No end in sight for volatility

by Meyer Sosland
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The world grain market was highly volatile in 2007, with prices at record levels. Even so, the coming year is likely to be even more uncertain, according to the experts who in November addressed the Global Grain 2007 Conference in Geneva.

"The agricultural markets have been extremely volatile," Dan Basse, president of Chicago-based AgResource, told the conference. "If any of us bought grains and held on, it was a very profitable year."

He identified the growth in population and the economy, particularly in Southeast Asia, as the main driving forces behind rising prices, rather than the increase in alternative uses for grain. "It’s that combination of population density and strong economic growth that has been fueling the rising grain markets," he said. "I think that’s more important than biofuels."

He predicted more uncertainty. "I can’t leave the impression with you enough that the volatility in the grain market over the next year is going to be acute," he said.

Although there is still a long-term bull market in place, agricultural markets rarely move in a straight line. "We are already at very, very historically high prices," he said. "It’s difficult to be bullish unless you’re prepared to bet on a major weather problem. The only cure for high prices is high prices."

For the first time since 2004, he predicted relative stability in supplies, with an all-grains crop, including soybeans, of around 1.65 billion tonnes, compared with 1.64 billion tonnes of demand. "Still, we’re left with grain stocks that are only marginally higher," he said.

He contrasted the current situation with what the world was used to prior to 1999, when stocks only declined because of adverse weather.

He identified a series of bullish and bearish factors affecting the market. On the bullish side, there was the continuing biofuels revolution, with rising mineral oil prices increasing the likelihood that biofuels would be profitable, and the growth in world livestock herds. Tight stocks meant the market could be affected by supply dislocation. He believed hedge and index funds would want to increase their investment in commodities in 2008.

There was also the formation of La Niña, which could affect weather patterns. "La Niña is around today," he said. "You will find weather forecasters already calling for a major drought across the U.S. next summer."

A further bullish factor was the expansion of China’s economy at a rate of 11% to 13% a year. China needed additional oilseed and vegetable oil imports to cool inflationary pressures, while the rising yuan was boosting Chinese purchasing power.

"The one big problem that they are seeing is the massive movement of people from the farm to the city," he said. "The Chinese government has to do something to slow this inflationary trend."

It left the Chinese government with no choice but to slow the economy. "China’s harvested acreage is basically holding steady," he said. "If China is to increase production, it has to come from yield. Whether the Chinese can get that yield increase is going to be very important over the next five to 10 years."

The fall in the U.S. dollar would contribute to the arguments for a bull market, by making grains more attractive as an investment. But there are also a range of bearish factors to consider. Slowing economies, particularly in the U.S. and Europe, would limit China’s scope for exports and thus put a brake on its economic growth.

"If the Chinese are making all these goods, who are they going to export to?" he said. "Agricultural markets are now closely linked to financial markets."

Agricultural production is set to rise next year in many countries. The European Union (E.U.) has abandoned its 10% set-aside requirement, while the northern hemisphere crop has experienced better weather as it went into winter dormancy.

To cap it all, current high prices were creating demand rationing, with end users cutting grain use.

The same high prices would mean greater production. "At these high prices, I don’t look at the market to continue up dramatically over time," he said. "I would expect this bull market to run over the next seven to 10 years."

The hugely increased role of the funds in grain markets could add to the volatility. He put the total fund investment in agricultural commodities at $150 billion in 2008. "If they were to liquidate a third of those positions, that would have a sizeable impact on price levels at the CBOT (Chicago Board of Trade)," he said.

For example, AIG/Goldman funds will rebalance in early 2008. Although there will be no big percentage changes in their agricultural allocations, AgResource estimates that, based on current prices, both funds would sell a combined 19,000 to 24,000 contracts of soybeans, 16,000 to 21,000 contracts of wheat, and buy 60,000 to 72,000 contracts of maize. This rebalancing will have a market impact in January and early February.

AgResource has predicted a sharp rise in world wheat production in 2008-09, taking the total to 648.10 million tonnes compared with 605.13 million in 2007-08. That figure included a U.S. crop of 63.1 million tonnes, up from 56.25 million the year before. Basse expected the E.U. crop to pass 130 million tonnes, making it the second largest on record.

AgResource’s estimate is 134.4 million tonnes, compared with the previous year’s 120.86.

Australia’s drought-stricken 2007-08 crop of 14 million tonnes is unlikely to be repeated. "History is against three consecutive droughts in Australia," he said. "We’re looking at a dramatic increase in Australian wheat production next year to 23.5 million tonnes." AgResource also predicted increases for Canada, up to 25.5 million tonnes from 20.6 million, the 12 former Soviet countries, to 95 million from 91.04 million, and India, up to 76 million from 74.89 million. "There is going to be much more competition in the world in the wheat export arena," he said.

China’s wheat production, however, would fall to 102 million tonnes from 106 million.

He recognized that 2008 would follow a bad year. "Everything went wrong that could have gone wrong with the wheat crops last year," he said. But Basse noted that there was a longer-term problem. "Wheat yields have generally been going nowhere since 2003," he said. "There will be pressure for the world to accept GMOs. The world is going to have to get much better yields."

He looked at the U.S. as an example. "U.S. acreage is going to have to reach up to somewhere in the region of 224 million hectares to grow what’s needed," he said. "No matter how I do the math, I can only get that to 220."

To do better, the U.S. would have to bring land out of reserve. "The U.S. government is going to have to tap the CRP (Conservation Reserve Program)," he said.

According to Basse, high grain prices are likely to mean that people in the west will have to spend a higher proportion of their income on food, compared with around 10% in the U.S. and Europe now. "I expect in the next five to 10 or maybe 15 years we will find ourselves back at around 15 percent in terms of the amount of disposable income you and I spend on food," he said. "Everything is going to be costing more as we look forward."

Both Basse and the speaker who followed him — Bob Steele, global wheat coordinator for Nidera — identified high freight prices as one of the biggest issues facing the sector. "Every time you turn around the freight costs you more," said Steele.

Basse said it could mean a shift away from trade in grain to more expensive products like meat. "At high freight rates, it makes more sense to import more value added," he said.

Even with the record-high grain markets, the percentage of freight in the delivered price is also at a record-high level, Chris Thomlinson, senior analyst at shipping broker Thurlestone Shipping, told the conference. "The trade needs to be fully aware of the freight market and trends," he said.

The freight market had been driven higher by demand from China. "There’s no doubt that coal has played a significant part in the development of this market, but the key is iron ore," he said. "Spot prices of iron ore have soared to record values. It’s indicative of an extremely tight market in China."

China is likely to need more iron ore as its own supplies diminish. "China’s (foreign exchange) in ore is declining, and it’s declining sharply," he said. "They might dig up much more iron ore, but the useful content of it is declining. There is little growth left."

Thomlinson added, "You (haven’t) seen (anything) yet in terms of what’s going to be moving on the water." The shipping markets have realized this and owners are investing in new tonnage. At the end of

February 2007, there were 905 bulkers for 2008-11 delivery. By the end of October, there were 2,227, a figure which represents 53%t of the current fleet. "Because we’ve had superheated freight rates, the price of new building has become very attractive for yards," he said. "It should be enough to really put the frighteners on anybody in the dry bulk market."

Even so, he expected to see a tight or tightening freight market for most of 2008, with supply growth starting to undermine the market in 2009. Even the most optimistic demand growth scenarios for trade do not outweigh the intended expansion in the dry bulk fleet.

Basse forecast a secondary high in old crop world wheat prices for early 2008, with quality wheat classes leading the rally.

Steele reckoned that most of the world’s buyers are well covered up until the first quarter. He expressed concern over government interference in some markets, particularly in Russia and Ukraine, which have moved to limit exports. "It’s just not going to go away," he said. "It will cause more volatility."

Brian Perrott, partner at the London, England law firm of Holman, Fenwick & Willan, said it is important in a volatile market to make sure you have the contract terms right. "We’re seeing the smallest of clerical errors converting into the largest claims," he said.