While it may feel like the IS family fell off the planet, we are actually alive and well. Insanely and unnecessarily busy, but well. The posts have been sparse over the last couple months, and my blogging motivation has been low, but we are doing well. In the near future I’ll write an update about what we’ve been doing, and what’s next, but today’s post is really about just one thing. My latest mistake So long as we are alive, we will continue to make mistakes. (Sure beats the alternative, right?!) Well we’ve been directly exposed to agricultural commodities for a couple years now, and I am rethinking the logic behind it.
To be more specific, I feel that many of the rules governing the pricing of our underlying agricultural commodities has changed. Sure, the irrefutable laws of supply and demand remain intact…..but much of the rest of the game has changed. Below are my three key conclusions:
Overcapacity in the United States– As always happens during boom cycles, the acreage of planted grain production in the US exploded over the last 15 years. A key driver of this boom was the extremely cheap credit over the last 8 or 9 years, but there were other important factors also. Cheap credit allowed farmers to buy more land, and encouraged the further expansion of highly leveraged corporate farms. The same cheap credit also allowed farmers, be it individuals or corporations, to get short term loans to keep their operations afloat until harvest time. It all worked well and good so long as the value of farm land and/or crops continued to climb. Unfortunately, they haven’t.
In addition to overcapacity resulting from more acreage being brought into production, the crop yield on a given piece of property has also continued to increase in recent years. American agriculture has done a remarkable job of increasing food production on the same amount of land, over the recent decades. In comparison to the 1950s, an acre of row crops today can expect to yield 400% to 500% more food. Obviously, the exact statistic varies depending on geography…..crop type…..etc, but it is obvious that more is being produced with less.
Strong dollar- The United States has produced much more food than we can consume nationally, for several decades. The US is a huge exporter of raw agricultural products. Since those products are being sold overseas, the exchange rate has a significant impact. The US dollar has appreciated against many world currencies over the last couple years, which makes our agricultural exports more expensive and places inflation pressures on many of our buyers. This dynamic has the combined function of being a headwind to sales and encouraging foreign competitors. For example, Russian and Australian wheat exports have taken a larger share of the world market recently, as their weakened currencies makes those products less expensive than American wheat exports.
Trade- Open trade is crucial for any product that requires foreign buyers. The recent wave of populist politicians has spent a great deal of time bashing the idea of “free trade”. While we can debate the merits of free trade at another time, it should be fairly obvious that a reduction in free trade will lead to fewer agricultural products being sold overseas. That will help throw the supply/demand dynamic out of whack…..unless production in the US is reduced by an equivalent amount. Eventually I think it will be, but it will take time for the balance to be restored if global trade becomes harder and harder.
One of the biggest casualties of the US pulling out of the Trans Pacific Partnership (TPP), might just be the American farmer. China imports a tremendous amount of agricultural commodities from the US, but I expect that number to moderate or even decline over the next few years. There are several reasons for this, such as modernizing farming practices in China and cheaper imports from other countries. The headline grabbing reason however, is the increase in tariffs and protectionism that the TPP was supposed to avoid. According to Reuters, China hiked it’s “anti grain dumping tariff” from 33.8% to 53.7% in the last 90 days. That makes an especially big difference when the US currency has already appreciated, and our goods need to cross the Pacific Ocean to get to the buyer.
This isn’t to say that I believe the price of agricultural commodities are going to go into freefall. I don’t. People will always need to eat, and eventually supply and demand dynamics balance themselves out. It is even possible that their value could rise as a result of a sharply declining US dollar, if the world for instance lost confidence in America….en mass. We had established and maintained these positions because I believed that the risk/reward balance was in our favor….and that this would be another way to hedge our US dollar exposure. It looks like that thesis was flawed, and we will be reducing our exposure to our agricultural commodity index ETF. We aren’t likely sell out completely, but our exposure will be capped in the $5k-$10k range……and I am likely to be trading around a tiny core position.
Please note that this whole dynamic could result in a great investment opportunity in the coming years. Farm land near ours (in Kansas) has declined as much as 20-25% over the last 2 years, as a result of a reduction in fracking activity and the prevailing price of grains being less than the cost of production. Eventually, a bunch of farmland will come out of production……either by foreclosure or simply because it is not profitable enough. Either way, the process should further depress farm land prices……provided the US dollar remains stable……and I would like to buy some acreage. Our sharecropper would be happy to take on some more acreage, and the return on investment should be worth my while, provided prices fall another 20%. While that may sound a bit like wishful thinking……prices increased 250% between 2000 and 2012. Here’s hoping we have cash and credit to capitalize when the boom turns solidly bust.
In what assets are you finding value currently?
Disclosure: We are long DBA. This post is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. Please do your own research, and/or consult a financial professional, before making investment decisions.