TMFDeej (99.47)

I hope you're not too hungry...

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