BofAML Explains Why The Ag Economy Isn't Likely To Get Much Better In 2017

The fact that farm incomes have come under increasing pressure over the past couple of years should come as little surprise to our readers (for those who missed our latest update, see: "Midwest Farm Bubble Continues Collapse As Farm Incomes Expected To Crash In 2017").  Unfortunately, at least according to Bank of America"s Global Ag Chemical team led by Steve Byrne, farmers shouldn"t expect a reprieve any time in the near future.

As BAML points out, the grain commodity farmers of the U.S. are locked in a vicious cycle, the result of which is a perpetually oversupplied market.  To summarize the key takeaways, farmers continue to plant so long as cash profits are positive (because depreciation isn"t a real cost and who cares about returns on capital anyway...silly finance people) while yield growth continues to outpace demand growth which leaves markets perpetually oversupplied and commodity prices well below what would be required to provide a normalized profit level for farmers.  Meanwhile, since farmers seem to be incapable of unilaterally reducing supply, an external supply shock (e.g. a weather-related event) seems to be the only hope of the industry ever normalizing again.

With that, here is a little more detail on the vicious ag cycle per BAML...

Yield growth per acre continues to average 1-2% per annum...

Yields continue to improve with no sign of abatement as seed technology improves and farmers utilize better information technology (precision ag) to gain better understanding of acreage and maximize yield potential. While weather can disrupt yields year-to-year, directionally yields have improved at a 1-2% CAGR for corn, soy and wheat since 2000. In our view, this will continue to place deflationary pressure on crop prices longer-term, particularly given the extent to which global yields trail yields in more developed ag economies.

...which continues to drive new record highs in production despite an already weak pricing environment.

Global corn production is similarly heading for a new record high in 2016/17, up 7% YoY and driven mostly by an almost equally big rise in yields. The US 2016/17 crop that was just harvested looks especially strong. Concerns over whether ear filling was impeded by the hot and dry summer weather are now fading as the harvest is done and the USDA revised up its yield estimate by 1% to 11.01mt/ha in November. Meanwhile, in LatAm farmers are currently planting for the 2016/17 harvest and production looks even stronger, up 26% on presumed yield normalization and exacerbated by a 7% increase in acreage.

Meanwhile, global corn demand is expected to recover somewhat in 2016/2017 but no where near the expected 7% supply increase.

Global corn demand growth slowed to just 2% per annum in the past two years, due to a drop in global pork production. Corn is the staple diet of the word’s more than 1bn pigs. The decline in pork production was mainly caused by an environmental crackdown in the Chinese farming sector, and the country’s pork production fell by 3% in 2015 and another 5% likely in 2016.

Then in March 2016, China ended its domestic corn price floor, giving relief to pig farmers, and corn demand started picking up again. Corn demand from pig production will continue to rise structurally in the years to come on the ramp-up of new modern mega farms in Northern China. Overall global corn demand can recover to 3% growth this market year (2016/17) and hold up at 2-3% growth annually in the years to come, in our view. However, we have started to see signs of slowing feed demand as elevated corn prices have led to substitution to other feeds, in some instances. Global feed demand levels will be key in determining the aggregate corn demand picture.

All of which is expected to keep global grain stocks at all time highs for the foreseeable future...

World carryout corn stocks are likely to finish 2016/17 at a record high, with stock-to-use ratios up marginally from the year prior. There is debate over the level of Chinese stocks, with estimates ranging from China’s corn reserve estimate of 270Mmt vs USDA estimate of ~110mn mt. The USDA expects Chinese corn production to decline by ~3% in 2016/17, and inventory levels to decline by ~8% in 2016/17 after swelling from 81mn mt in 2013/14 to 110mn mt in 2015/16. Recent policy aimed at reducing production out of lower-yielding regions could also help alleviate China’s elevated inventory position. Media reports have also indicated more than 900 companies have applied for import quotas for 2017, which could be supportive of global prices. USDA data suggests soybean inventories in China remain elevated as well and account for over 20% of global stocks (Chinese stocks to use ration remains well over 100%). China accounts for over 60% of global soybean imports, and thus inventory levels in China are a key factor in gauging global demand expectations. A clear indication of a drawdown in Chinese soybean stocks could provide price support, in our view. Nonetheless, China’s inventory levels, trade data and policy direction will remain key components of corn and soybean prices in the coming year.

And, of course, as long as cash margins remain positive then farmers keep planting...which doesn"t do much for that weak pricing environment.

Farm income, planted acres of row crops, and commodity prices all peaked in 2012 following the prior decade long super-cycle. Prior periods of ag credit cycle downturns lasted 5 years (68-72) and 9 years (83-91) while ag business cycle downturns have averaged 2 years since 1960. Inflation adjusted crop prices have been declining for over 100 years as gains in productivity (+1-2%) and acreage expansion (0-1%) outpace gains in demand (1-2%). New technologies such as precision agriculture and gene editing could accelerate productivity gains in the medium term. Cyclical upside could occur from increased demand for protein, reduced supply from marginal acres, or a weather event.

We expect cash margins for corn, soybeans and wheat to collectively be slightly higher than the prior year, but well below the ~2007-2014 profitability boom amidst elevated prices. We expect crop commodity prices for each to remain low amid elevated global stocks. Profitability will also likely remain a challenge and at similar levels to prior year levels exacerbated by elevated leverage, with US farm debt to net cash income at its highest level since 1984.

In our view, cash margins may have room to fall before seeing a rational supply response. Margins are still above breakeven levels that occurred 15 years ago (1999-2003) and not at levels that could drive meaningful changes in farmer behavior, such as walking away from land rent or simply not planting acres in a given year.

But, at least farmers have that whole trade war with Mexico to look forward to...luckily Mexico is just our second largest corn importer...

In our view, the risk of a trade war with key importers of US crops remains a key risk for the US ag economy. Trade with China (14.8%) and Mexico (13.6%) represent top destinations for US ag export demand. Additionally, a potential border adjustment tax could significantly inflate fertilizer prices and together with lower grain prices could further impair farmer margins. Potential reform to the Renewable Fuel Standard is also a downside risk for US growers given 40% of domestic corn demand is derived from ethanol. A stronger USD resulting from proposed policies would also be a headwind for US growers. Washington will remain critical for agriculture with upside risks being the status quo and downside risks being more meaningful.

It"s pretty rough when your only hope of making money in your chosen profession will come only after a devastating weather event that may or may not force you into bankruptcy.

Mexico Prepares Plan To Ditch U.S. Grain Imports As NAFTA Showdown Looms

America"s Midwest farmers can"t seem to catch a break.  First, an epic collapse of grain prices over the last couple of years have threatened to wipe out family farmers (see "Midwest Farm Bubble Continues Collapse As Farm Incomes Expected To Crash In 2017") and now, thanks to the pending NAFTA showdown threatened by President Trump, Mexico, the single largest importer of U.S.-grown corn, has announced plans to find alternative grain sources in South America.  Per Bloomberg:

The Consejo Coordinador Empresarial, one of the nation’s top business chambers, is examining countries such as Brazil and Argentina to add new sources for soy, corn and wheat, according to Juan Pablo Castanon, the group’s president. Exports from those countries could help Mexico adjust to the difficulties that a Nafta renegotiation might present, he said.

“The renegotiation might bring increased costs to imports, and our own exports might be hurt, so we need to find new markets,” he said in a phone interview, adding that the group’s efforts are still in the initial stages. The chamber, established in 1976, represents the country’s main agricultural, industrial and financial industry organizations, among others.

"We’d like to keep the trade deal as it is, but right now we have to look for alternative producers and Brazil and Argentina could work,”
Castanon said.

Of course, any move by Mexican businesses to import raw materials from other countries could hit U.S. farmers hard. Mexico is the largest buyer of U.S.-produced corn, spending $2.5 billion in the 2015-2016 season, ahead of Japan’s $1.8 billion, according to the U.S. Grains Council. Moreover, Mexico has spent $800 million on U.S. corn so far in the current season. 

Of course, grain imports aren"t the only raw materials for which Mexico is actively looking for alternative sources as Sigma Alimentos SA, Mexico"s meat-packing conglomerate, is also looking to Brazil and Chile as alternative supply sources.

The push is not limited to grains, Castanon said. Other imports such as meat are also being considered. “An economy as important as Mexico’s needs to have secure supply sources on many fronts,” he said.

Sigma Alimentos SA, the meat-packaging unit of Mexican conglomerate Alfa SAB, is looking into countries such as Brazil and Chile as new sources of raw materials, Chief Financial Officer Eugenio Caballero said on a call with investors last week.

Switching suppliers isn’t as easy as flipping a switch. Mexico depends heavily on rail for imports from the U.S. and Canada, which wouldn’t work for goods from South America. But Mexico’s ports could handle imports from the south, and the benefits would outweigh the costs, Castanon said.

“We need to open new doors,” he said. “As the trade talks progress, we’ll see how we need to make use of them.”

So where does that leave the American farmer? Well, not in a great spot given the already dire position they"re in.  For those who missed it, below are some stats from the USDA detailing the financial condition of the American farmer.

* * *

Real farm incomes in 2017 are expected to sink below 2010 levels which represents a 36% decline from the recent peak and a 14% decline since 2015.

Meanwhile farm debt continues to rise at an astonishing rate...

While farmer leverage has spiked to the highest level since at least 1960.

And of course, lower incomes means less money to spend on shiny new John Deere tractors with equipment capex expected to decline 35% compared to 2015.

And finally, farmer returns have crashed to the lowest levels ever.  We"re not sure about you but a 2.1% ROIC seems a "little low" even in our current rigged interest rate environment.  So, there"s only a couple of ways to fix that problem...either commodity prices have to recover quickly or farmland prices need to come down substantially.  Which do you think will happen first?

Midwest Farm Bubble Continues Collapse As Farm Incomes Expected To Crash In 2017

Earlier this week the U.S Department of Agriculture released its biannual report of farm incomes which paints a very bleak picture for the American farmer.  In its first forecast for 2017, the USDA sees real farm cash receipts down 14% versus 2015 and 36% from the previous high set in 2012 as farm debt continues to soar and leverage surges to all-time highs. 

As the Wall Street Journal notes, the deadly combination of rising input costs, lower grain prices, a strong dollar and excessive leverage will likely force many of America"s Midwest farmers out of business in 2017.

Costs for seeds, fertilizer and equipment climbed so high and grain prices dropped so low that he still lost more than $120 an acre. Afraid to come up short again, Mr. Scott decided last fall not to plant 170 acres of winter wheat, close to a third of the usual amount. U.S. farmers sowed the fewest acres of winter wheat this season in more than a century.

“No one just grain farms anymore,” said Deb Stout, whose sons Mason and Spencer farm the family’s 2,000 acres in Sterling, Kan., 120 miles east of Ransom. Spencer also works as a mechanic, and Mason is a substitute mailman. “Having a side job seems like the only way to make it work,” she said.

She and her husband have declared bankruptcy before. Farmers around Sterling lost $6,400 on average in 2015, the latest available data, after profits of $80,800 a year earlier, according to the Kansas Farm Management Association.

Meanwhile, America"s share of the global grain trade has been cut in half since the 1970"s giving domestic farmers less control over pricing which has grown increasingly volatile over the past decade.

The U.S. share of the global grain market is less than half what it was in the 1970s. American farmers’ incomes will drop 9% in 2017, the Agriculture Department estimates, extending the steepest slide since the Great Depression into a fourth year.

“You keep pinching and pinching and pretty soon there’s nothing left to pinch,” said Craig Scott, a fifth-generation farmer in this Western Kansas town.

American farmers’ share of the global grain trade has fallen from 65% in the mid-1970s to 30% today, giving them less sway over prices. More producers and more buyers around the world also mean more potential disruptions from bad weather, famine or political crisis.

Corn prices once varied year-to-year by less than $1 a bushel. Since 2006 they have shot up and dropped more than $4 a bushel.

So where does that leave the American farmer?  Real farm incomes in 2017 are expected to sink below 2010 levels which represents a 36% decline from the recent peak and a 14% decline since 2015.

Meanwhile farm debt continues to rise at an astonishing rate...

While farmer leverage has spiked to the highest level since at least 1960.

And of course, lower incomes means less money to spend on shiny new John Deere tractors with equipment capex expected to decline 35% compared to 2015.

And finally, farmer returns have crashed to the lowest levels ever.  We"re not sure about you but a 2.1% ROIC seems a "little low" even in our current rigged interest rate environment.  So, there"s only a couple of ways to fix that problem...either commodity prices have to recover quickly or farmland prices need to come down substantially.  Which do you think will happen first?