Debunking The Bear Case For Poultry, Pork And Beef

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Includes: PPC, SAFM, TSN
by: John Zhang

Summary

The ethanol corn mandate is being challenged.

Bears are wrong on the potential impact of this bill.

Surplus corn would lead to better margins for producers.

Earnings of major meat producers are unlikely to be negatively affected.

In recent months, a bill to end the ethanol corn mandate in the Renewable Fuel Standard has been introduced by a bipartisan group of senators. This has led some commentators to conclude that beef, poultry and pork prices will fall dramatically alongside corn prices if the bill is passed, potentially causing a drastic drop in the earnings of major meat producers such as Tyson Foods (NYSE:TSN), Pilgrim's Pride (NYSE:PPC) and Sanderson Farms (NASDAQ:SAFM).

Several journalists/writers have written on the bear case for the food industry relying on the corn argument. The argument made by the bears and proponents of the bill can be summarized as such:

  • Corn is a key ingredient in producing animal feed.
  • The ethanol corn mandate diverts 40% of US corn supply towards producing biofuels instead of food.
  • The mandate has resulted in rapidly rising corn prices since 2005, which is the primary cause of higher food prices.
  • When the bill eliminates the ethanol corn mandate, protein prices will follow corn prices lower.
  • This will have a severe negative impact on the earnings of major pork, poultry and beef producers.

1st Premise: Corn is a key ingredient in producing animal feed.

Nothing controversial here, this premise holds up.

2nd Premise: The ethanol corn mandate diverts 40% of corn supply away from animal feed and towards producing biofuels.

Here's where things get a little contentious. Proponents of the bill such as Sen. Diane Feinstein asserts that the massive amounts of corn used for ethanol production causes the cost of livestock feed to rise. However, these proponents have not dealt with the fact that a large amount of by-product in the production of ethanol is used as cattle or livestock feed.

There are two main methods of producing ethanol with corn: Dry Milling and Wet Milling. Both processes generate by-products that can be reused as animal feed. In Dry Milling, the fermentation process produces both "beer" and "stillage". Beer continues to be processed into ethanol, whereas stillage is easily converted into dried distillers grain with solubles (DDGS), which is a high-quality feed for cattle, pigs and poultry.

(Source: Renewable Fuels Association)

Similarly, Wet Milling also produces DDGS, which is then resold as animal feed. This is because ethanol production only requires the starch inside a corn kernel. Hence, the fiber, protein, fat and other nutrients are recycled in the form of DDGS, and used for livestock feed.

(Source: Renewable Fuels Association)

However, given that the Renewable Fuels Association is not the best source of information given their vested interests to prevent the ethanol corn mandate from being eliminated, we checked with other more unbiased sources. After reading academic papers such as this, this, this and this, we concluded that the process indeed creates a significant amount of DDGS, which is a highly nutritious feed. For every bushel of corn used to produce ethanol via Dry Milling, 17 pounds of DDGS by-product is produced. In Wet Milling, 1.6 pounds of corn oil, 2.6 pounds of gluten meal and 13.5 pounds of gluten feed are generated per bushel. All these by-products are reused as animal feed.

Hence, the argument that ethanol and animal feed are in competitive supply is a false dichotomy. Ethanol and livestock feed are partially in joint supply (both produced in the same process), and the impression that corn used for ethanol is resulting in a significant decline in animal feed is misleading.

3rd Premise: Higher corn prices have been the primary cause of higher food prices. Hence, when corn prices fall, beef, poultry and pork prices will follow corn prices lower.

Although I found this plausible at face value, a deeper look at the movement of corn, beef, poultry and pork prices tell somewhat of a different story.

Note that corn prices rose to a peak in mid-2012 before falling drastically till now. Hence, if the hypothesis that rising corn prices are the primary cause of higher meat prices, we should see a correlation between the change in corn and meat prices. However, as we see below, this is not the case.

(Source: Indexmundi)

To account for the typical poultry production lifecycle of 3 months, I correlated poultry prices to corn prices 3 months earlier. Even as corn has fallen from mid-2012, poultry prices have continued to surge higher. Overall, poultry prices have a steady upward trajectory, perhaps reflecting the growing demand/consumption. Furthermore, from 2008 to 2010, when corn prices dropped dramatically, poultry prices remained steady. In fact, the correlation coefficient between the two prices is only 0.61, suggesting there is a weak positive correlation. As observed above, poultry prices are typically very stable due to shorter production lifecycles compared to cattle and swine. Hence, whilst corn prices have fluctuated wildly, poultry prices have been mostly unaffected as supply moderates to demand very quickly. This supports the finding of a weak positive correlation.

(Source: Data taken from Indexmundi)

Similarly, in the case of beef and corn prices, there is no strong correlation. Given that it takes approximately a year to grow a harvestible herd of cattle, I took the corn prices one year before and correlated it to the beef prices to account for the production lifecycle. Even though the correlation coefficient is slightly higher than chicken at 0.74, it would be tenuous to conclude there is a strong relationship between corn and beef prices. The higher correlation compared to poultry could be due to the fact that feed costs are a higher percentage of production cost for cattle compared to poultry. Hence, although the data suggests corn prices influence future cattle prices to a moderate extent, it is not as significant as the bears would claim.

As usual, the price points of corn is adjusted 6 months earlier than the price point of pork to account for the typical production cycle.

The impact of corn prices on pork prices is the weakest compared to beef and poultry. Having a correlation coefficient of only 0.47, we can effectively rule out corn prices as the primary driver of pork prices. Hence, the bear hypothesis that pork prices will follow corn prices lower is debunked.

Overall, whilst corn prices do affect protein prices to varying degrees, past periods of data have contradicted the idea that meat prices will follow corn prices lower. Whilst beef would be the most heavily affected protein, the impact on poultry and pork prices is relatively smaller. Thus, while the bear case has merit on this point, the impact of corn prices on overall meat prices is not definitive.

4th Premise: Lower corn prices will have a severe impact on profits of food producers like TSN, PPC, SAFM and Hormel Foods (NYSE:HRL).

Naturally, if the ethanol mandate is eliminated, there will be an excess supply of corn in the short term, pushing down corn prices. The bears assert that an excess supply of corn and high food prices will result in rapidly increasing production, leading to lower food prices and pressuring margins.

However, past data has shown that lower corn prices, and hence lower feed prices, are actually extremely beneficial to poultry, pork and beef producers as it leads to increased margins, even during periods of growing meat prices.

As noted previously, corn prices began to fall in mid-2012, and have largely been on a downward trajectory ever since. During this same period, margins increased across major meat producers.

The same trend can be observed for Tyson Foods and Sanderson Farms.

Hence, lower corn prices are actually good for meat producers, as margins increase and prices do not drop significantly. Therefore, if the ethanol corn mandate is passed, leading to a surge in short-term supply of corn, it would actually benefit meat producers and increase earnings.

Conclusion

Upon closer examination of the bear case for meat prices, there are significant gaps in reasoning. Moreover, many claims are invalidated by past data. Lower corn prices are not likely to result in lower profits for meat producers, and whilst beef prices may fall, poultry and pork prices would remain relatively stable even if corn prices fluctuate wildly.

Disclosure: The author is long PPC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.