Mother Nature has unleashed her fury in ways not seen in most peoples’ lifetime. With the unseasonably mild winter, tornados, the recent Tropical Storm Debby that caused widespread flooding, and now severe drought conditions, 2012 is shaping up to be the year of natural disasters and as commodity investors know, an angry mother nature can mean a market full of volatility [for more commodity news subscribe to our free newsletter].
Currently, 63% of the nation is experiencing drought conditions with much of the plains all the way to the Ohio valley experiencing even worse conditions that NOAA labels as extreme. Although some relief is forecasted, NOAA estimates that many areas would need 9 to 12 inches of rain to end the drought and that is unlikely to occur.
Seed technology has evolved to make crops more resilient to dry conditions but technology can’t combat what is now referred to as the worst drought in recent history.The U.S. Department of Agriculture is now forecasting a total harvest of 12.9 billion bushels representing a 12% drop from their June estimates. Investors were caught off guard by this more bearish than expected forecast causing corn prices to soar more than 30%.
For investors bullish on corn, the recent news resulted in profits but if the forecasts are correct, short-term profits may give way to longer-term economic pain and much tougher market conditions for investors to navigate [see also Invest Like Jim Rogers With These Three Agriculture Stocks].
Most of the corn found in the Midwest won’t be served on family tables as corn on the cob. It will be processed and used for the feeding of livestock and the production of ethanol. A corn and soybean mix is the primary food for most livestock and as corn becomes less plentiful and price of futures contracts climb, farmers are forced to pay more to feed their livestock.
Because the price of livestock rises long after the price of the feed, the higher prices farmers are forced to pay reduces their profit margins. Next year’s yields will be affected as farmers have fewer profits to reinvest into their farms. This may increase food inflation, causing more strain on consumers’ budgets.
Each year farmers adjust the amount of each crop they will plant in their fields. The USDA predicted this year to be a larger than normal corn crop due to the increasing demand of corn for use in the manufacture of ethanol. Beans and wheat are not only in shorter supply because of a smaller crop but when corn prices rise, farmers use more of these crops to feed their livestock. This, along with a smaller yield due to the drought, will cause other crops to have some degree of correlation to the price of corn [see also Jim Rogers Says: Buy Commodities Now, Or You’ll Hate Yourself Later].
Corn is more than a source of food. It now serves as an energy source and that has made the supply of corn under increased pressure to meet the demands of both energy and food consumers.
It takes one-third of a bushel of corn to produce one gallon of ethanol. In 2011, farmers used about five billion bushels of corn to feed their livestock while 5.05 billion bushels of corn were used to produce the ethanol that powered Americans’ automobiles and other machinery.
A report by the Agricultural Marketing Resource Center found that the price of corn correlates with other fossil fuels. This correlation has increased as corn-based ethanol has become a more substantial source of energy. Just as gasoline prices move with the price of oil, the report found an increasing correlation between corn, oil and gasoline, making the 2012 drought worrisome for energy traders as well as grain traders [see also 25 Ways To Invest In Crude Oil].
Commodities traders know that price fluctuations in everything from grains to gold correlate to overall market conditions. With the price of corn driving up the price of staple grocery items like meat, cereal and many other items, some economists worry that increasing prices will place added pressure on households already feeling the effects of high unemployment, lower wages and debt obligations. A slower economy puts pressure on all commodities and these variables are hard to predict, according to seasoned traders.
Most agree that prices will rise but not everybody believes that the increase will be as dramatic as some predict. The USDA reports that only 14.6 cents of every dollar spent at the grocery store goes to farmers. The remainder of the price of food comes from processing, advertising and other overhead costs meaning that most of consumers’ food costs aren’t as levered to conditions in the fields as some report.
Implications for Traders
Commodities traders have heard these alarms sound many times in the past. They remember the parabolic rise of oil in 2008 only to see it fall a short time later and they’ve seen corn fluctuate as much as 48% since June of this year.
For new commodities traders, attempting to take in to account weather conditions and USDA forecasts that many criticize as largely inaccurate makes for a difficult trading environment. One study found that the average error in USDA corn forecasts was +/- 4% from 1990-2010 equating to about a half of a billion bushels. Even the most seasoned traders know that when a commodity rises or falls outside of the norm, it will often revert to the mean [see also Doomsday Special: 7 Hard Asset Investments You Can Hold in Your Hand].
The 2012 drought is quickly earning the distinction of the worst in modern history and while that may present short term trading opportunities in corn, traders may find the ripple effects to other commodities far from profitable.
Disclosure: No positions at time of writing.