted, long-only commodities index ETF.

Recently, HAI associate editor Lara Crigger chatted with Fernandes about his outlook for grains in 2010, including what's behind the current grain stockpiles, why farmland makes a smart contrarian play and why generic seeds aren't as good an idea as they might sound.

Crigger: With un-encouraging export data coming out of the ag space, is 2010 going to be a down year for the big three—wheat, corn and soybeans?

Fernandes: What's interesting about the export data in grains is that although the shift between soybeans, wheat and corn happens based on demand and substitution, the actual infrastructure that allows the exporting of grains is limited in some fashion. We work pretty regularly on the hedging side with some of the folks who ship grain down the Mississippi River via barge, and if you look at their numbers over a 10-year period, they're pretty steady. As of 2005, the largest export terminal for corn has been running 24/7; it doesn't really have any additional capacity.

In '06, '07, and early '08, we had a huge overflow of grain exports going out in export containers, or those containers that you see in a shipyard that get put onto an 18-wheeler and deliver goods to Wal-Mart. Folks have figured out: They need to get back to Asia, so they filled them up with corn and shipped them back. It was a cheap round trip and return, and it actually competed with the Panamex. A lot of exports went out that way and helped bolster the basis for the physical price of the grains. But as the U.S. demand for Asian goods fell, the supply of containers sat empty; you actually had less of a transportation means to get them out there.

So I don't think there's any super catalyst on the export side in 2010 that's going to push prices higher. But as the economy improves, and as long as this "cheap round-trip shipping" exists, those commodities become more attractive to foreign buyers.

There are two developments we think will happen, although probably not in 2010; they're probably more 2011 events. First, there's a really large export terminal being built in the Pacific Northwest by some grain companies, and when completed, that can be a big catalyst for soybean exports. Second, it's our opinion that the Chinese yuan is maybe poised for some kind of re-peg, which would make U.S. beans more attractive than perhaps Brazilian beans.

Crigger: Interesting you say that, since earlier in the week, we saw China cancel orders for over 192,000 tons of soybeans from the U.S. in favor of Brazilian ones.

Fernandes: The U.S. dollar has actually made a pretty strong move off its bottom over the past 10-15 weeks. The dollar—which the yuan is tied to—has been weakening versus the Brazilian currency, which made beans more attractive from the U.S. But now the dollar's made a reverse course.

It's our contention that if and when the Chinese currency revalues against the U.S. dollar, it's actually going to have more purchasing power buying the U.S. beans over Brazilian.

Crigger: What about wheat? Recent predictions estimate that we'll see stockpiles 52 percent higher than last year's. Will 2010 be a down year for wheat?

Fernandes: Wheat's an interesting situation. I don't know that anyone can really give you the whole picture, but there's a couple things going on in wheat.

So first of all, in general, we have tons of stockpiles of U.S. wheat. And one of the reasons for that is that it's a money maker from a cash and carry perspective. Large commercials buy wheat simply for the fact that they can make a cash and carry; they put it in a warehouse, and it stores pretty well over a period of multiple years. The futures curve gives them a nice leveraged return.

But maybe because we've produced too much wheat over the past couple of years, we have "basis dislocation" - basically where the cash prices and the futures prices were not converging. As a result, the commercials and the exchanges have gotten together to come up with a variable storage rate, which is going to start up on the July contract in Chicago. Most likely, it will produce less incentive for farmers to produce too much wheat. The commercials that bought it for cash and carry will either make more or less money, depending on how it works out. The market will fix itself.

Wheat's a little bit of a stepchild relative to corn and soybeans, from a stockpile vs. demand situation. But in general, if you lump the group together, I'd say that the global-stocks-to-usage ratio isn't necessarily over the top. It's kind of the opposite. When you look at global production of grains, including beans, on a per capita basis, that number is down.

Crigger: Technology advances have made it ever more efficient to grow crops. Will we ever hit critical mass when it comes to new technology? And if not, then are agricultural prices doomed to a permanent downward spiral?

Fernandes: I think it really depends on what side of the agriculture investment you're in. The farmer or the farmland owner benefits from the technology, because even if the commodity price goes down, if he's producing twice as much, his income goes up. So from the chain of the producer to the middleman to the commercial like Cargill, their earnings would be higher. The actual commodity price isn't always higher, but revenue from production is up.

But that doesn't happen overnight. And demand may outpace technology in the short run. Monsanto seeds have a trend line of a 1.5-2 percent increase yield every year. But the demand from ethanol and large hog populations in China—well over a billion hogs today—there's a large consumer changing the landscape. So I think technology will always continue to improve, but in the short run, we think demand will outpace technology for five years.

Crigger: Is farmland an overlooked opportunity for investors?

Fernandes: Yes. We think it will be a great long-term investment, a great place to be. Most people on an institutional level don't get too excited about it, because it's a low yielder. It yields maybe 2-4 percent on investment, net of taxes, from a landlord perspective. That's pretty low in an environment where muni bonds are yielding over 10 percent in some situations. A lot of institutional investors, you show them farmland investments, and they really don't get too excited. So from a contrarian standpoint, that's not too shabby.

But you have to be careful. People piled into farmland investing in the 1980s, and interest rates went higher and clobbered a lot of levered investments, most of which were farmers. It really depressed farmland prices, and it took more than a decade to improve the appetite for farmland.

So you've had a pretty big move in the prices. If I go back to Iowa in the early 2000s, farmland in the average acre made about $1,500 to $2,000 per acre. Now you're pretty solidly at $3,500 per acre on average, and that includes less desirable land. Premier land may be $5,000, $6,000 per acre. So there's been a big move there, and it's not for the faint of heart. But you don't have contango, and so on. Farmland's something that we're interested in, and we're working on some investments there. It's a good place.

Crigger: There's been a lot debate over whether Monsanto will actually ever let generic seeds come to market. What do you think?

Fernandes: It's interesting, because I see it from both sides. After a lot of thought on the subject, I believe that we have one of the most satisfying windows in the history of the world, in terms of human beings being able to thrive and have the opportunity to live decent lives—and a lot of that has to do with cheap food.

Now, I don't have any affiliations with the seed companies. But unlike medicine, where you just want to be price competitive, generic seeds might not be the best thing for everyone. We call it brown-bagging it, when you basically harvest your own seeds and regrow the crop without going to a for-profit seed manufacturer, and the result is probably worse for everyone in the long run.

Crigger: How so?

Fernandes: If you take a company like Monsanto (NYSE:MON) and look at what the return on equity is, I think it's probably a good investment. But they're not running margins like a software company. They have a lot of R&D, and a lot of probably high-paid employees and processes. And they need to protect that IP to continue to advance.

I totally understand the whole Franken-corn argument about 'what are we really getting ourselves into?', but when you look at the fact that you've been able to increase these yields at 1.5-2 percent compounded over time—and unlike the monetary system, where all you do is add zeroes or more liquidity to the system, this is real production. It has to take into account weather systems and a lot of things. That's been a real productive asset to the world, and it really flows through to all of us, no matter what socioeconomic place you sit in.

So from the perspective of a humanist and an environmentalist, it's been good. Let's not forget, there's been a lot of legislation about actually taking farmland out of production over the next 30 years, because it produces carbon (and planting trees would reduce carbon). That's going to drive prices higher. So the only way you'd ever be able to prevent the world from having a shortage of food is folks like the high-end seed producers increasing their yields to an even greater rate.

So if I were a farmer, I would probably consider a cheaper seed if I thought I could make more money doing it. But in the long run, for society, I don't know if it helps.