Food Price Inflation: Where Are The Risks?

BMI View: We continue to expect CBOT grain prices to generally average lower in 2014 than 2013 as supply improves and demand growth remains relatively subdued. However, we highlight some key flashpoints that could drive food prices higher in the coming months. In particular, we see upside risks to prices from prospects for stronger ethanol production, the possible return of El Niño, improved livestock production and trade disruptions. The effect of these issues could be exacerbated by speculative sentiment, which has been rebounding and shows room for further upside.

After three major food price spikes in the preceding five years, CBOT grain prices (which include corn, wheat, soybean and rough rice) generally declined sharply over 2013, falling by an average of 25%. Only prices for rice (which is relatively lightly traded) managed to buck the trend. A key reason for the collapse in prices was a massive rebound in grain supplies during the 2013 calendar year, brought about by record high plantings (particularly in the Americas). As a result of the supply surge, all four major grains recorded a surplus in 2013/14, grain prices (particularly corn and wheat) were some the worst performers in the entire S&P GSCI commodities universe, and food prices registered the most significant level of deflation since the global financial crisis. Analysts' forecasts were slashed continually throughout the year, and speculators scrambled for the exits. The fall in CBOT prices had a significant impact on food prices globally as the US is the world's largest food net exporter and most of the major grain contracts globally are based in the US.

A Significant Rebound In Grain Production

High Prices, High Plantings
S&P GSCI Grains Index With Planting Season

Food Price Inflation: Where Are The Risks?

BMI View: We continue to expect CBOT grain prices to generally average lower in 2014 than 2013 as supply improves and demand growth remains relatively subdued. However, we highlight some key flashpoints that could drive food prices higher in the coming months. In particular, we see upside risks to prices from prospects for stronger ethanol production, the possible return of El Niño, improved livestock production and trade disruptions. The effect of these issues could be exacerbated by speculative sentiment, which has been rebounding and shows room for further upside.

After three major food price spikes in the preceding five years, CBOT grain prices (which include corn, wheat, soybean and rough rice) generally declined sharply over 2013, falling by an average of 25%. Only prices for rice (which is relatively lightly traded) managed to buck the trend. A key reason for the collapse in prices was a massive rebound in grain supplies during the 2013 calendar year, brought about by record high plantings (particularly in the Americas). As a result of the supply surge, all four major grains recorded a surplus in 2013/14, grain prices (particularly corn and wheat) were some the worst performers in the entire S&P GSCI commodities universe, and food prices registered the most significant level of deflation since the global financial crisis. Analysts' forecasts were slashed continually throughout the year, and speculators scrambled for the exits. The fall in CBOT prices had a significant impact on food prices globally as the US is the world's largest food net exporter and most of the major grain contracts globally are based in the US.

High Prices, High Plantings
S&P GSCI Grains Index With Planting Season

A Significant Rebound In Grain Production

Aided by excellent growing weather, the 2012/13 South American grain crop (harvested at the start of 2013) and the 2013/14 North American grain crop (harvested starting in the middle of 2013) were the largest ever. High grain prices in the middle of 2012 led to the largest ever area dedicated to grain crops in South America, and high prices towards the end of 2012 led to the largest US corn crop in 80 years, and the largest since the US began planting soybean (which generally competes with corn for acreage) in the early 1960s.

Driven by these dynamics, global soybean production for the 2012/13 season increased by 11% year-on-year (y-o-y), while 2013/14 corn production increased by 12% y-o-y, the largest increase in a decade for both crops. Indeed, Brazilian soybean production in 2013 was strong enough to allow the country to supplant the US as the world's largest soybean producer. Global wheat production growth was the weakest in the complex for the 2013/14 season, yet still grew by 8% y-o-y. This growth was driven largely by the key players, particularly in the Black Sea region, but other producers saw significant increases as well: North African production on aggregate reached record highs, and production from Canada (among the world's largest exporters) was so strong that massive backlogs and rail car shortages ensued ( see 'Logistics Bottlenecks Will Hurt Export Potential', January 31). Among the 40 largest grain crops recorded around the world in 2014 (the top 10 for soybean, top 15 for corn and top 15 for wheat), only six crops saw a y-o-y production decline, and none of these was corn. By contrast, 20 crops saw y-o-y declines in the 2012 calendar year (10 for wheat alone), with 12 crops experiencing declines of at least 10%.

Supply Improvement Of Late
Select Grains - Global Stocks-To-Use (%)

Core View: Inflation Will Be Moderate, But Trouble Spots Appear

We still expect grain prices to average lower y-o-y in 2014. As outlined in our respective commodity price forecasts, we have long expected production growth for key grains in the 2014 calendar year to come in below 2013 levels, mainly owing to a smaller area dedicated to crops - a result of the collapse in prices. Indeed, we forecast a decline in global production growth from three of the four main crops in 2014, with only rice output growth expanding. However, global markets remain relatively well-supplied by recent historical standards, and global demand growth from the various livestock sub-sectors for feed remains subdued as high prices either prevented or delayed herd rebuilding in 2013. For example, the global beef cattle herd was lower in 2013 than in 1985 even as retail meat prices in key markets in Europe and the US reached record highs. The result of our relatively moderate grain demand growth outlook for 2014 is that even with the reduced supply prospects, all four major grain markets will remain in surplus for the 2014 calendar year, only the 11 th such occurrence in 50 seasons and the first since the 2010 calendar year, illustrating the improvement in market supply.

A Return To 2010 Unlikely
S&P GSCI Grains Index & % chg y-o-y

Even though we are forecasting lower average prices in 2014, we have held the view that grain prices are likely to remain in deflation only until H214. Food price inflation will re-appear in H214 owing to low base effects after the S&P GSCI grains index collapsed throughout 2013. Indeed, having held technical support around 400, the index has already been trending higher in recent months, in line with a view we've had since September that grains prices would find support around that level by the end of Q413 ( see 'Monthly Grains Strategy', September 18, 2013). Assuming the grains index remains at the current spot rate (as of March 14), the index will return to inflation by late July. Moreover, most of the price risks for grains lie to the upside, and include geo-political concerns, weather issues, improved grain demand and investor sentiment. We tackle the risks in turn below, analysing each in terms of the probability of occurring (denoted as "occurrence") and the potential impact in the event of occurrence (denoted "impact"):

Risk 1: Will US Ethanol Production Surprise To The Upside?

Occurrence: Moderate; Impact: Moderate

One of the key reasons we are forecasting continued global grain surpluses for 2013/14 season is that we are relatively pessimistic regarding US corn and soybean consumption growth, which constitute, respectively, 35% and 20% of global demand. This leads us to expect a massive 60mn tonne corn surplus for the 2014 season, and a 14mn tonne soybean surplus. Roughly half of US corn consumption is accounted for by ethanol production, while 40% of corn consumption and almost all soybean consumption is accounted for by the livestock sector. One factor behind our pessimistic US corn consumption figures is the view from our Oil & Gas team that ethanol production will fall by roughly 2% in 2014, mainly due to limited export prospects, regulatory concerns and improved US energy security ( see 'Biofuels Faced With Shrinking Demand', November 28 2013). By comparison, the US Department of Agriculture (USDA) sees food seed and industrial (FSI) corn demand, which acts as a proxy for ethanol production, rising by 6% in 2014.

Production Waning
United States - Weekly Average Ethanol Production ('000b/d)

A key factor supporting our view for reduced ethanol production is our expectation for the US Environmental Protection Agency (EPA) to reduce the country's ethanol mandate, in line with general market expectations and the EPA's own unofficial stance from Q413. Most market observers expect the mandate to fall by 10% to around 13bn barrels, largely owing to reduced supply growth prospects among ethanol producers due to the factors mentioned above. Moreover, most of the trade protection and subsidies afforded the sector have already been removed, and the newly passed 2014 Farm Bill provides fewer production incentives for corn farmers than previous bills (corn is the main feedstock for ethanol).

Ethanol's Declining Share
United States - FSI % Of Total Corn Consumption

However, the risks to ethanol production lie mainly to the upside, as the collapse in the price of corn has made many ethanol producers profitable again. Indeed, according to Bloomberg data, generic ethanol profitability, as measured by USc/gallon, is at its highest level since 2011, and share prices for ethanol producers have risen considerably. For example, US ethanol producer Greenfield Energy has seen its share price increase five-fold since the end of 2012, around the time corn prices started collapsing. Ethanol production itself (as measured by the US Energy Information Administration in thousand barrels per day) rose throughout 2013 and remains close to five-year highs.

Sector Outlook Improvement
Rolling Four-Month Generic Ethanol Margin (USc/gallon) LHS & Greenfield Energy Share Price (US$)

This has prompted suggestions from market participants that the EPA, which has yet to decide on the 2014 mandate after weeks of delays, may actually raise the limit. Indeed, prices for RINs (Renewable Identification Number), which are effectively replacement credits, have risen in recent weeks in wake of the speculation. The USDA is currently forecasting FSI consumption in 2014 to remain roughly flat compared with the previous five-year average, suggesting that ethanol production growth will be minimal at best. However, an increase in the mandate, combined with improved production prospects on the back of lower corn prices, provides upside risks to our view for corn prices to average USc425/bushel in 2014 and 2015.

Overly Optimistic On Ethanol
United States - FSI Corn Consumption ('000 tonnes) & Growth (%)

Risk 2: Improving US Livestock Production, But Fewer Exports

Occurrence: Low; Impact: Moderate

A second factor behind our relatively subdued US corn consumption growth outlook for 2014 is our view for lacklustre US livestock production growth, particularly for beef. We are forecasting total livestock production to be effectively flat in 2013/14 around 40mn tonnes, mainly owing to a poor outlook for cattle, the largest sub-sector in US livestock ( see 'Beef Production Revised Lower' December 4). By contrast, the USDA currently forecasts US corn consumption for feed to increase by 22% y-o-y. We believe this is overly optimistic, especially considering that the agency's internal forecasts have US livestock output increasing by only 1% for the year.

Big Need For Feed?
United States - Corn Feed Demand & Livestock Production, % chg y-o-y

There are two issues related to the US livestock industry that could lead to higher grain prices than we currently anticipate. Firstly, corn demand could increase owing to reduced use of animal beta-agonists. Despite the decline in herd sizes in recent years, US meat production has increased largely on the back of higher slaughter weights. These higher weights were a function of many factors, including animal genetics, better breeding conditions and higher-quality feed. However, some of it was due to the use of animal beta-agonists. Cattle were given (among others) a beta-agonist called Zilmax, while pigs were given Ractopamine; both are designed to increase the animal's muscle mass, creating higher slaughter weights.

Relentless Rise
United States - Average Slaughter Weights For Hogs (RHS) & Cattle (lb/head)

The use of animal drugs has become more contentious in recent years, with animal rights and other environmental groups complaining that Zilmax reduced animal mobility, while several governments (including Russia, the EU and China) have either banned imports of pigs given Ractopamine or banned its use for domestic production. Partly as a consequence, some US meatpackers, such as Tyson Foods, have now pledged to only buy Zilmax-free cattle. Although the decision to reduce the use of drugs in animals may curry favour with consumer groups, feedlots looking to maintain slaughter weights may have to increase feed as a substitute, leading to higher demand for corn and soybean and putting upside pressure on prices, since the US is traditionally the world's largest grain exporter.

The Indispensible Exporter
Select Countries - Net Grain Exports ('000 tonnes)

Secondly, US meat exports could decline on the back of rising domestic meat prices and disease concerns. Regarding prices, US retail and wholesale beef prices are at record highs owing to tight supplies. This has been exacerbated by virus outbreaks in the pork sector ( see 'Pig Virus Concerns To Be Felt Over Coming Months', February 28). Given that the US has become world's largest meat exporter as well, domestic market tightness could increase food inflation abroad, particularly in Asia, Africa and Central America, which are the key importers of US meat.

Big Gains In Market Share
United States - % Of Global Meat Exports

Risk 3: The Return Of El Niño

Occurrence: Low; Impact: Moderate-High

Weather will forever remain an adversary for farmers, but excellent growing conditions were undoubtedly a key factor behind the success of the 2013 crops. Prior to 2013, agricultural production was dented (in some cases significantly) in 2006-2007 and 2010-2012, largely due to the presence of weather events including El Niño and La Niña, both of which form due to changes in ocean temperatures. There is growing speculation that the El Niño weather pattern is currently forming, which will bring wet weather to Latin America and parts of Africa but dry weather to Asia, and could have a significant impact on rice production. Wet weather elsewhere could lead to an uptick in disease outbreaks, particularly in Africa, where anti-fungal chemical use is relatively minimal.

La Niña (which has the opposite effects as El Niño) was a key driver of the poor performance of crops in 2010 and 2012, and our analysis indicates that all El Niño events have typically led to lower grain yield growth than no event over the last 50 years. (There was no event during the 2013 calendar year, which coincided with a surge in grain production globally). We currently rate this risk as having a moderate potential impact largely because there is no definite consensus that El Niño will form, as scientists say it is too early in the cycle to predict its formation with certainty. However, there are already signs of crop stress due to erratic weather, particularly in the United States, where many parts of the country have seen the coldest winter in decades and where wheat soil conditions are already showing signs of deteriorating.

Whither The Weather?
Global - Average Grain Yield Growth Under Various Weather Conditions, % y-o-y

The effects of erratic weather could be exacerbated by currency depreciation among emerging markets, particularly large importers. Our Global team is generally bearish on emerging market currencies with the exception of Asia ( see 'Global Strategy: FX', March 11, 2013), and countries that rely on food imports (particularly in Africa and Central America) could see food price pressure rise in the coming months. Even China may feel the pinch of rising food prices given its dependence on soybean imports.

Risk 4: Potential Trade Disruptions

Occurrence: Low; Impact: High

Although we are not expecting any significant politically motivated trade disruptions over the coming months, we note that food prices tend to react violently when they occur. Consequently, we cannot rule out a significant move higher in prices if trade disruption occurs. There are two geographical flashpoints that could lead to higher prices: Firstly, the currently escalating tensions between Russia and the West over Ukraine could lead to disruption. Our core view for Ukraine remains that whatever sanctions are enacted on Russia (as of the time of writing there are none), they will have relatively limited impact, and commodity trade in the region is unlikely to be significantly affected ( see 'How Vulnerable Are Commodities To Sanctions On Russia?', March 6). Indeed, this view has been supported by recent statements from the Ukrainian agriculture minister stating that exports are progressing as normal, plantings are occurring as scheduled, and there has been no interruption to credit, fertilisers or fuel.

However, global grain markets are particularly sensitive to trade disruptions in this part of the world even though the Black Sea region combined constitutes less than 20% of global grain exports. This was seen during the periods of significant food price inflation in 2010 and 2012, which coincided with poor Black Sea wheat crops. Moreover, should the Crimea region be declared a conflict zone by insurance companies, the insurance premium on shipping companies operating at Ukrainian ports (and even Russian ports if the entire Black Sea region becomes involved) could discourage trade out of the concerned ports (see 'Global Wheat Outlook: Black Sea Focus', March 5).

Small Shares But Key Players
Select Countries - Wheat Exports (% of global)

The second flashpoint is in Latin America, where political and logistical concerns remain the key risks. Brazil is notorious for its poor infrastructure, and expectations for another record grain crop (largely due to record soybean production) will put further strain on the country's resources. Local reports suggest that the average wait time for grain loading is 75 days at the Port of Paranagua, which could increase as we head towards the main export season starting in May.

Evidence Of Hoarding?
Argentina - Soymeal Stocks ('000 tonnes)

In Argentina, disruption may take the form of hoarding, as many farmers are anticipating a further depreciation of the peso and are stockpiling soybeans, the payment for which is in US dollars ( see 'Soybean Exports No Panacea For Government Shortfall', January 27). Soybean stockpiling could be further exacerbated by government attempts to increase grain export taxes.

Plenty Of Room To Run
Select Grains - Net Long Speculative Positions

Speculators Eager To Pounce

Any of the concerns listed above could be exacerbated by speculative sentiment. Investors largely deserted agricultural commodities by the end of 2013 after witnessing prices falling for a year (corn and wheat) or more (sugar, coffee, cotton). However, since the start of 2014, speculative sentiment has improved considerably for several crops, notably corn, wheat and coffee. Given that speculative positions remain well below the levels seen in 2010 and 2012, there remains further upside potential should fundamentals deteriorate.

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