Why Are ABCD Singing The Blues?

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Includes: ADM, ADZ, AGA, AGF, BG, CORN, DAG, DBA, DIRT, FUD, JJA, RJA, SOYB, TAGS, UAG, USAG, WEAT, WEET
by: Craig Pirrong

It's pretty clear that the major agricultural trading firms, notably the ABCDs - Archer Daniels Midland (NYSE:ADM), Bunge (NYSE:BG), Cargill, and Dreyfus - are going through a rough patch of tight margins and low profits. One common response in any industry facing these conditions is consolidation, and in fact, there is a major potential combination in play: ADM approached Bunge about an acquisition.

I am unsatisfied with most of the explanations given. A widely cited "reason" is that grain and oilseed prices are low due to bumper crops. Yes, bumper crops and the resulting low prices can be a negative for producers, but it does not explain hard times in the midstream. Ag traders do not have a natural flat price exposure. They are both buyers and sellers, and care about margin.

Indeed, ceteris paribus, abundant supplies should be a boon to traders. More supply means they are handling more volume, which by itself tends to increase revenue, and more volume means that handling capacity is being utilized more fully, which should contribute to firmer margins, which increases revenues even further.

Greg Meyer and Neil Hume have a long piece in the FT about the potential ADM-Bunge deal. Unfortunately, they advance some implausible reasons for the current conditions in the industry. For example, they say: "At the same time, a series of bumper harvests has weakened agricultural traders' bargaining power with customers in the food industry." Again, that's a flat price story, not a spread/margin story. And again, all else equal, bumper harvests should lead to greater capacity utilization in storage, logistics, transportation, and processing, which would actually serve to increase traders' bargaining power because they own assets used to make those transformations.

Here's how I'd narrow down where to look for more convincing explanations. All else equal, compressed margins arise when capacity utilization is low. In a time of relatively high world supply, lower capacity utilization would be attributable to increases in capacity that have outstripped gains in throughput caused by larger crops. So where is that increased capacity?

There are some hints of better explanations along these lines in the FT article. One thing it notes is that farmer-owned storage capacity has increased. This reduces returns on storage assets. In particular, when farmers have little on-farm storage, they must sell their crops soon after harvest or pay grain merchants to store it. If they sell their crops, the merchant can exploit the optionality of choosing when to sell; if they store at a local elevator, they pay for the privilege. Either way, the middleman earns money from storage, either in trading profits (from exploiting the timing option inherent in storage) or in storage fees. If farmers can store on-farm, they don't have to sell right after harvest, and they can exploit the timing options and don't have to pay for storage. Either way, the increased on-farm storage capacity reduces the demand for, and utilization of, merchant-owned storage. This would adversely impact traders' margins.

The article also mentions "rivals add[ing] to their crop-handling networks." This would suggest that competitive entry/expansion by other firms (who?) is contributing to the compressed margins. This would, in turn, suggest that ABCD margins in earlier years were abnormally high (which attracts entry), or that the costs of these unnamed "rivals" have gone down, allowing them to add capacity profitably even though margins are thinner.

Or maybe it's that the margins are still healthy where the capacity expansions are taking place. Along those lines, I suspect that there is a geographic component to this. ADM, in particular, has its biggest asset footprint in North America. Bunge has a big footprint here too, although it also considerable assets in Brazil. The growth of South America (relative to North America) as a major soybean and corn exporting region and Russia as a major wheat exporting region reduces the derived demand for North American handling capacity (although logistical constraints on Russian exports means that Russian export increases won't match its production increases, and there are bottlenecks in South America too).

This would suggest that the circumstances of the well-known traders that have more of a North American (or western European) asset base are not representative of the profitability of grain trading overall. If that's the case, consolidation-induced capacity "rationalization" (and that's a major reason to merge in a stagnant industry) would occur disproportionately in the US, Canada, and western Europe. This would also suggest that owners of storage and handling facilities in South America and Russia are doing quite well at the same time that owners of such assets in traditional exporting regions are not doing well.

So, I am not satisfied with the conventional explanations for the big ag traders' malaise during a time of plenty. I conjecture that the traditional players have been most impacted by changes in the spatial pattern of production that have reduced the derived demand to use their assets, which are more heavily concentrated in legacy production regions facing increased competition from increased output in newer regions.

Ironically, I'm too capacity constrained to do more than conjecture. But it's a natural for my Université de Genève students looking for a thesis topic or course paper topic. Hint, hint. Nudge, nudge.