This is an excerpt from Itau BBA’s latest commodities research note.

Bottom Line: Current grain price rally is not over yet, markets are not fully pricing in total production fall in USA.

Grain prices rose sharply in June and July following a supply shock in U.S.crops. The current price correction does not fully account for the extent of the crop damage going on in the U.S., therefore, expect more price increases in the near future. Current market players expect a maximum loss of 10% in corn and soybean production, when we could be looking at over 20% declines on a yearly basis.

Our objective with this piece is to shed some light on this theme, explaining the reasons for the recent spike in prices and also why the current loss could be stronger than currently forecast. First of all, we will discuss what has happened with the climate in the past few months and the implication for grain crops, briefly reviewing the reasons why the U.S. is so important to the global grain market. In order to assess future prices, we will try to understand what is currently priced in the market curves and what will have to be priced in the near future. Climate conditions are the main source of volatility in agricultural prices. Demand for this type of goods usually has low price elasticity and emerging-market countries remain a steady source of demand growth. Therefore, almost all variability comes from the supply side, particularly changes in climate. Technology developments in the past decade have helped to enhance the endurance of crop seeds. Nonetheless, the sensitivity to weather variation remains high. During the crop cycle, which usually lasts 120 days, there are some development phases that demand specific amounts of water and temperature conditions in order to achieve full yield potential. Therefore, any negative climate impact will depend on the size of the deviation from the norm and its timing.

Climate has been very harsh for U.S. crops this year. Over the past three months, rains in the Corn Belt (Primary growing region for corn and soybeans in the United States, combining Iowa, Illinois, Indiana, Ohio, Minnesota, South Dakota, Nebraska, Kansas and Missouri) were 50% to 70% below average. Adding to the already stressful situation, temperature across the Cornbelt was 1 to 3 degrees Celsius above normal standards. Specifically in the month of July, a critical period for crop development, average temperature was 28 degrees Celsius, which is exceptionally high even for summer patterns. High temperatures not only increase watering needs due to higher evaporation, but temperatures above 30 degrees Celsius are also damaging to productivity in the current crop stage.

Both the lack of rain and hot temperatures are producing severe to exceptional drought conditions that span almost every U.S. state. The current drought is one of the worst in the past 50 years and could even get worse unless climate conditions regain normality soon.

The timing of these deviations couldn’t be worse. The drought affected crops in the pollination phase, when the plant needs a minimum amount of water in order to form the pollen and generate the grain. The result of lack of humidity in this period is ears with less than normal grains or, given the severity of adverse conditions, without grains at all. This type of damage is irreversible and therefore an improvement in climate conditions from this point on can only prevent further deterioration.

How can we assess the impact of the current drought on 2012/13 crop production? During the growing season, the U.S. Department of Agriculture releases a weekly report on crop conditions, including an evaluation of crop quality. The possible conditions range from very poor, poor, fair, to good and excellent conditions. This periodic survey is conducted by over 4000 USDA associates, and therefore are very reliable. Statically, USDA’s crop quality assessments are closely related to final crop yields, giving a weekly measurement of crop productivity. Very poor crop conditions means complete or near crop failure, poor conditions are equivalent to heavy losses to yield potential. Fair means less than normal crop conditions. Only good and excellent conditions mean normal and above potential yield perspectives. With these definitions in mind, let’s take a look at current crop conditions:

Corn conditions worsened from an initial assessment of 75% of good and excellent quality at the end of May to 23% in only 12 weeks. Very poor plus poor conditions are currently at 45%, which is the worst in the history of this measurement series, which starts in 1986. Such low-quality assessments were last seen only in 1988, when end-of-season quality reached 19% of good and excellent and productivity fell by 29.4% year over year. Our estimates for the current crop, taking into account current quality levels, points to a decline of 26% in total production, which, if accurate, will have to produce a deep adjustment on the demand side.

Given the already low carry-over inventory levels, total supply will take a hard hit, forcing demand to fall 14.5% compared with what is currently forecast by the USDA. The adjustment will have to be divided between food, feed, ethanol production and exports. A key fact to watch will be whether the EPA will grant a waiver on the minimum ethanol that needs to be mixed with gasoline. EPA has the mandate to modify ethanol requirements in extreme events like this. Total ethanol production accounts for 38.5% of total corn use, and a reduction in ethanol requirements could mean a great relief to the balance between supply and demand.

The U.S. produces nearly one-third of total world corn, and so the U.S. drought will likely impact world balances. Considering current USDA demand forecasts and our supply estimates, global inventories could fall to 11% of total use in 2012-13, the lowest level since the start of the series in 1962. While Brazil had a strong winter crop and has enough to supply increased exports and domestic consumption, other important corn producers are reporting lower yields due to hot and dry weather in Europe, Australia and Asia.

The soybean scenario is not better. The oilseed is produced mainly in Brazil, Argentina and the U.S. The world already suffered a 10% decline in production due to the La Niña effects in 2011-12, depleting inventories. The current U.S. crop was expected to improve the stocks situation, which is quickly turning the other way around. Current quality assessments in the U.S. show that 37% of the crop is at very poor and poor quality levels. U.S. production will fall by 12% in 2012-13 due to lack of rain and a consequent loss of quality. Inventories in Brazil and Argentina are already running at very low levels, and the diminished production in the U.S. will produce stressed global inventories by the end of 2012, with demand adjustments in order.

Wheat, on the other hand, suffered losses of a smaller magnitude, both in the U.S. and Europe, and inventory levels are still comfortable, ranging a little below 30% of total use in global terms. Nonetheless, given the substitutability of corn and wheat, wheat should accompany the upward trend in corn prices.

Conclusions

Given these dire prospects for grain output, what can be said about prices? We believe that markets are not factoring in the full potential fall in production yet. Current market consensus points to production declines of no more than 10% for both corn and soybeans. The USDA still forecasts grain production above last year’s level. USDA will release the first production estimates using current crop conditions in the August WASDE release, due Friday, August 8. The speed of USDA forecast adjustment will give also the rhythm of price movements. If the Agriculture department recognizes the full extent of the effects of the drought on U.S. production, price correction will be very swift.

Can these losses be reverted if the climate improves? For corn the damages are practically irreversible, given that the critical development phase experienced very harsh climate conditions. For soybeans, there is the possibility of some improvement in quality if climate conditions are favorable until the end of August, however, quality recovery usually is shallow, not surpassing 7%.

Therefore, prices will continue to rise at least while the uncertainty over the crop shortfall remains. We expect corn prices to rise close to 30% by year end and soybeans close to 10% . Markets will also be watching the climate and the planting plans for the growing season in South America at the end of 2012. Assuming that both South America and the next U.S. crops have near-average yields and maintain the 2012/13 acreage, we believe that inventories can be slowly rebuilt, allowing corn and wheat prices to fall back through 2013. Soybean prices, on the other hand, should remain pressured beyond 2013, given the level of stock declines.

Source: Itau BBA (Giovanna Siniscalchi)

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