TL;DR
- Higher interest rates have led to reduced commodity inventories and contango curve structures, encouraging speculative short selling. This positioning differs dynamically from historical carry trades.
- The war in Ukraine has disrupted production and exports. Russia is now targeting infrastructure to undermine Ukraine’s pricing power. This could allow Russia to dominate regional trade flows. Lower Ukrainian production and higher transportation costs could lead to more significant disruptions.
- Agricultural production in Argentina has declined due to economic turmoil, while Brazil’s continues growing. This shifts trade flow opportunities to more stable nations like the U.S., Canada, the EU, and Australia.
- Factors transforming U.S. agriculture include plateauing corn/soy acreage, expanding renewable diesel capacity, increasing oilseed demand, and new crushing plants coming online. The U.S. may pivot from being a global soybean oil exporter to feed the growing domestic demand, while maintaining or even increasing soybean meal exports.
- Overall, tightened supplies and shifting trade flows suggest opportunities for price volatility. Macroeconomic instability in key exporting nations could further disrupt global agricultural markets. The trends point to increased uncertainty and potential for supply-demand imbalances.
All asset classes are recalibrating themselves to the higher interest rate environment, and the commodity markets are no exception. We’d first like to highlight a few developments as we believe they provide important context around the current positioning and dynamics of the marketplace before discussing other major trends that we think will have future pricing implications.
In our opinion, higher interest rates have had two major consequences on commodity markets. Firstly, as rates increased, companies de-stocked to just-in-time inventory because their freed-up cash could now earn a yield. Previously, when rates were low, companies had weeks, if not months’ worth of inventories on hand because their cost of capital was so low. Secondly, higher rates have also meant higher storage costs, which need to be reflected in the curve structure.
As a result, many commodity markets, especially agricultural markets, moved into contango. The resulting wide carries have encouraged speculative short selling to capture the roll yield. If we look back historically, passive short selling related to large carries would typically have been the result of burdensome stockpiles. Today, however, the passive short is trying to capture the roll yield resulting from these higher interest rates. While both scenarios aim to achieve the same outcome, they are dynamically different. In the past, the short could rely on physical deliveries as a stopgap, while the same is not true for today’s environment.
Many countries are major producers of agricultural products, but here we will focus on three areas: Russia/Ukraine, Brazil/Argentina, and the United States. We are seeing major changes occur in these three regions that will likely have a lasting effect on trade and potentially even alter the current composition, which has been driven by the interest rate environment.
Russia/Ukraine
The war in Ukraine has now been ongoing for more than 18 months. While we cannot be certain, we believe it’s likely that Russia’s initial goal was to retake land along with enormous amounts of resources, both in terms of production (land) and infrastructure (ports), to increase control of regional trade flows. Ukraine is a top ten producer and exporter of wheat, corn, and sunflower seed.
However, as the war dragged on and the Ukrainian counteroffensive became more formidable, Russia pivoted. Russia started to target infrastructure critical for trade capabilities, such as ports, grain terminals, and crush plants through drone strikes. If Russia could not succeed in taking control of production and the assets to move it, the next best outcome was to prevent its biggest competitor from being able to move its supply. By targeting this infrastructure, transportation, and insurance costs increase. These costs are absorbed by the Ukrainian exporter through discounting interior prices paid to the Ukrainian farmer. We speculate a goal of this strategy is to drive domestic prices low enough that the Ukrainian farmer goes bankrupt. This accomplishes the same goal for Russia; control/dominate trade flows from this region.
At the same time as Russia pursued this new strategy, government entities assumed control over many of the joint ventures that were in place with multinational agribusiness companies. Additionally, some of these companies decided to exit Russia altogether. Thus far, Cargill, Glencore, Viterra, Olam, Louis Dreyfus, AGCO, Bunge, ADM, Corteva, and Linas Agro Group have either withdrawn or suspended operations.
If successful, Russia will see Ukraine’s pricing power diminish due to lower production and higher transportation costs, while Russia will become a dominant price setter. The wheat market has seen this dynamic play out this year. These dynamics are analogous to OPEC and oil prices. While the story is far from over, we highlight these developments due to their potential to alter trade flows and pricing powers, leading to greater disruptions and price volatility going forward.
South America
In South America, the main theme has been the divergent trend between the supply growth of Brazil and Argentina. While farmer margins and weather play the most critical roles in determining supply, it is difficult to overlook how politics, taxes, and the general state of the economy might impact farmer decisions. Argentina has been plagued by government corruption for many years, leading to a massive devaluation of its currency and hyperinflation. The consumer price index hit 124% year-over-year in August despite interest rates being at 118%. Its unofficial currency rate, referred to as the Blue rate, has exceeded 800:1 versus the USD, compared to 175:1 two years ago and roughly 10:1 ten years ago.
From the late 1990s to 2010, Argentina’s soybean production grew from 10 million metric tons to over 50mmt. Its production peaked in 2015 at 61.4mmt, and since that time, it has steadily declined to a 5-year average of 43.8mmt. While some of this decline can be attributed to unfortunate weather patterns, it is hard not to see the correlation between inflation, interest rates, deteriorating economic conditions, and a general decline in production levels.
Conversely, as evidenced in the chart below, Brazil continues to experience tremendous growth. This is not to say Brazil has not also experienced episodes of corruption and currency devaluation, but the negative effects have been much more contained, allowing the agriculture industry to adapt and continue reinvestment and expansion. In the late 1990s, Brazil produced around 20mmt of soybeans. This past season, they produced a record of 156mmt, with yields surpassing U.S. records.
Argentina’s agriculture industry faces a challenging road ahead, with little hope of recovery or reaching its full potential due to policy missteps, hyperinflation, and currency devaluation. As a result, the responsibility will shift to other nations to step in and seize the trade flow opportunities that arise. We bring attention to Argentina’s situation as a cautionary tale for Russia as well. The ongoing war and sanctions are beginning to have a detrimental impact on Russia’s economy, currency, and foreign investments. If economic conditions continue to deteriorate, Russia’s agricultural sector may find itself on a similar path as Argentina did a decade ago. These changes don’t occur overnight, but a noticeable trend may be emerging.
United States
Taking a broad stroke across the U.S. agricultural industry, there are a few notable developments in recent years; combined U.S. corn and soybean planted acres plateauing, continued expansion of renewable diesel capacity, and a declining share of global trade.
For the past several years, U.S. farmers have not planted more than 180 million (give or take a few) corn and soybean acres combined. This is probably a function of many factors; urbanization infringing on farmland, a mature U.S. ethanol industry discouraging expansion, a rise in specialty crops, and increased global competition. But, much like the early 2000s when ethanol transformed the farming industry, increased renewable diesel capacity, increased crush capacity, and shifting trade flows could once again transform U.S. agriculture.
The renewable diesel industry has been around for many years, but it is receiving more attention because capacity is exponentially increasing, thereby increasing demand for the feedstocks needed to run the facilities. Between July 2022 and July 2023, renewable diesel production capacity in the U.S. increased 77% to 3.7 billion gallons. If all the planned capacity gets constructed, capacity will reach nearly 6 billion gallons by the end of 2025. So, what does this mean for U.S. agriculture? It takes roughly 7.5 pounds of feedstock to produce 1 gallon of renewable diesel. Recently, soybean oil has accounted for 40% to 50% of feedstock throughput. Given this projected increase in demand, the U.S. crush industry has started to expand. The U.S. currently has about 60 crushing plants. Over the next few years, 10 have announced plant expansions, while another 13 are planned for new construction. There are an estimated 500,000 bushels per day that are expected to come online between 2023 and 2025, and another 800,000 bushels per day in 2026.
There are several conclusions to draw, or potentially draw, from these developments. The U.S. crush industry will demand more soybeans, bringing the acreage battle between soybeans and corn to the forefront. Historically, crush plants crushed to produce meal with soybean oil inventories viewed as by-products. Going forward, crush plants will crush for oil, and meal inventories will have to be cleared. Lastly, considering the push to produce more soybean oil to meet growing renewable diesel demand, we wonder how seed companies might alter soybean genetics to produce a higher oil yield.
Conclusion
The fallout from the war in Ukraine is yet to be determined. Considering the damage done to agricultural infrastructure, it is highly unlikely that Ukraine will be able to maximize production for the next several years, if not longer. At the same time, while Russia has experienced tremendous production growth, deteriorating economic conditions may impede further growth. Ultimately this should shift global trade flows to more stable nations, such as the U.S., Canada, the EU, and Australia. The bigger risk to consider is if Russia might go down the same path as Argentina, with strong government controls over exports, hyperinflation, and a general decline in agricultural productivity. Argentina has a presidential election this month. Will the new president be able to reshape Argentina’s agricultural sector? It’s highly doubtful though we could see Brazil continuing to ship excess soybeans to Argentina to maximize Argentina’s crush capacity. Argentina will become the dominant soybean oil exporter as the U.S. becomes a domestic market, and we expect that both countries will compete for soybean meal market share.
About the Author
Paul Caruso is currently the Director of Commodity Investments at Ancora. He joined Ancora in 2019 as a Portfolio Manager in the Alternatives group. Paul specializes in commodity investing and is primarily responsible for investment decisions and idea generation for the strategy. Prior to joining Ancora, Paul worked as the Director of Commodities Procurement for The J.M. Smucker Company, where he oversaw commodity spend risk management. From 2011 to 2014, Paul worked with Gamma-Q LLC as a Senior Portfolio Manager. There, Paul launched and managed a commodity fund focused on agriculture and livestock. Paul also has experience in trading and investment analysis from his time with Galtere International Macro Fund, Rothfos Corporation, and The Windham Group Inc, where he began his career in 2002. Paul’s early career also had a focus on hedging and commodities. Paul earned a Bachelor of Arts degree in Economics from Columbia University.
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