The Commodity Investor: Drought Creates Disruptions and Opportunities in Agricultural Markets

Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestselling Commodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. 

An unprecedented drought in the United States has resulted in price spikes across a number of key agricultural commodities, including crucial grains such as corn, wheat, and soybeans. This drought, which has ravaged much of the Midwestern United States, including the all-important Corn Belt, has caused price shocks not experienced in years. In fact, a drought of this ferocity has not been seen since the 1950s! In this edition, the Commodity Investor examines the consequences of this drought for commodities and offers solutions on how to best handle this exceptional event.

An unprecedented event

A drought of this magnitude doesn’t come along very often. Specifically, the last time we saw a drought like this was in 1956. More than 50 years later, despite all the technological improvements and industrial developments, we are still reliant on basic factors such as the weather. While we’re far from the Dust Bowls of the 1930s, which rendered whole states barren and unproductive, this drought is causing severe disruptions in global agricultural markets.

Since the drought began in the United States in the middle of June, prices for critical agricultural commodities have gone through the roof. Since June, soybeans are up a record 24 percent, wheat prices are up 41 percent, while corn prices are up 59 percent! While these astronomical and abnormal price swings are not sustainable in the long run, they do create short- and medium-term price distortions that are extremely disruptive to the marketplace.

Many countries, international organizations, and NGOs are worried that these types of price swings can result in higher food prices across the globe, hurting consumers around the world. We are seeing higher prices for food staples, but the transferring of higher food prices to the kitchen table isn’t as straightforward as many think. For example, when corn prices go up it is more likely for the price of milk to go up rather than the price of cereals or cornflakes. Why? Because the corn used in cornflakes is processed and enhanced using starches and other additives that aren’t subject to the same kind of price swings.

On the other hand, these price spikes have a direct impact on the corn that farmers use as grain feed for cows to produce milk, meat, and other dairy products. As farmers pay more for the corn they feed to their livestock, prices for milk and other products will increase. Therefore, while fears of higher food prices are real, they are much more complex to quantify than you may think. Furthermore, as I examine in the section below, the market is a self-regulating mechanism and has ways to deal with such price swings.

Winners and losers

Already we’re starting to see major market realignments as producers and consumers seek to adapt to this new environment. Japan, for example, is the largest importer of corn in the world. Japan is one of the few industrialized countries that imports almost all of its corn consumption needs. While Japan is a leading exporter of high-end finished products such as cars and consumer electronics, it has not been blessed with any significant natural resources. Indeed, Japan must import large amounts of corn, wheat, and soybeans to sustain its population. In fact, Japan also imports almost all of its oil and natural gas demands as well.

The biggest supplier of corn to the Japanese has traditionally been the United States. In any given year, the US may supply up to 80 percent of Japanese corn imports — up until the drought started in June this year, the US supplied 85 percent of Japanese corn imports during the first half of 2012. As the drought started rearing its ugly head, prices in the United States began to skyrocket. As a result, Japanese corn buyers began diversifying their purchases and started looking elsewhere for their corn supplies. Enter Brazil.

Brazil isn’t currently experiencing the scorching drought that its North American counterpart is going through. As a result, its corn is priced way below that of American farmers; in some cases, Brazilian corn is $20 to $30 cheaper per ton than American corn. Since Brazil has an important export base, Japanese buyers are now shifting their purchases to Brazil and away from the US. Japan, which imports about 15 million tons of corn per year, may import one million tons or more from Brazil this year, up more than 25 percent year-on-year. That is a direct result of the drought in the United States.

And that’s a key component of any disruptive market event: it will create winners and losers, and it’s up to the astute investor to determine which market participants will benefit from disruptive events and establish positions that will benefit from these market trends. With this in mind, the Commodity Investor currently likes Brazilian grain producers and exporters as they are uniquely positioned to pick up the slack and replace corn that’s affected by droughts in the United States, India, and other key producers.

One company that has a strong and increasing presence in the Brazilian grain space is CHS (NASDAQ:CHSCP). Although it’s based in the United States, CHS has a very large footprint in Brazil. It owns a logistics and distribution company that’s operational throughout Brazil; it also owns a fertilizer storage and blending service company in the South American nation, and it recently acquired a large grain distribution and export company.

In addition, CHS has operations in the United States, so it can alternate between strong revenue generation as the cycle shifts between these two agricultural powerhouses. Founded and run by a farmer’s cooperative, you can be sure that management knows what it’s doing in the space. The stock has performed solidly, up 12 percent in the last 12 months. And a quarterly dividend of $0.50 is an extra sweetener for this stable stock.

Securities Disclosure: I, Amine Bouchentouf, have no positions in the stocks mentioned.