The Amber Waves Of Pain?
by Brian Pretti CFA, Contrary Investor. August 15, 2008
It was in March of 2007 that we penned a discussion entitled "The Inflation Maize." The bottom line is that it was a discussion centered on reviewing the character of domestic ethanol production, how that impacted corn dynamics specifically, and suggesting that meaningful food price inflation was to come. To be honest, we had no idea just how fast domestic ag prices were to fly over the subsequent year. Corn, wheat and soybean prices took off to the upside like bottle rockets and blew through what were literally three decade trading ranges and price highs. Of course at this point, the ag theme in terms of investing is more than well known. And although many are calling it a spike or a bubble, we're not so sure that's the case at all. Despite a lot of the equities that reflect the greater ag theme having done more than quite well over the last year, until recently of course, we're of a mind that the ag and food price inflation theme more borders on being secular than cyclical. So, in the spirit of and set against these macro comments, it's time to have a quick check in on domestic ethanol and the greater ag theme.
Very quickly a repeat of a chart we’ve showed you in the past. This is the macro. We expect to ultimately break above the former late 1980's/early 1990's rate of change highs in the annual rate of change in the CPI food component. When? We wish we knew. But sooner rather than later would not surprise us in the least. We've made a few modifications to the chart we showed you earlier. First, you can see the rising longer term lows in rate of change since the early 1990's through to the present. Secondly, the declining tops trend line dating back to 1990 was broken in 2004 and retested successfully in 2006. For all the chart breakout devotees of the world, this one has longer term change in trend written all over it, no?
As you might guess, we have a lot of charts that tell the larger story here. We'll keep the commentary brief. We're indebted to the wonderful folks at the Renewable Fuels Association for much of the data regarding ethanol you will see. They are an industry advocacy group for the corn and greater ag community involved in renewable biofuels of all kinds. Before getting started, as we have maintained for many a moon now, we believe corn based ethanol is a relatively uneconomic proposition. Moreover, it's the unintended consequences of ethanol related US energy policy that really interests us in terms of investment themes. But, what is important to realize is that as the price of actual crude moves ever higher, and this is especially true over the last year, the hard core economics of corn based ethanol change in terms of becoming more attractive at the margin. Hence, the higher crude prices grow, the more potential capital is attracted to the corn based ethanol industry. Let's get to the big picture.
First, all of the numbers we are presenting below are through year-end 2007. There are a few estimates floating around for 2008 that we will weave into the discussion. Point blank, decade to date, the number of biofuel plants that have come online in the US only has nearly tripled, and also doubled since 2004. In other words, a lot of capital has been sunk into plant and equipment over a relatively very short period of time. Regardless of changing micro energy ethanol economics month-to-month or year-to-year, there is no way these sunk capital costs are going to be sidelined in terms of forward production. As you'll remember, one of the largest warnings we have given you over the last two years in terms of residential real estate prices has been stranded or sunk capital among the builders. The builders spent so much on entitlements, permitting, land costs, infrastructure improvements, etc., that they literally had to continue building well beyond what was the recognizable cycle peak for the industry and the asset class. Stranded capital among the homebuilders remains an issue to this day. So too is stranded capital or sunk capital costs an issue for ethanol production, again regardless of short-term economics.
Certainly the recognition of the true energy efficiency economics of ethanol is being addressed by the industry as the number of ethanol plants currently under construction as of YE 2007 has fallen from YE 2006. These folks are not blind. A number of prior capacity expansion and build out projects have been put on hold. But again, as crude prices creep higher, these delayed capacity build out projects will be waiting in the wings for their respective curtain calls.
As of the latest annual report from the RFA, these folks believe maybe 2 billion gallons of project capacity has either been delayed or cancelled, but this is out of about 5 billion in former capacity expansion projects previously announced. As you can see in the chart below, through YE 2007, about 6.5 billion gallons of ethanol production capacity are up and running. The estimates for what will come online in terms of capacity additions in 2008-2010 would bring this number to between 8.5 and 10 billion gallons. A meaningful increase? You bet.
So there it is. This is what the infrastructure of US domestic ethanol capacity looks like right now, along with a few tidbits as to where capacity is headed as we move forward. Does this represent meaningful demand for corn and have implications for the price of corn as an ag commodity? C'mon, do we really have to answer that question for you? Let's drill down a bit into what is happening to physical corn. First, as you can see below, the physical demand from the ethanol industry for actual bushels of corn as an input has almost increased fivefold over the last decade. Through YE 2007 it's up over 100% since YE 2004. Massively meaningful in terms of marginal demand and pricing. Overwhelmingly meaningful.
And as you would only expect, corn as a commodity has dutifully responded by doubling in price over the recent past. With 68 new ethanol plants still under construction on top of a 2007 YE base of 139 (a near 50% industry capacity expansion), the demand for corn in ethanol production will only increase in the remaining years in the current decade.
As a quick tangent, let's put this demand from the US corn ethanol industry into a bit of broader perspective. From the folks at the US Department of Agriculture, it's estimated that 9% of total world corn supply is the demand figure for the US only corn based ethanol industry. Remember, the US is the world's largest producer/exporter of ag products by far. But what is absolutely clear is the growing displacement factor of ethanol versus food use for corn that is increasing at a rate much greater than increased production.
But perhaps as amazing as the above numbers may seem, in good part they pale in comparison to the level of US corn ethanol demand as a percentage of US specific corn production. Using numbers the folks at the USDA again have provided, in rough terms US corn ethanol demand could easily soak up one-third of total US corn production in 2008, up from 11% in 2004. Over this very same period of time, total corn acreage planted in the US has increased only 19% at best. Without question, more production is absolutely on its way to meet these demand numbers, especially if prices remain elevated, as we certainly expect they will.
We know we've dragged you through the data point mud in terms of reviewing the character and dynamics behind the US corn based ethanol industry. But we believe this is very important to keep in mind as this incredible infrastructure build out causing a big increase in actual bushel demand for corn is occurring at the exact time emerging market populations are demanding more and better ag products, given their rising level of wage growth. In one sense, a bit of the perfect storm as global demand and supply collide, with demand for corn based ethanol energy simply adding fuel to an already open fire. Although we see a lot of ranting and raving over food price inflation, we believe it's meaningful to review the actual supply and demand facts behind these claims. US corn based ethanol is an important adjunct story to the greater ag theme playing out right before our eyes. And it's not about to dissipate in significance anytime soon.
As explained, ag commodity prices are being driven by a perfect storm of sorts with multiple drivers coming together at one time. The weak dollar is raising commodity prices of all types in global markets. Shame on us. A misplaced US corn based ethanol policy has had and will continue to have direct price consequences on really global ag commodities. Although we'll save this for yet another discussion, or portion of a discussion, current inventories of such basics as corn, wheat and soybeans rest at multi-decade lows. And finally, and really most important in the longer-term picture, globalization has and will continue to cause higher food production demand from the emerging economies. The perfect storm can only be assuaged for now through higher prices. Inevitably the global economy will respond with efforts to increase both production and yield, but that takes years. So for now, the global supply and demand picture will clear through price. The second step in economic response ahead will be yield (think fertilizer and seeds) and finally increased acreage planted. The bottom line is that for now, global ag dynamics mean that agricultural remains a very attractive investment theme. The downside is that it is far from a mystery and has attracted a lot of hot performance oriented money. Expect volatility in financial asset prices that reflect the theme, despite sound fundamental underpinnings. Exactly what we have been seeing over the last few months.
© 2008 Brian Pretti