The Inflation Maize
by Brian Pretti CFA, Contrary Investor. June 8, 2007
You know that many a Fed official has made more than a few comments recently about still being concerned about inflation. Of course these comments are disingenuous at best, given that the Fed and Treasury are indeed THE key provocateurs of these very inflationary pressures vis-à-vis ongoing monetary expansion, but you already know that and this is fodder for another discussion.
Today I want to focus specifically on potential forward ag inflation possibilities related to US ethanol policy. In many a CPI and PPI report as of late, food and energy were the culprits in terms of driving headline prices higher. In fact, at least in terms of the PPI component related to food, this has been happening for a good quarter+ now. A lot of charts lie ahead so I'll try to keep the commentary relatively brief and to the point. It just so happens that over the recent past, we've also been experiencing the food component of CPI inflation running above the headline number itself (on a year over year rate of change basis). Hence, the acceleration in food prices is dragging reported CPI higher for now. Here's the very short term history of the difference between the year over year change in CPI numbers for food price inflation less the headline rate of change itself. Again, for now it's only been over the recent past where food prices have sped up just a bit, although we've seen this in the past more as a result of non-food prices softening. The important issue is what's to come and could this influence monetary policy outcomes at some point given the perceptual importance of CPI and PPI numbers?
One last item for perspective. As a percentage of the total CPI calculation, food accounts for 13.9% as a sub sector, the second largest component of the report. The following table gives you a feel for the current component weights that drive the headline CPI numbers:
|Component||Weight In CPI Calculation|
From a global perspective, we all know that the ongoing increase in standards of living throughout emerging economies will increase the demand for global agricultural products. Chicken, cattle and hogs being primary beneficiaries, but this global trend will clearly extend to grains, corn and soybeans as well. We've been experiencing pricing spikes in a few of these ag commodities already as of late, but not necessarily as a result of some type of rocketing forward in global food demand. That's still to come as a long term or secular trend. Short term, it's in very good measure a response to what's happening with US energy policy. As is more than clear at this point, US energy policy reaction to global crude price increases decade to date, to say nothing of increasing US dependence on energy imports, has been to showcase corn based ethanol as a possible key to future US energy independence.
I'm not going to debate the economics of ethanol here, as this discussion is more concerned with the perhaps unintended consequences of current US energy policy. Personally, corn based ethanol seems to make little economic sense in terms of looking at relative energy inputs needed to produce ethanol set against units of energy gained with the end product. In good measure it's a very large farm subsidy, but as you know, the farm belt happens to be quite contiguous to US geographic areas most economically darkened by manufacturing sector outsourcing of the current decade. A smart political move to encourage corn based ethanol production? Maybe. A smart economic move? We'll see. As you'd guess, the point here is the potential for that portion of US energy policy driving ethanol production to influence headline US inflation rates ahead. Let's have a quick peek at a few ethanol facts.
Someone's Sneakin' 'Round That Corner. Could That Someone Perhaps, Perchance Be Mack The Knife?
In 2006, US ethanol production was up 25%. As of year end 2006, US ethanol production is up 300% from year end 2000. Below are two quick charts that tell the story. The first is a quarter century plus history of the number of bushels of corn used in domestic ethanol production. Talk about a bull market.
Its twin sister is the number of gallons of fuel ethanol production occurring domestically over the same period as chronicled above. Complete direction similarity with what you see above.
Remember, the two charts above really reflect the usage of corn to produce ethanol with what is already existing capacity. What's really important and will tell the tale of potential food price inflation of tomorrow is the next chart in this series. Below we are looking at the prior decade history in ethanol fuel plants under construction or currently undergoing expansion. Importantly, just what do they represent? Tomorrow's production. Tomorrow's demand for corn in the ethanol production process. Potentially tomorrow's food price inflation. That's all.
For now, 68% of fuel ethanol production is used in reformulating gasoline, 26% is used in discretionary blending and 6% is consumed by winter oxygenate. Looking ahead, ethanol demand would really kick in big when car manufacturers ramp up flex fuel vehicles (FFV's). FFV's can handle and operate on an 85% blended ethanol concentration. The average automobile in use today can handle no more than a 10% ethanol blend. Will manufacturers ultimately be successful in building and marketing FFV's? Of course it really depends on the price of crude and retail gasoline along with the level of government subsidies directed toward the ethanol industry over time. We'll just have to see how it all plays out. But for now, the chart above tells us there are more than a few believers willing to put some meaningful capital down on the bet that ethanol usage increases meaningfully.
For anyone who has even tangentially followed the commodity markets as of late, you know how "anticipation" regarding the ethanol related facts above has influenced the short-term price of corn. After literally spiking almost 100% in a year, corn has recently backed down from recent highs. Certainly anticipation and speculation related to future ethanol production drove this initial maniacal price spike, but again, the really important question is what happens from here? It simply goes without saying that corn and corn-based products are a key staple in really the global food supply. High fructose corn syrup being a primary example of a widespread corn based sweetener. It just so happens that the US provides the bulk of global corn exports. The corn feedstock need of US based ethanol production certainly has consequences globally. Will what you see below and the facts of anticipated US ethanol production to come influence food price inflation statistics? Does this question really need an answer at this point? All charts below use CRB data.
Let's have a look at a few fallout effects from the move to increased US fuel ethanol production. First, what we'd term the substitution effect. For those farmers growing alternative crops, any thought of sustainable higher prices for corn will lead more than a few to switch from existing crop growing to corn. A prime substitution candidate would be soybeans. The more corn plantings are substituted for former soybean production, down goes soybean supply and up go existing prices. And so what has happened to soybean prices as of late? As always, nothing occurs in isolation. Exclusive of the temporary spike in Chinese soybean demand a few years back, soybeans rest near what would otherwise be a decade high. Exactly the same deal as with corn in the chart above.
Will higher corn demand and prices draw more acreage plantings? Isn't this the very cornerstone of capitalism, that profits attract investment? You better believe it. To the extent increased corn plantings supplant production of alternative crops, there's a very good chance that with reduced alternative crop supply, prices will rise for those alternatives along with the rise in the price of corn itself. Result? Higher broad based food price inflation. Are we seeing a bit of the same substitution phenomenon with wheat as seems to be the case with soybeans? Just have a look.
In addition to crop planting substitution being a potential problem for broad based food price acceleration, ag commodity prices dependent on corn as an input cost or feedstock will be influenced by potentially much higher ethanol demand driven corn prices over time. A poster child for this input cost issue is cattle. Corn fed beef will become much more expensive to raise if indeed corn prices remain elevated for some time.
Will anything discussed here dramatically influence short-term financial market or economic outcomes? It's a good bet the answer is no. But it's the larger trends we need to successfully identify in order to achieve correct asset class and sector exposure. Will changes in inflation perceptions over time influence individual asset class and sector investment results? Most definitively. Dedicating capital to alternative energy is not a past time at this point, but rather serious business as global economies accelerate competition for what are ultimately scarce energy assets. It's the unintended consequences of so many actions that always seem to sneak up on you. Food price inflation will be an issue. It's just a good thing so many folks focus on inflationary measures totally devoid of energy and food pricing, right? It's just a shame, though, that "core inflation" has zero percent of our minimum daily requirements of vitamins and minerals.
© 2007 Brian Pretti