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Albeit a little rain has slightly reduced its impact, the U.S. drought has continued to decimate crop yields, resulting in a considerable surge in grain prices. The impact on corn and soybeans has been the most noteworthy as their production and yield estimates are forecasted to be even lower than the U.S. Department of Agriculture's (USDA) estimates. The drought has also negatively impacted ethanol makers and meat producers, which use these grains as a key component of livestock feed. Meanwhile, the ethanol mandate that requires 9% of corn-based ethanol to be mixed in gasoline is also losing support amidst increasing corn prices. In this scenario, we recommend investors to take long positions in grains ETFs, primarily in iPath Dow Jones UBS Grains Total Return Sub-Index ETN (NYSEARCA:JJG). PowerShares DB Agriculture Fund (NYSEARCA:DBA) and Teucrium Corn Fund (NYSEARCA:CORN) are other options to play the further worsening of the drought. We also add DB Agriculture Double Long ETN (NYSEARCA:DAG) to our long holdings. We recommend investors to short crop insurers like ACE Limited (NYSE:ACE), Everest Reinsurance (NYSE:RE) and Endurance Specialty Holdings (NYSE:ENH), ethanol makers like Archer Daniels Midland Co. (NYSE:ADM) and meat producers like Tyson Foods Inc. (NYSE:TSN) and Smithfield Foods Inc. (NYSE:SFD) as part of our portfolio.

Drought Update - Recent Developments

Recent storms over the weekend have dampened the impact of the worst drought since 1956 in some calamity-stricken areas, but other areas only got meager relief. According to weather service forecaster, Daryl Williams, it's a start. But I always say that it takes several months to get into a drought and it will take several months of above average rainfall to get out of it. The rain is encouraging, but certainly not a drought-buster.

However, there are limited signs of the drought easing in the main corn and soy producing region, the U.S. Midwest. Recently, an agricultural advisory firm, Pro Farmer, took some farmers, traders and buyers to a tour of Midwestern corn and soybean fields and gave estimates of corn and soybeans' yield per acre and total output, which were lower than the USDA's forecasts. The following table summarizes the differences in year-end estimates for corn and soybean production and yield per acre.

Pro Farmer's estimates

USDA's forecasts

Difference

Corn production

10.48

10.78

2.79%

Corn yield (bushels per acre)

120.25

123.40

2.55%

Soybeans production (billion bushels)

2.60

2.69

3.35%

Soybeans yield (bushels per acre)

34.80

36.10

3.60%

Analysts are expecting corn's yield per acre to be at its 16-year low (121.5 bushels) and production to be at an 8-year low (10.5 billion bushels). Similar expectations for soybeans are at an 8-year low (36.6 bushels per acre) and a 4-year low (2.7 billion).

According to Reuters, the new-crop soybeans have just hit a contract high "after farm newsletter Pro Farmer estimated U.S. soybean production will be worse than what was forecasted by the U.S. Department of Agriculture." Some traders are expecting prices to mount further so as to curb demand. In addition, the gain is also supported by an indication from China - the world's largest oilseed importer - for some measures to support its depressed economy.

The chief economist of the CME Group (NASDAQ:CME), Blu Putnam, thinks that the drought will continue to increase the prices of corn and soybeans, as their harvests are expected to squeeze to multiyear lows. This will result in less grain being available for livestock feeding in emerging countries due to higher demand from their expanding middle class, who are "eating more beef, poultry and pork."

According to the USDA's crop progress report published last week, almost 4% of corn crop was harvested due to early planting last spring and very high temperatures, accelerating crop's development.

Price Updates

The Chicago Board of Trade (CBOT) November soybeans' futures have just hit a contract high of $17.6 per bushel, surpassing its previous best of $17.44, set on August 23. CBOT's December corn has also risen to $8.11 a bushel.


(Click to enlarge)

Source: CME Group

Impact on Ethanol Makers and Food Producers

Fuelling corn prices have been detrimental for ethanol makers like Archer Daniels Midland Co., as they have led to a significant increase in the feed costs of livestock producers. Consequently, the support for the ethanol mandate, which requires U.S. fuel companies to mix 9% of corn-based ethanol into gasoline, is decreasing, and several White House and Senate members are requesting the Environmental Protection Agency (EPA) to waive this mandate. As a paradigm, a letter by Arkansas Governor Mike Beebe to the EPA says, put simply, ethanol policies have created significantly higher corn prices, tighter supplies and increased volatility.

Both Obama and Romney have supported this mandate (called the Renewable Fuel Standard), although the latter has been skeptical of subsidies in the renewable energy sector.

Meat producers like Smithfield Foods Inc. and Tyson Foods Inc. have also suffered from increased prices of agricultural commodities, as they use grains and soybean meals in animal feed. According to an estimate by the United Nations (UN), global food costs increased by as much as 6.2% last month as a result of augmenting grain prices.

Trading Ideas

We reiterate our previous recommendation of taking a long position in JJG, as it has a high soybean and corn (more than 78%) exposure. CORN is a pure play on its namesake commodity, but is not our favorite at present due to the recent volatilities associated with corn's prices. DBA is also a good option for taking a diversified position in agricultural commodities, but JJG is the best of the lot as it offers exposure to only those commodities that are impacted by the drought the most (corn, soybeans, and wheat). DAG can also be a good option for a long position.

Fertilizer stocks, especially CF Industries Holding Inc. (NYSE:CF) and MLPs like Terra Nitrogen Co LLP (NYSE:TNH), CVR Partners LP (NYSE:UAN), and Rentech Nitrogen Partners LP (NYSE:RNF) were our favorites to play rising corn prices, but we now feel they have already rallied considerably.

We continue to recommend shorting crop insurers including ENH, ACE and RE. Other potential shorts can be ethanol producers like ADM and meat producers like SFD and TSN so as to complete our "drought portfolio".

Source: U.S. Drought And Food Inflation: Impact Of Corn, Soybean, Ethanol