Extreme Weather, Food Inflation: A Potential Entry Point for Agricultural Commodities

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Includes: BAL, COW, JJG
by: Ian McAbeer, CFA

You don't need to be a farmer or an economist to understand that weather events can have a dramatic impact on agricultural production from one year to the next. Much of the country has received above-average rainfall in the past few months and there has been widespread flooding as a result. The Mississippi River, for example, is currently experiencing a 100-year flood event.

If you live in most parts of the country – such as the West Coast, the East Coast, or the Midwest, you might not realize that Texas and the greater Southwest have scarcely received any rain at all this year. In fact, much of Texas is currently suffering through an "exceptional" drought – the highest level achievable. In other words, if the drought in Texas were a hurricane it would be a "Category 5." A drought simply doesn't get any worse than this and the present conditions in the Southwest have been compared to the dust bowl years of the 1930's. In fact, the seven month period from October 2010 through April 2011 is officially the driest ever recorded in Texas.


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Partly as a result of the drought, Texas has also been scorched by wildfires this year. According to the Texas Forest Service, wildfires have burned 2.5 million acres in the state just within the first four months of 2011. This represents a burned land area that is almost equal in size to the entire State of Connecticut.

Of course, the flooding along the Mississippi river and the exceptional drought and fire conditions in Texas are of greater significance than just a casual conversation about the weather. Such events will have an effect on people throughout the country, due to the eventual impact on commodity prices. Texas, for example, happens to be the second largest agricultural producer in the United States, and is the largest producer of both beef and cotton, producing more than 20% of the nation's beef and up to 40% of the nation's cotton each year. Texas is also among the leading producers of hay, rice and sorghum (a crop grown for animal feed). The drought conditions have resulted in reduced water availability for agricultural and farming operations within the state, while the fires have had a devastating impact on cattle ranchers due to the loss of grazing land.

The Texas Farm Bureau had the following to say in a recent statement:

"Texas farmers and ranchers are in an extremely critical situation as we prepare for June and the hot summer months. Crops are shriveling in the field. Pastures are burning. Many farmers likely will have little or nothing to harvest. Some ranchers already are selling their herds.”

These events are contributing to volatility in certain commodity prices, although not always in the most obvious ways. The lack of rainfall has decreased and delayed cotton plantings so far in 2011 with less than 20% of the crop being planted year-to-date. Without a significant amount of rain in the next 3 weeks, Texas faces the likelihood of a failed cotton crop. Additionally, up to 60% of this year's Texas wheat crop has already failed and will not be harvested.

In cattle markets, the situation is more complex. Ranchers have less available land to graze, while hay and feed prices are moving higher, so it becomes uneconomical for many ranchers to maintain their herds. As a result, ranchers are slaughtering their cattle early, which will create excess short-term supply in the beef market and temporarily put downward pressure on prices. Meanwhile, ranchers that have been trying to expand their herds are now unable to do so because they lack the grazing land and low-cost feed to justify herd expansion. This lack of investment will ultimately put upward pressure on beef prices over the long-term.

It is interesting to observe how extreme weather at either end of the spectrum ultimately has the same impact on food production. For example, Arkansas is the largest producer of rice in the nation and flooding along the Mississippi River is expected to wipe-out at least 10% of the entire domestic rice crop this year as fields are drowned in water. Ironically, the drought in Texas has put it's rice fields under pressure because rice requires more water than any other food crop and the state is running short of agricultural water! Texas is the 4th largest producer of rice in the nation.

Finally, it's important to understand that a shortage of one commodity can lead to higher prices in numerous other commodities. For example, with diminished domestic production of rice and sorghum, there will be higher-than-usual demand for potential substitute commodities, such as wheat, corn and soybeans. The net effect is that a shortage in one commodity often contributes to higher prices for other, somewhat similar commodities.

We are experiencing both a 100-year flood and a 100-year drought occurring in neighboring states, with the ultimate impact on agricultural commodities being the same: lower supply and higher prices. Those of us who live in Texas and the greater Southwest are hoping for some rain to come our way, although long-term weather models show little rain in the forecast until July, at the earliest. Meanwhile many people in the remainder of the country, and particularly the Midwest, are praying for the rain to end.

Regardless, much of the damage for this year is already done and I suspect that the recent price decline in agricultural commodity markets may be near its end, as the fundamentals of supply and demand once again move to the forefront. For those looking at an entry point for a long-commodity trade the time may be near, particularly in those that appear to be hardest hit, such as cotton (NYSEARCA:BAL), grains (NYSEARCA:JJG), and livestock (NYSEARCA:COW).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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