The commodities boom and its impact on grain farming

By Lance O. Rice

It appears that the commodity market has now caught the world’s attention. This once largely insular world of commodities trading has pushed itself to the forefront of our economic news with the prices of some of our most basic raw materials surging to new all-time highs. In fact, many of our most important commodities, such as oil, natural gas, copper, steel, wheat, soybeans and corn, have all seen dramatic price increases over the past several years. Additionally, the currency markets have witnessed the value of the U.S. dollar fall to all-time lows relative to the Euro currency unit. Weighed against the Federal Reserve Board’s trade weighted index of major currencies, the dollar has declined by more than 20 percent since 2002. What are the forces driving these rapid and dramatic price movements and how do they impact agriculture, one of our most important industries here in the Midwest? Further, how do farmers and ranchers use these markets to manage risk and increase the profitability of their operations?

Commodity and futures basics

A commodity is simply a fixed quantity of a natural or man-made resource. Furthermore, there are specific qualitative factors associated with each particular commodity. Both these factors enable the creation of a marketplace in which participants can buy and sell resources (commodities) that they either produce or utilize. Several examples: A barrel of West Texas Intermediate Crude consists of 55 gallons of a specific grade of crude oil; a bushel of corn is defined to be 56 pounds of grain of specified quality with moisture content below 14 percent.

Through standardization of quantity and quality, traders, producers and consumers can use the marketplace for these goods to either reduce or increase their exposure to future commodity price movements. An example might be helpful. A farmer that produces 100,000 bushels of corn during the year might find that the market price for his coming crop is quite attractive during the spring, well before he has even planted the first seed. Prudence might lead him to wish to sell a portion of his production at these prices to lock in a certain profit on at least that portion of his crop. In other words, the farmer wants to hedge his bet on what the price of corn will be at harvesttime. He obviously likes today’s price and might feel that if weather conditions are near normal there should be an ample supply of corn at harvest, leading to potentially lower prices for his grain. To implement this “hedge,” he would sell futures contracts on his corn. A futures contract on a commodity is an agreement to deliver a specific amount of the commodity at some specified future date. If the price of corn declines, he could deliver grain against his sale, or as an alternative to delivery, he could close the futures contract prior to settlement, locking in the gain (he sold corn high during the spring and bought it back cheaper in the fall) on the price of corn. In this instance, he would market his grain locally at the prevailing market price for his corn. Any gain in his futures position would be considered a hedge gain and be part of his crop proceeds.

Conversely, a corn miller might have the need to ensure a cost-effective supply of grain for the coming fall. Unwilling to take the risk that corn will be cheaper near harvest (a severe drought could make the price of his key input, corn, skyrocket), he might be willing to buy corn for fall delivery, via the very same futures market. In effect, both producer and consumer of corn have laid off some portion of the price risk that they face.

Both commodity and currency markets (and futures markets, for that matter) function best when they are “deep and wide,” meaning that there are lots of participants with different objectives. Enter the speculator. By taking risks that others may be unable or unwilling to take, speculators generally increase liquidity in markets. Obviously the speculator is attempting (betting) to profit from price movements in his or her favor. Having many participants with opposing objectives ensures that markets “price” a commodity or currency as efficiently as possible. This market price reflects all pertinent, known information—therefore establishing the best “price” based on supply and demand, which is currently the world’s best method for determining a fair price.

The commodity bull market—demand

No less sage an investor than Jim Rogers has been arguing for years that we are in the midst (or beginning) of a long-term commodity boom. A quick look at the prices of many of our important commodities would lead one to believe that Mr. Rogers is on the right track. Oil now has recently traded over $110 per barrel. Wheat has traded this spring at $13 per bushel on the Kansas City Board of Trade. According to the Wall Street Journal, the price of rice has increased by 147 percent in just the past year. Causation of what certainly appears to be a commodity boom can be laid at both ends of the market—on both supply and demand.

We have seen dramatic increases in the demand for raw materials, particularly from the developing world. Countries such as China, India and others are seeing their economies grow at rapid and sustained rates, increasing their demand for raw materials like cement, steel, oil and grains. Chinese oil consumption has doubled in just the past decade. With 20 percent of the world’s population, China now consumes 50 percent of the world’s cement production. China was a net exporter of soybeans as recently as 1995. Last year, China imported a net 31 million metric tons of soybeans.

At the same time, U.S. demand for corn and soybeans has increased dramatically due to our national policy of increasing our use of renewable fuels. Total corn usage in the U.S. has gone from 7,799 million bushels in 2000 to over 10,600 million bushels in 2007—an increase of over 35 percent! Ethanol use of corn alone has gone from 628 million bushels in 2000 to a projected 6,500 million bushels in 2007.

Furthermore, it appears that both these “macro” demand drivers have relatively inelastic demand curves. This simply means that it takes a relatively large price increase to bring about a moderate decrease in demand. Take, for example, U.S. demand for gasoline. National gasoline consumption has only now turned lower (just within the past few months as the U.S. appears to be entering a recession) for the first time since 1991. In other words, it has taken high and sustained high prices to force even a modest decline in gasoline consumption in the U.S.

Certainly the value of the U.S. dollar relative to other currencies must be held accountable for a portion of the rapid price increases in many commodities. Since most commodities are traded in dollars, a depreciated dollar necessitates a higher price of oil, grain or any other commodity (in dollar terms) just to keep the price constant in foreign exchange terms. An example: The European Union has historically been a major importer of soybeans. In 2000, the U.S. dollar bought approximately one Euro, thus one bushel of soybeans cost about $5 in both the United State and in Europe. With the Euro now trading at about $1.58 U.S. dollars, a bushel of soybeans now costs Europeans about $8.22 versus the U.S. price of about $13!

The commodity bull market—supply

While demand has been on an inexorable increase, the supply of many commodities has been growing slowly, if at all. Take oil, for example. Oil production has been just meeting demand for some time, even in the face of dramatically higher prices. OPEC oil production has increased by only about 20 percent in the past eight years. Crude oil production in 2007 was actually lower than 2005. Meanwhile, U.S. refining capacity has remained relatively stable (at about 16 million barrels per day) over the past 15 years. It is worth noting that U.S. refining capacity is currently lower than it was 20 years ago.

Wheat is another important commodity that has actually seen production wane over the past 10 years. As a result of stagnant wheat prices, world production has gradually declined, from 207 million metric tons in 2000/2001 to a projected 125 million metric tons for the 2007/2008 marketing year. Accordingly, ending world wheat stocks have gradually declined. For the marketing year 2000/2001, USDA’s ending wheat stocks as a percentage of total use were pegged at 35 percentage. In the 2006/2007 marketing year, that figure was just over 20 percent and is projected to be just18.5 percent in 2007/2008.

Price being the ultimate signal to farmers, production declined. With an on-farm price of just $2.62 per bushel in 2000/2001, wheat simply became less profitable than other crops. On certain marginal farmland, it simply became unprofitable to farm. What transpired was a sort of “just-in-time” grain delivery system. Prices remained stagnant until there was some sort of production problem, usually due to adverse growing conditions. Prices would spike until additional production came online, only to return to previous low levels. If you want to think about just-in-time markets, think oil market after Hurricane Katrina.

What we are seeing now, with wheat prices over $10 per bushel on the Kansas City Board of Trade, is a weather-induced price spike piled on top of our just-in-time ending stocks. A series of poor wheat crops around the globe, combined with reduced U.S. plantings (due in part to acres being switched from wheat to corn, soybeans, etc.), has led to a perfect storm in the wheat market. Wheat prices are now easily triple of what they were just two years ago.

A new era for farming

A sea change has taken place in farming. That change is called energy. Thomas Malthus postulated in 1798 that crop production would be unable to keep pace with the world’s growing population without some check. Presumably that check would bring the world’s population back down to the level of food production. Well, for 2,000 years plus, Malthus has been proven wrong. Agriculture has continued to innovate and bring new technologies to crop production, keeping a growing world well fed (excepting political reasons behind starvation). The green revolution of the 1940s, ’50s and ’60s is just the most well-known example of the dramatic increases in productivity that have occurred in agriculture over the past 60 years.

Enter the large-scale use of grain for the production of energy rather than as a food (for either humans or animals). Persistently low grain prices in the 1970s, ’80s and ’90s led farmers as a group to seek new markets for their abundant production. Ethanol was the one solution that gained footing as a means to utilize these massive grain supplies. After all, corn was cheap, and paying a farmer to produce a more environmentally friendly fuel than oil was politically attractive. Add in the continuing increase in the price of crude oil, a substantial portion of which is produced by “unfriendly” countries, and you have an industry in warp drive. Ethanol now consumes almost 25 percent of U.S. corn production—up from essentially nothing just 10 years ago.

Will Malthus be proven wrong again? It remains to be seen. Certainly more land will come back into production in response to historically high prices. But will it be enough? Will the combination of more and better technology, combined with more acres, be enough to both feed the world and provide another source of energy for our thirsty cars and trucks? It is too early to tell. One thing is certain; this is a new era for farming—an era of ever more risk.

Managing risk in today’s agriculture

While the change brought about by higher grain prices has been a huge boon to farmers, it is not without risk. Prices for agricultural commodities have increased dra­mat­ically, but so have the costs of farming. The prices for certain types of fertilizers have tripled over what they cost just two years ago. Indeed, there have been some instances of shortages of some types of fertilizers in certain locales. Agriculture is also an energy-intensive business, and fuel prices are more than double what they were just four years ago. The government safety net for agricultural producers is based in part on grain prices. Namely, low grain prices. These price-sensitive safety nets are supposed to protect farmers from market prices below their costs of production. With dramatically increased costs of production, these price-based safety nets are now essentially useless. Managing this risk on both sides of the equation (crop sales and crop inputs) is now more important than ever.

Traditionally, farming has been a livelihood with a business component, but now more than ever it’s a business with a livelihood component. In other words, if the farming enterprise is not run as a business, and run well, it may cease to be a livelihood for those involved. This means being able to take advantage of profitable prices as well as controlling costs. Many farmers are adept at using forward sales (contracting with a local elevator to lock in the price of grain today for delivery at a later date), futures sales (on the Chicago Board of Trade, the Kansas City Board of Trade or the Minneapolis Grain Exchange), and the use of options to either put a floor under the price of grain or to leave gain on some upside potential on any grain that may have previously been sold. Controlling costs now means more than shopping for the best local price. It sometimes means locking in the price of inputs far ahead of when they will be used. Problems arise in this area when suppliers cannot or will not lock up prices for inputs that match the timeframe of their crop sales. For example, selling corn in 2010 at what appears to be a profitable price based on today’s input costs could be a losing proposition. Factor in the fact that farmers must carry these input costs until the crop is actually produced and sold, and you can see that obtaining and maintaining an adequate credit facility is of the utmost importance.

Successful farm operators, large or small, will be adept at taking advantage of high grain prices and controlling costs. This “gold rush” in farming will certainly result in some operators overexpanding their operations. The potential profit will be too much for some. On the other side of the coin, not obtaining enough scale (size of operation) will mean that some producers will be unable to compete or will need to find a profitable niche outside of industrialized agriculture.

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