The Outlook For U.S. Farming

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Summary

Despite a minor rally in soybean and cotton prices over the summer, which they have now largely retraced, U.S. arable farmers continue to face the consequences of excessive production.

U.S. livestock farmers face a similar predicament, although prices of these products began to decline two years later than crop commodities and are probably that much further from leveling out.

The outlook for U.S. agriculture is much the same as it was this time last year, before news of the effects of drought in Brazil sparked a (fairly short-lived) rally.

Barring either a severe shortfall in U.S. output or a weakening of the U.S. dollar, the prospect for a recovery in the U.S. agricultural economy remains distant.

Arable Farming

When I wrote about the outlook for the U.S. agriculture sector around this time last year, I mentioned the beneficial effect that disastrous crop U.S. failures might have on inventories. I argued that reduction of inventory backlogs is the only way for the American farm sector to return to economic health. But I neglected to discuss the possibility of crop failure elsewhere. The 2016 growing season did not end up being nearly as disastrous for American farmers as I expected, precisely because of this circumstance: Severe drought in Brazil improved the situation for U.S. soybean, cotton, and to a lesser extent corn exports, considerably. This prevented the extraordinary accumulation of excess, unsalable inventories that threatened the U.S. at the start of the year, and which so concerned me. The Brazilian drought sparked the price recovery these commodities enjoyed in the first half of 2016 (i.e., at the start of the Southern Hemisphere harvest, when it became clear how bad the damage to Brazilian crops would be):

Brazil does not export internationally significant quantities of wheat, so wheat prices were not affected by the drought there and continued to weaken throughout last year until the final quarter.

However, a year after my failed forecast, it is hard to justify any other stance than to repeat it. The situation facing American arable farmers is, for the most part, the same as it was at the start of 2016:

· U.S. inventories once again set record highs in 2016. The absence of Brazilian competition prevented U.S. inventories of corn, beans and cotton from ballooning as much as they threatened to do last year. But given a continuation of extraordinarily high yields, little withdrawal of land under these crops in the U.S., continued growth of production outside of the U.S. despite Brazil's difficulties, and the foreign exchange barrier to U.S. exports, American inventories will continue to grow:

Major Arable Crop Inventories

USDA Estimated Increase over Crop Year 2015/16

US Stocks

Global Stocks

Wheat

21.6%

3.8%

Corn

35.6%

5.8%

Soybeans

113.8%

7.3%

Cotton

31.6%

-8.3%

U.S. arable farmers continue to suffer from their extraordinary productivity. There is evidence that they have scrimped a little on fertilizer and seed. But they have by no means retrenched, as the expected increase in acreage under the major crops clearly indicates. Consequently, production continues to mount inexorably.

Productivity is one aspect of U.S. agriculture's problems, but the inability to dispose of the inventories that productivity inevitably produces exacerbates it. For several of the most important agricultural commodities, the U.S. is the world's swing producer ─ a sort of green Saudi Arabia, enjoying unmatched costs of production and correspondingly large market shares. However, American farmers' cost advantages relative to their non-U.S. competitors have been eliminated, or very nearly so, by the strength of the dollar:

The rally in the Brazilian real during 2016 did not help U.S. agricultural competitiveness as much as it might have, since Brazilian crop production was under pressure in any case. The appreciation of the Russian ruble probably contributed to the sharp increase in Russian wheat inventories that the USDA estimated occurred over the course of the year, but a considerably higher production also must have been a factor.

Apart from "more of the same," American arable farmers will face additional challenges in 2017. While it is by no means impossible, a second year of drought in Brazil (currently the biggest competitor to the most important American crops other than wheat) is probably unlikely. At any rate, we will know about it in the next couple months.

The recent appreciation of the real provides only limited protection to American agricultural exports, given that, at current levels, it is still seriously depressed. A weak currency increases fuel, seed, fertilizer and pesticide costs for Brazilian farmers relative to Americans, but decreases labor costs. It may affect capital and farmers' short-term borrowing costs either way, depending on government and central bank decisions and capital market reactions to them.

But perhaps at least as threatening is the consequence of political change in Argentina: The new government has removed massive tax disincentives on agricultural exports. The USDA expects the Argentine corn harvest, which will begin shortly, to be 26% higher than in 2016 and the wheat harvest 33% higher. Argentina is potentially one of the world's most productive regions for the major grain and oilseed crops, and it looks likely to recapture its former agricultural glory quickly. Although it is traditionally associated with wheat and beef, there is no obvious reason why it could not also be competitive in other crops as well ─ sugar beet comes to mind. Further, there is little to prevent it from eventually developing an export industry in hogs and poultry based on its already strong positions in corn and soybeans.

Then there is the issue of demand. If we are to believe futurists' prognostications, the long-term outlook is not terribly rosy:

The rate of growth in world demand for agricultural products has slowed, because population growth has declined and fairly high levels of food consumption have been reached in many countries. Growth in demand will slow further in the future.

United Nations Food and Agriculture Organization

However this pessimism bears little on current market conditions. As the quotation indicates, growth is not as great as it was a decade ago, but at present global consumption of the principal agricultural commodities continues to increase fairly healthily.

Over the last five years global consumption of soybeans, cotton, corn and wheat has grown at 3.7%, 1.1%, 2.3% and 1.5%, respectively. These are quite respectable numbers, considering an estimated world population increase of 1.17% per annum during the same period. Note that the lumpiness of growth rates may be a product of data acquisition more than of actual volatility of demand. Note also that corn demand is influenced by changes in ethanol production as well as consumption as food or feed.

Which is all well and good, but output of the most important food commodities, and therefore inventories of them, are growing faster. Food items do not have indefinite shelf lives ─ unlike agricultural commodities such as cotton or rubber ─ but with reasonable care they can last a fairly long time. Inventories have to adjust to consumption levels eventually, and as with oil, it seems that the swing producer may have to do much of the adjusting: Saudi Arabia in that case, American farmers in the case of agriculture. The drought in Brazil demonstrated that a significant production shortfall even in one of the major exporting countries is not sufficient to draw down U.S. inventories. Only a weaker dollar, and the access to world markets that it would open up, could save American arable farmers from the threat of burgeoning inventories.

Livestock and Dairy

The economics of livestock rearing are quite different from those of arable farming. Since a substantial proportion of costs is feed, livestock operations tend to benefit from weak crop prices.

Low feed prices encouraged farmers to increase herds and, in the case of beef and hogs, bring fatter stock to market. Combined with reduced pork and poultry demand from China, this resulted in excess supply from 2014 on, driving down prices. Livestock prices peaked about two years later than arable crops, so meat producers are still in the midst of the first, steepest part of a price decline. So prices are that much further from leveling out.

Market dislocations as a result of swine and avian diseases complicated, but for the most part pretty much reinforced these trends. Further, meats are to some extent competitive with each other. Poultry takes much less time to reach marketable size than hogs and especially cattle, so cattle farmers blame some of their many woes on excessive poultry (and to a lesser extent, hog) production in reaction to last summer's brief price rally in those products' prices.

Like their arable brethren, livestock farmers are also suffering from exchange rate effects on their international competitiveness, making it difficult to liquidate excessive inventories except through brutal price reductions. Further, the strong dollar is sucking in imports. For example Australia, which has long been a bigger factor in international beef markets than the U.S., actually exports more than a third of its production to the U.S. New Zealand and Uruguay are other significant suppliers to the U.S. Most U.S. pork imports are from Canada and Denmark.

Dairy farmers face similar challenges of over-production and inventory build in a context of reduced international competitiveness. Having ramped up capacity to meet what seemed to be ever-increasing Chinese consumption of powdered milk, the industry was blind-sided by the sudden decline in demand from that source. Market intervention by the USDA in September, when it purchased 11 million pounds of cheese to be given to food banks, helped breath some life into dairy prices, as has news of widespread reductions in the dairy herd. Slaughter of dairy cattle, however, only exacerbates the difficulties of beef cattle ranchers.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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