2016 Outlook: Tough markets create opportunities for adaptable producers

{1db977c1-0983-4b04-9387-9c82229d8762}_Ethanol_articleMichael Swanson, Ph.D., Wells Fargo Chief Agricultural Economist

A recurring theme in the 2016 outlook for the agriculture and food sectors is challenging. The long-term trend of improving demand due to population growth and developing country income gains has met with some difficult cyclical developments. For the U.S. producers, the stronger dollar tied to better U.S. overall economic performance remains the most difficult challenge. Even products like almonds, with few overseas competitive producers, will face weaker demand from key importers such as the European Union with the Euro trading at 1.05 to the U.S. dollar compared to 1.25 one year ago. Amongst the key export markets for U.S. producers, only China has maintained its strength of currency. However, while its currency has been stable, China’s growth rate and imports have been slowing down and troubling markets that previously have taken for granted China’s growth. So, given these challenges, what is the outlook for some of the key sectors in 2016?

net-Trade-balance

Protein sector

Protein exports comprised of beef, pork, and poultry make up the lion’s share of the key consumer-oriented category for the U.S. agricultural sector. Year to date, these three proteins have comprised 27% of the total exports in the category, and all three proteins exemplify key competencies for the U.S. within the global market. These proteins rely on world-class domestic feed markets combined with state-of-the-art livestock and food processing practices to create the safest and most cost-competitive suppliers in the global protein market. Between 2000 and 2012, the weakening U.S. dollar enabled foreign market penetration, and export intensity reached all-time highs.

Both pork and poultry reached 20% of production as net exports in 2012, as depicted in the graph below. However, for the USDA’s optimistic 2016 pork and poultry exports forecast to come true, pricing will be pressured downward to match that of foreign competitors like Brazil.

percent-of-production-as-net-exports

The beef sector, which formerly has been the least dependent on the global market for exports, also faces a major retrenchment in 2016. The much-needed rebuilding of the beef cow herd began in 2014 and will continue in 2016. The USDA’s projected recovery to 30.5 million beef cows hardly constitutes an excessive supply. For perspective, the beef cow herd was 32.5 million in 2008 when the U.S. population was 305 million. The U.S. population should grow to 324 million in 2016, leaving the market with 2 million less beef cows and 19 million more consumers. So, why the huge decline in feeder and fed cattle prices? Simply stated, the incredible run-up in prices overshot the real change in supply and demand. The weaker prices are payback for the demand sector. Secondly, three of the top four export markets have seen weaker exchange rates. So, 2016 will be a tough adjustment for cow/calf operators who became overly reliant on the unsustainable prices of late 2014 and early 2015.

USDA Cattle Prices per Hundredweight

Dairy sector

Just like proteins, the U.S. dairy sector has grown faster than its domestic constraints thanks to the global markets. 2015 statistics through August show 11% of milkfat and proteins being exported. This level is down from 2014 and the record high of 13% export of production. This modest decline in the export market produced a major softening in milk pricing. Year-to-date, 2015 milk prices have dropped $7 per hundredweight from 2014’s record high, a 30% decline. Once again, competitors such as the European Union and New Zealand benefit from their weaker currencies. The dairy futures indicate that this export battle will continue for the foreseeable future. Class III milk contracts offer an average value of $15.75 per hundredweight for 2016, and any optimism is strictly regulated to the end of the year. 2017 projects a current average of $16 per hundredweight, and suggests little support for a quick turnaround. Only the most cost competitive dairy producers will produce profits even with cheaper feed prices.

Row crop sector

Cheaper feed that allows proteins to compete for market share in the export battle comes at the expense of the row crop sector. Once again, the theme of a stronger U.S. dollar works against the ability for the U.S. to easily export. In the global grain and oilseed markets, no one seems to be prospering with $4 per bushel corn and $9 per bushel soybeans, but no one seems willing to substantially reduce production either. Countries such as Russia and Ukraine have their own problems, but major devaluations of their currencies have key import markets in the Middle East and North Africa looking to them for sourcing feed grains and milling wheats as opposed to the U.S. with its stronger dollar. On the oilseeds’ side of the equation, Brazil, Argentina, and Canada can also offer dollar-based discounts to grow their exports at the expense of the U.S. With 40% of the U.S. production of wheat and soybeans being exported, this competition limits upside potential. Likewise, 20% of U.S. corn also needs to be exported to meet the USDA’s estimates.

Weaker exports of grains and proteins have a currency exchange basis, but the ethanol market has a different source of weakness. $40 to $50 per barrel crude oil places a limit on the value of ethanol. Ethanol is projected to consume 5.2 billion bushels (44% utilization) of corn out of the total domestic demand of 11.9 billion bushels. This caps ethanol producers’ ability to pay more for corn without an increase in crude oil prices. Taking the USDA’s averages for November 2015 ethanol and Dried Distillers Grain (DDG), ethanol was offering about $5 per bushel of revenue at the plant. The cash cost of converting a bushel of corn into ethanol and DDG has a wide range depending on the plant technology and operator, but even a good operator spends at least 35-55 cents per bushel. With a 2.8 gallons-per-bushel relationship, ethanol producers need to buy their cash corn at around $3.50 to $4.00 per bushel to break-even. This “cash in to cash out” relationship rules the market for the largest consumer of corn.

US Crop Production

At the farmer level, the adjustment process to the stronger U.S. dollar and the weaker energy market continues to grind away. 2015 saw the second strongest crop production year ever using a “corn equivalency” metric. The corn equivalency weights crop production relative to the long-term price ratio to corn values. Soybean has a 2.5 weighting, and wheat has a 1.5 weighting, based on their pricing to corn over the last two decades. Two consecutive record years of production have helped producers by presenting record volumes to sell, but also hurt producers by depressing prices. Currently, the 2016 Chicago Mercantile Exchange (CME) futures don’t offer any relief for producers who require higher prices to cash flow.

Underneath the crop price surface, the cost factors continue to adjust to the new $4 corn and $9 soybean world. The top five categories of expense; cash rent, fertilizer, seed technology, machinery, and crop chemical account for more than 80% of spending per acre. Every single category will be forced down to meet the lower revenue per acre based on their contribution to yield. This adjustment process will be painful as input suppliers try to make their case for their share of the lower revenue. Producers must understand and manage to the different marginal revenue products of the inputs. But most producers do not have a firm handle on either the concept or the numbers. This makes the adjustment process a long and confusing slog, but the market will work out the right numbers for all the inputs after trying all the wrong ones. The producers who make the right decisions most quickly will prosper at the expense of the laggards.

cumulative-value-of-field-crops-in-the-US

What about all the other field crops like hay, cotton, and rice? They will continue to dance to the same tune as the “Big Three” field crops that set the market for cash rents and inputs, while also dealing with the strong U.S. dollar. Some “program crops” have unique support mechanisms that help to lessen the sting of the current market. Even with support programs, crops like sugar and peanuts have felt the pushback of millions of acres looking for some place to make some money. However, even a couple hundred thousand acres of additional production in crops such as dry beans or rice can swamp prices without a strong export market to absorb them. This should cause farmers to be cautious about looking to far a field for a substitution crop to offset the pressure from corn and soybeans. It is far too easy to look at today’s prices when making an acreage allocation decision.

Conclusion

The strengthening dollar and weak crude oil prices will make 2016 a challenging environment for both livestock and crops. No one can accurately forecast how long these developments will be in place, and there are as many stories as there are storytellers in the market place. Unforeseeable events that shock the market and change market trajectory can always occur, but producers should not count on them for short-term help. 2016 will be a year for tough decisions made and implemented quickly in order to preserve working capital and prepare for opportunities in 2017 and beyond.

James Cardoza

Michael Swanson, Ph.D. , Wells Fargo’s Chief Agricultural Economist, forecasts key agricultural commodities such as wheat, soybeans, corn, and cotton, along with livestock sectors such as cattle, dairy, and hogs. Additionally, he helps develop credit and risk strategies for Wells Fargo’s customers, and performs macroeconomic and international analysis on agricultural production and agribusiness.

Michael joined Wells Fargo in 2000 as a senior economist. Prior, he worked for Land O’ Lakes and supervised a portion of the supply chain for dairy products, including scheduling the production, warehousing, and distribution, and also supervised sales forecasting. Before Land O’Lakes, Michael worked for Cargill’s Colombian subsidiary, Cargill Cafetera de Manizales S.A., with responsibility for grain imports and value-added sales to feed producers and flour millers. Michael started his career as a transportation analyst with Burlington Northern Railway.

Michael received undergraduate degrees in economics and business administration from the University of St. Thomas and both his master’s and doctorate degrees in agricultural and applied economics from the University of Minnesota.