Agriculture Has Legs

The soaring prices of agricultural commodities have hit the covers of both The Economist and Barron's. According to contrarian wisdom, the story concerning "the silent tsunami" on the cover of the former should signal a peak in prices, while the negative cover story in the latter should be proof of just the opposite. Certainly, many are talking about the boom in agricultural commodities (with rice as the latest hot topic) and this could be taken as a bearish sign.

Grain prices did have a sharp drop in March (before the Barron's article), which appeared, for a time, to indicate a top in these markets. However, prices quickly recovered and, in the case of corn, surpassed previous highs.

Undoubtedly, agricultural commodity prices will eventually peak and then decline. Grains and oilseeds have spiked on many occasions before -- in the early 1970s and in 1996, among others -- only to come back down just as quickly. (The base to which they return, of course, is always higher than the previous.)

This time will be no different. However, for this to happen, one of several stimulus events is likely to occur first. There could be a significant increase in production, as a result of either more land coming under cultivation or an increase in yield per acre, or, most likely, a combination of both. A severe economic downturn worldwide could bring a decrease in demand, especially for those crops that go into animal feed, as people restrict their diets. The demand for biofuels, encouraged by government regulation, could decrease significantly if the political winds change. Investors (or speculators, as some prefer say) could flee the market as a result of crunch in liquidity or of any of the factors mentioned above.

All of these events are possible, yet I do not see any as being imminent. Production will undoubtedly increase, barring any weather disasters, as a consequence of rising prices. However, unlike in some other sectors, this takes at least one season, if not more -- agricultural supply is not fully elastic, for obvious reasons. Even so, this season should see some improvement, as Australia is expected to have a large wheat crop -- a welcome change for those farmers, following on last year's drought.

Though a severe economic downturn could limit the demand side of the equation, especially for those crops used for animal feed, people still need to eat -- placing something of a floor under the market. In the meantime, the Chinese, as they experience the increase in affluence associated with that country's rapid economic growth, are raising the protein content of their diet, therefore raising the demand for grain inputs.

Another potential negative stimulus would be a reworking of current biofuel requirements and incentives, which would have a large impact on projections for demand growth. If price pressures grow intolerable, this would certainly be a way to somewhat alleviate surging demand for corn and soybeans. However, as this would be a political solution, one could watch for indications of a consensus in this direction -- a consensus which does not currently appear to be on the horizon.

Finally, Barron's forecast a flight of investor capital (a contrary signal?) in their late March cover story. Though a drop in liquidity or a change in investment fashion would certainly exert downward pressure on many commodities, the grains remain backed by real-world supply shortages. Ending stocks of agricultural commodities are at their lowest levels in years; the USDA estimates that US corn stocks will reach only 1.2 billion bushels this September.

Given current planting predictions, if demand does not fall and yields remain the same, these stocks could fall to 300 million bushels next year. For other crops, this year's ending stocks estimates are 160 million bushels on September 1 for soybeans and 242 million bushels on June 1 for wheat, both historically low numbers. World stocks of wheat are especially low, as a consequence of last year's poor weather.

I am not arguing that "this time it is different." It is not; eventually, agricultural supply will catch up with demand, but it will take a little time. Until that occurs, there is still money to be made on the bullish side of the argument. My money, therefore, is on a continued rise in agricultural commodity prices, at least in the near-term, while maintaining a watchful eye on the factors described above.

This bullish cycle should continue to carry over to agricultural stocks -- Potash, Monsanto, Agrium, Terra Industries, and others continue to be good investments. They have had an incredible run, which is certainly a negative factor, but their valuations are reasonable when compared against their growth rates and forward P/E ratios.

Monsanto (MON), the most richly valued, has a forward P/E of 32.62, but has an estimated annual growth rate of 36.9% over the next five years. Potash (POT) has a forward P/E of 17.66. Agrium (AGU) has a forward P/E of only 12.44; Terra Industries (TRA) has an even lower forward P/E of 11.91. The latter two also sport price to cash flow ratios below the industry average and are especially attractive. All have bright prospects; as mentioned above, part of the solution to bringing prices back down is bringing demand in line with supply -- all of these companies have a role in making that possible.

I am certainly willing to stand behind my predictions; as my subscribers know, I am long several of these stocks and adding to my positions.

Disclosure: Author holds shares in Agrium

Comments

[User 160313:]

what do you think of tra's results?

2008 Apr 25 12:37 PM