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February 25, 2008 – Comments (7) | RELATED TICKERS: PBR

I came across an article by A. Gary Shilling, frequent contributor to Kudlow's CNBC show (which I can't stand BTW and I'm a relative conservative individual), this weekend (link: http://www.forbes.com/free_forbes/2008/0310/110.html?partner=yahoomag) and I was shocked at how wong I believe he is.  He's looking at things the way they used to be, not the way they are now.  In his article he stated that we are in the midst of a massive recession and that investors should "Sell or short commodities, perhaps via exchange-traded funds, stocks in companies that produce them or futures. Commodity prices, still high, are poised to fall hard as the worldwide recession takes hold.  Chinese demand, terrorism and talk of peak oil drove crude prices. Agricultural prices were hyped by biofuel's popularity, droughts and the prospect of a shift in demand in poorer countries from grain to meat. So institutional investors rushed into commodities, believing they are a relatively stable asset class like stocks and bonds. Individuals bought commodity-backed ETFs. That enthusiasm will soon be history."

Let me tell you that he is dead wrong about a coming drop in agricultural commodities.  The leaders in the commodities boom, like wheat, corn and soybeans continue to hit record highs daily.  The skyrocketing prices of these commodities is in turn causing other ag commodities like oats to soar as farmers dedicate more acres to the leaders of the rally.  A rising tide lifts all commodities. 

There are several underlying factors behind the sharp rise in commodities especially grains and soybeans. The first is the rapid economic growth in China. As per capita incomes increase in China, the Chinese people consume more energy and higher quality foods which means primarily meat. The production of meat requires corn and soybeans.

Another factor is the excess liquidity caused by too much money in circulation around the world which leads investors to what to own hard goods instead of than hold dollars.

All of these reasons pale in comparison to the major factor behind the rapid rise in grain and soybean prices...the policies of our own federal government. The U.S. has always had a surplus of land which resulted in too much production pf grains and low grain prices. This all changed when Congress passed new energy legislation in August 2005 which required the blending of ethanol in gasoline. The situation became much worst this past December when Congress passed and the president signed another energy bill which significantly increased the amount of ethanol gasoline blenders are required to use.

There are approximately 220 to 222 million acres of farmland in the U.S. available for the production of corn, soybeans and wheat. Of this total approximately 27 million acres will be required this year just to raise corn to produce the ethanol which Congress requires gasoline blenders to use. Another 34.8 million acres are tied up in a federal program called the Conservation Reserve (CRP). This is a program created in the mid-1980 to take some of the excess farmland out of production and use it for pheasant hunting etc. The program was established because we had too much land in cultivation which keep grain prices at or below the cost of production. Now that we need these CRP acres back in grain production the Bush Administration refuses to allow farmers out of their contract with the government which requires the land to be idled for 10 years.

Bottom line, the demand for grain which is increasing as a result of the economic growth in Asia and the federal mandate to use ethanol in the U.S. exceeds the acreage available to produce grain. Grain and soybean prices are likely to go much high with major consequences for food prices.

Food prices could easily increase 6% to 7% in 2008 compared to an average of just 2.9% per annum over the past 25 years. If there should happen to be a drought this year food prices will increase even faster. The only hope for a political solution anytime in the future is the outlook for a new President and Sec. of Agriculture in 2009.  Whoever is President, however, will likely want to get reelected which requires the support of voters in the Farm Belt thus the odds of a major change are not likely. In addition. any change in the ethanol mandate requires an act by Congress and Senators from Iowa and Nebraska have the ability to stop any reform.

The spike in food prices is still 6 to 12 months away but I would be surprised if the Federal reserve is not aware of what is happening. In the interim the rising cost of grain will pressure the margins of most of the food companies. These companies will act as quickly as possible to pass along the higher raw material cost to consumers. Meanwhile as corn, soybeans and wheat prices continue to rise, oats follow along. Oat Futures gaped higher today closing at an all-time high of $4.15 per bushel. In December the price was $2.80 per bushel. Spring wheat futures in Minneapolis which is the type of wheat used to make pizza dough and specially bread rose almost $4 per bushel today closing at over $23 per bushel. Prior to this year wheat futures had never traded over $7 per bushel. There are steps the government could take to control the escalating price of grain and food but no one in Washington seems to have any interest. They could modify the ethanol requirement or allow farmland to exit the Conservation Reserve Program but after all this is an election year and you have to keep those voters in Iowa happen. By the time consumers begin to complain about high food prices there will be a new Administration and it will be someone else's problem. So there's why Schilling is wrong about agricultural commodities.

On the Oil side of things he is wrong as well.  Oil will continue to rise because:

A) it is priced in dollars and the U.S. government will continue to cut interest rates and spend money that we don't have in stimulous packages causing the deficit to rise.

B) Unlike in the past when Saudi Arabia could just open up the spigots and let oil flow freely until the price came down, production from its major fields seems to have peaked (I am in the middle of reading an outstanding book on the subject Twilight in the Desert).

C) Even if OPEC could increase production to lower the price of oil, I don't think that they want to.  The only reason that they would have done so in the past is out of fear that $100 oil would cause a crushing global recession and the world has already proven that it can handle oil at this price level nicely.  This argument is summed up quite nicely in the following article: http://seekingalpha.com/article/65878-opec-will-assure-oil-prices-stay-in-a-reasonable-range?source=yahoo

D) The "easy oil" is not around any more.  Schilling himself cites PBR's huge recent find as evidence that oil prices will fall because there is an ample supply (I am long PBR), but he completely ignores how expensive it is to get oil from deepwater locations like this.  Converting oil sands to energy is very expensive as well.

E) Demand for energy from countries other than the U.S. continues to grow.

F) People will continue to drive more and more automobiles.  Light vehicle sales are exploding in the BRIC countries.  Even if newer vehicles are more fuel efficient than they were in the past, the new $2,500 Tata Nano uses a heck of a lot more fuel than the alternative modes of transportation for potential buyers would, like walking, bicycles, or mopeds.

I think that I could go all the way to Z on how wrong the commodity bears are, but I've got to head home for dinner.  The bottom line is that traders could cause a short term pull-back in the prices of some commodities, but the long-term bullish trends are here to stay.  Perhaps I'll get fired up and post some more on the subject later.

Deej

Long PBR

7 Comments – Post Your Own

#1) On February 25, 2008 at 7:27 PM, LordZ wrote:

BLAH BLAH BL:Ah was there a point to all this ???

I almost feel stupider for reading the entirety of what you blogged.

From my understanding the wheat yield has been extremely poor this year (drought), its not like theres some huge conspiracy and its not like you can instantly plant more fields, or fix this shortage with rate cuts or policy. Demand hasn't gone up for wheat, but the supply has been affected from the bad harvest.

OIl is evil and the sooner we can stop using it, the better, but we have become dependant upon cheap oil, now were are almost forced to buy it regardless of its cost.

Alternatives that have been squandered and squashed need to resurface, I would love to tell those c - suckers in the middle east that they could go f themselves that we are no longer dependant on their oil to function : that we have liquidified coal and have created vehicles that drive on natural gas or water.

There has been technology out there that could have greatly lowered our dependance on the crappy oil that comes out of the middle east, hopefully oil will become so expensive that it will no longer be feasible to use and we will have no choice but to utilize the technology that had been pushed aside and prevented from coming to be.

 

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#2) On February 25, 2008 at 9:12 PM, TMFDeej (99.43) wrote:

Hi LordZ.  Hmmmm, not very nice.  My point was that the price of food and oil are going to continue to rise, despite the fact that there is a good chance that the economy will go into a recession.  This is the exact opposite of what a lot of the analysts like Shilling are predicting will happen. 

I don't see how reading about the current supply and demand fundamentals for agrucultural commodities and oil would make you stupider, but if it does so be it.  I have been adding companies that are related to the oil and gas industry to my personal and CAPs portfolios in place of consumer discressionary stocks and I am looking for ways to play the agricultural boom that aren't already outrageously priced.  I was in Monsanto for a while, but foolishly with a small "f" sold it too early because companies with P/E ratios in the 50's often scare me.  I should have held on to it, but hindsight is always 20/20 I suppose.

I never indicated that there is some huge government conspiracy to force the price of grains higher.  I actually believe that most conspiracy theories are a joke, except for that whole grassy knoll thing, oh and there's that alien that the government is hiding in Area 51, and oooooh and of course we never really landed on the moon...hmmmm I'm getting carried away it must be my government implant acting up again.  My point was that the government is inept and that politicians efforts to win votes in farming states like Iowa (nothing against IA most of my relatives are actually from there and I've been there a million times), just that the current government polcies which mandate the use of huge amounts of corn to produce ethanol while at the same time limiting the number of acres of crops that can be planted through the Conservation Reserve during a time of increasing global demand is absurd.  This doesn't even get into how inefficient the use of corn to produce ethanol is.  I would be all for a cellular ethanol program or for eliminating the taxes that we place on Brazillian ethanol that is made much more efficiently using sugar cane.

Thanks for reading and shaing your wonderful thoughts

Deej

Unfortunately, no current position in MON 

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#3) On February 25, 2008 at 10:16 PM, dwot (54.45) wrote:

I'm going to cast my vote with Shilling.

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#4) On February 25, 2008 at 10:20 PM, dwot (54.45) wrote:

The comments are in line with your view...

I think Deja vu:

"Don't buy it. For months now the debate has been over whether America will have a hard landing or soft landing, the answer hinging on how big 2007's housing disaster turns out to be. Well, there won't be any housing disaster. We won't have a landing at all, soft or hard. Right now the U.S. and global economies are both accelerating.

You can see right through the housing crash story by looking at the prices of housing stocks. The market knows what the economic worrywarts do not, which is that the housing sector is already making a comeback. In the last six months housing stocks are up 24%, well ahead of the overall market. If housing were destined to fall apart in 2007 these stocks wouldn't be so strong now

Did you know that housing sales are up in the last few months, not down, and that inventories are lower than six months ago? We're accelerating, not landing. This is true not just in housing but also pretty much across the board."
- Kenneth L. Fisher
Forbes, 02.26.07

 

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#5) On February 26, 2008 at 2:14 AM, zygnoda (27.13) wrote:

 Liquidified coal.....  No thank you!  I loathe coal.

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#6) On February 26, 2008 at 5:47 AM, TMFDeej (99.43) wrote:

Thanks for the comments dwot.  It's great to have an intelligent conversation on the subject.  I'm not so sure that I agree with Fisher either.  I keep going back and forth about whether we are headed into a recession or not.  I don't think that I have to choose one camp or the other to play the investments that I am looking at.  If we're not going into a massive recession then commodity prices will certainly continue to rise.  Even if we are though I believe that the supply and demand dynamics for agricultural commodities and oil / gas are such that they will likely continue to increase anyhow.  A combination of rising prices and no or negative growth, aka the dreaded stagflation, is definitely not a good thing so let's hope that the U.S. economy rebounds quickly.

Keep those comments comming.

Deej 

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#7) On February 26, 2008 at 9:29 AM, CycleFreak7 (< 20) wrote:

All of the problems in the U.S. (financial, housing, weakening USD,etc.) can be laid squarely on U.S. government monetary policy.

Going back to 2000 ... so the markets crash big time as a result of the dot-com bubble. Did the Fed really need to slash rates all the way down to 1% to "save" the markets? No. It certainly helped the wealthy and the Wall St. crowd, but it doomed the average U.S. citizen.

Then we have monkey-boy GWB spending billions a DAY on foreign conflicts in which the U.S. has no business being involved.

The recession and increased commodity prices are the result of the complete failure of the U.S. financial system. With equity at a point that it's barely wortht he paper on which it is printed, anyone with some brains is (more like, already has) moved investments from stocks to commodities.

This has created the commodity bubble. Make no mistake, it's another bubble. It may not be done expanding, but it is still a bubble. 

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