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Return of the Good Times: How Long Will They Last?
Michael Boehlje, Distinguished Professor
Without a doubt, crop agriculture is experiencing the best times it has had in decades. So the question is how long will this last? Like most commodity industries, agriculture is a cyclical business, but the key question is whether the next cycle will be from a higher plateau. Answering the question of whether these good times for crop agriculture are sustainable is difficult, but one way to obtain some insight into the answer is to assess the current and future supply and demand forces shaping the industry. In the spirit of helping you discover your own answer, we will here attempt to identify what to watch. Five fundamental forces, three influencing demand and two influencing supply, will shape the future of the agricultural industry. We will discuss each in turn.
Ethanol and energy
Ethanol will be using almost 30% of the U.S. corn crop by 2009 with total ethanol production reaching almost 14 billion gallons. Numerous analysts have suggested that total demand for ethanol longer term is likely to be approximately 15 billion gallons from corn with the additional renewable fuels coming primarily from other sources such as cellulosic ethanol. In fact, some are concerned that within the next 12 to 18 months, ethanol supplies in excess of 12 billion gallons may be difficult to absorb in the market because of inadequate transportation/logistics and refining capacity to move the product into the fuel supplies on the East and West coasts. Even Federal Renewable Energy policy suggests that corn based ethanol is not expected to fulfill more than 15 billion gallons of the mandated 36 billion gallons of renewable energy that is required to be produced by 2022. Further challenges to the continued growth of the ethanol industry are the growing food _ fuel debate precipitated in part by rising food costs which some blame on increased use of agricultural products for the energy rather than the nutrition markets; the current debate about whether ethanol and bio-fuels in general are as environmentally responsive as originally perceived and whether they may actually contribute to green house gases and global warming rather than mitigate those problems; the debate about continuing or reducing the $.51 per gallon subsidy for ethanol production when it expires in 2010; the increased discussion of reducing the $.54 tariff and the import quotas on Brazilian ethanol imports given that corn based ethanol is 20% more expensive to produce than sugar based ethanol in Brazil; the slow growth in the E85 market and distribution capacity and the fact that a 10% blend of ethanol will likely only require approximately 14 billion gallons (given that mobile fuel consumption totals only 140 to 150 billion gallons in the U.S.) unless the E85 market expands rapidly and/or the automobile industry warranties engines above the 10% blend; and the margin pressure and profitability prospects for ethanol producers with $4.00 plus corn prices if ethanol prices decline back below $2.00 per gallon. The corn based ethanol industry may encounter some short-term growing pains, but the 36 billion gallon mandate for renewable energy by 2022 suggests increased crop-based energy demand. In essence, the key questions are whether corn-based ethanol demand will mature, and how quickly will other biological sources of renewable fuels such as cellulosic materials be commercially available.
Exports and exchange rates
Most analysts expected that the increased use of corn for ethanol production would come at the expense of exports, but that has not been the case. Exports of corn as well as soybeans and wheat have in fact grown dramatically in the past 2 years. The fundamental reasons for that growth are the continued strong economies and purchasing power of China, India and much of Asia — as well as the declining value of the dollar; the dollar has declined not only relative to those countries buying our grain products, but it has also declined relative to the currencies of competing exporters of those products. The value of the dollar currently is below the record low levels of the mid-1990s, and this has resulted in prices of agricultural products in importing countries being only modestly higher than 2-3 years ago when we experienced a much stronger dollar but almost 50 percent lower commodity prices. So it is critical to watch the growth in personal income and food demand in Asia and foreign exchange rates and currency values to understand whether or not the foreign demand for U.S. agricultural products will continue to be strong.
However, the declining value of the dollar is a two-edged sword relative to the agricultural industry. Although a lower currency value increases our competitiveness in selling agricultural products in global markets, it also increases the cost of imports. And an increasingly larger proportion of agricultural inputs are being imported rather than produced domestically. In contrast to 3-5 years ago when a vast majority of our fertilizer was produced domestically, almost two-thirds of our nitrogen is now imported and P&K are also increasingly sourced from outside the U.S. borders. The same is true increasingly of chemicals for pest control. A significant explanation for the dramatic increase in the cost of production for corn, soybeans and wheat in the Midwest (a 50 to 60 percent increase in production costs) is the increased dependency on imported raw materials and the higher cost due to increased transportation costs as well as the lower value of the dollar.
The food vs. fuel debate
The food vs. fuel debate is in reality not a serious debate in the developed countries of North America and Western Europe. Certainly, food prices have increased in the developed and developing world as a result of higher energy related transportation costs; weather related shortages of some products — particularly wheat; and increased bio-fuels demand for agricultural raw materials historically used only in the nutrition markets including sugar, palm oil, soybean and other vegetable oils and corn. Higher food prices faced in North America and Western Europe are likely to result in only small shifts in food consumption patterns. However, the prospects for a reduction in the growth of animal protein consumption in the developing countries is real. Prior to the growth in the energy driven demand for agricultural raw materials, the exciting longer-term opportunity for U.S. agriculture was the growing demand in the rest of the world for animal proteins. As consumers in China and Asia in general experienced growing real incomes, they were beginning to change their diets from a primarily vegetable-based protein diet to an animal protein-based diet. In fact, this dietary transition and the longer-term sustainability of income growth in the rest of the world was the growth story for U.S. agriculture prior to ethanol. But bio-fuels is changing and challenging that story. First, higher feedstuffs prices have and will continue to result over time in higher costs of production to produce animal proteins, and thus higher prices for a smaller animal protein industry. These higher prices for animal proteins are pricing that product out of the diet of many potential consumers in the developing world. Animal protein consumption is very responsive to higher prices i.e. the quantity purchased declines significantly with higher prices. And higher food prices in general are reducing the real purchasing power of those consumers who spend 60-70 percent of their disposable income on food compared to 10 percent in the U.S. The result in essence is a significant deceleration of the speed of dietary transition from vegetable to animal based proteins, and thus a slowdown in the growth in global demand for animal and meat products. To put this issue in context, one must remember that the growth in demand for agricultural products prior to ethanol was not from the domestic food market, but from the export market; and the fastest growing agricultural exports were in fact the animal protein complex. As noted earlier, income is growing rapidly in China and India, in particular, and they are using much of that increased income to buy food, particularly meat and animal products. But if the demand from the bio-fuels market for agricultural raw materials keeps feed costs and thus the cost and price of meat and animal products high, the concern is that the growth in global animal protein consumption may be stymied because of these higher prices.
Furthermore, this potential slow down in the growth in demand for animal proteins combined with the increased expansion of animal production in the rest of the world, Brazil, Poland and Eastern Europe, China and East Asia and the current increasingly skeptical attitude in the U.S. about the value and importance of exports and free trade as exemplified by a non-compliant current and proposed Farm Bill and recent protectionist perspectives surfacing in the political dialogue, present serious challenges to U.S. participation in global animal protein markets. In essence, if ethanol demand matures and we have blunted the growth in global animal protein demand as well as positioned the U.S. to not be as successful a competitor in supplying that reduced demand, what is the next cycle of demand growth which is essential to maintain high grain prices and a strong agriculture as we continue to increase production capacity through productivity-increasing technology adoption?
Global production
As implied earlier, in the long run food production can increase significantly in the rest of the world because, in contrast to most of history, global access to both production technology and financial capital has profoundly changed the constraints and unshackled the productive capacity and capability in much of the rest of the world. In the U.S., most of the land and water needed for agricultural production is being fully utilized, and allocation of additional land and water resources to agricultural production is highly unlikely. In essence, the "plant" in terms of crop production is operating close to full capacity. This is clearly not the case in much of South America (Brazil, Uruguay, Bolivia and Argentina) as well as in parts of Eastern Europe where adoption of new technology and market driven business models have the potential to dramatically increase agricultural output. U.S. animal production is not constrained by the same land and water resources, but expansion in the animal industries faces equally limiting constraints with respect to siting livestock facilities and the regulatory permitting process. Most food companies globally source and sell and although transportation and logistics costs are rising, they are unlikely to reverse the continuing trend of increased global rather than local production of food products. In essence, the U.S. will face increasingly global competition in a business climate where agricultural production can be more cost effectively expanded in other countries than it can in the U.S. Longer term, agricultural output is likely to grow more rapidly in the Americas in the Southern hemisphere compared to the Northern hemisphere, and in Europe in the East including countries of the former Soviet Union compared to the West.
Weather and wheat
Weather worldwide continues to have a profound impact on production and supplies even in spite of new genetics. Although corn and soybean producers in the Midwest have continued to see increasing yields over the past 5-10 years with little weather disruption, that is not the case for South America nor for wheat production globally. In fact, world wheat output has suffered from yield reducing weather events for the past 5 years. Weather patterns are clearly unpredictable, but continued weather-shortened wheat crops for the next five years is not a likely. Furthermore, the current high prices for wheat suggest significant expanded production in wheat acreage throughout the world, and one should remember that many more locales in the world have the capacity to produce acceptable wheat yields compared to corn and soybean yields that require generally better soils as well as larger quantities of water and more predictable moisture conditions. A significant increase in wheat acreage combined with more normal weather events could result in a relatively quick, say 3-4 years, change in the wheat supply-demand balance from one of current shortages to fully adequate if not burdensome supplies. And if that is the case, wheat prices will decline dramatically, and what is now primarily a food product would again become a feed product substituting for corn and other energy sources in livestock rations. One should not forget the old pricing adage that "wheat caps corn", if increased wheat supplies would result in wheat prices declining to for example $5.00, it will be difficult to maintain corn prices much above $4.50 because of the10 percent higher nutritional value of wheat in livestock rations. The crop to watch in terms of acreage, yield and production may be very likely wheat , current high prices encourage significant expansion in global production; wheat is more adaptable throughout the world to a variety of soil and weather conditions and thus production capacity expansion is much less limited compared to corn and soybeans; and global weather may be more favorable for wheat production during the next three or four years. In essence, wheat production and prices may be the bell-wether of the future of the cropping sector during the next 3-5 years.
So what?
Certainly other forces within the agricultural sector as well as outside the industry could have important implications for the continuation of strong prices and incomes for the next 3-5 years. A world-wide recession combined with high food prices would have a dampening effect on global food demand and thus prices and incomes. Weather shortened global supplies could result in even further increases in commodity prices and incomes. Continued rising cost of fertilizer, seed and chemicals along with higher land prices and rents will continue to eat away at the current high margins for tenants we see in crop production; total costs to produce the 2008 crop have increased by 50-60 percent from 2007 to approximately $4.00 for corn, $9.00 for soybeans and $6.00 for wheat.
The agricultural industry is currently well positioned financially to buffer some weakness in prices and/or increase in costs margins are currently high by historical standards and could be reduced without creating significant losses for crop farmers, and the debt load in the industry is currently low which combined with relatively low interest rates suggest that widespread financial stress similar to that experienced in the1980s is highly unlikely even if we do experience some price declines and margin compression. The key however is to monitor the changing business climate for the industry and position for the unknown. We may be in a new paradigm of perpetual prosperity for agriculture, but that is very atypical of any commodity industry. Monitoring the five forces we have summarized here may help you assess how long this prosperity will continue and when the cyclical downturn will occur. It is highly likely that history will repeat itself.
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