This year, farmers look poised to deliver the largest corn crop in history, as weather conditions combined with aggressive planting to flood the market with the product. That means low corn prices, which is bad for farmers and for the companies that benefit from higher grain prices. But could prices be approaching a turning point, creating an opportunity for investors?
Investing in the stocks of commodity producers is not for the faint of heart, the risk averse, or the uninformed investor. Stock investing is inherently risky—and adding on the effects of commodity prices can make the stocks of commodity producers even more volatile. If this is an area of the market that interests you, it’s important to do your homework. To help understand the current trends in the agricultural industry, we turned to three Fidelity investment professionals.
The Fidelity managers say the cycle of grain prices may be reaching a low, and a price recovery could provide a cyclical tailwind to stocks in the industry that are levered to a rise in commodity prices.
“In the last several years, corn, wheat, and soy have gone through a cycle of drought and then very favorable weather conditions,” says Tobias Welo, manager of the Fidelity® Select Materials Portfolio (FSDPX). “We have gone from a peak of $8 a bushel for corn down to $4—which is close to the cost to produce the crop. This doesn’t mean we’re at the trough now, but I think we’re reaching a level where the invisible hand of supply and demand should start to come in and help solidify the market.”
The crop cycle
In 2012, farmers suffered through a drought so bad as to likely happen only once every 30 years. The amount of corn produced that year fell dramatically and the reduced supply caused prices to spike to $8. Farmers responded by trying to cash in on the high prices; they planted corn on a record number of acres and weather conditions improved. These changes helped the supply to recover. As that supply came into the market, the price plummeted. But today’s prices may have come down so far as to be unsustainable. “Ag is self-correcting,” says Fidelity research analyst Steven Calhoun. “Today’s prices are below the breakeven point for many farmers, so I don’t anticipate that farmers will plant 92 million acres of corn again next year—it could be 88 million acres or less. At the same time, we have just seen the best weather conditions in 30 years, so the probability of that repeating next year is low.”
Less acreage and worse weather could combine to reduce supply once again, and that could send the price cycle in the other direction.
“2013 was a difficult year for commodities and commodity producers, as commodity prices broadly declined due to supply-and-demand concerns and a widespread sell-down from commodity futures investors,” says Joe Wickwire, manager of Fidelity® Global Commodity Stock Fund (FFGCX). “Amid the negativity, I saw companies with very good fundamentals and the potential to deliver attractive returns go on sale. I especially liked North American agriculture names.”
Finding the winners
A knowledgeable and sophisticated investor can attempt to profit from higher prices on corn or grains by buying futures contracts, or investing in exchange-traded funds (ETFs) that hold those contracts, though futures contracts come with their own risks and complexities. Improving grain prices would also have an impact on companies throughout the agriculture industry. Some parts of the agriculture industry are not as closely tied to the cycle of grain prices—for instance, seed manufacturers. But other companies are helped by rising prices—for instance, fertilizer companies and agricultural machinery makers.
On the other hand, high prices can pose a challenge for companies that rely on corn for an input, for instance poultry companies and food processors that may not be able to pass on higher prices to their end consumers.
But choosing the right investments may take more than simply buying all the names in a given industry. Welo and Calhoun start with a view on the price cycle, but they also do deep work on individual companies that may help to identify the best investment opportunities. “We don’t just say, ‘Ag prices may rise; buy everything,’” says Welo. “It comes down to very specific company stories.”
Recently, they have found opportunities in two of the cyclical parts of the agriculture industry tied to fertilizers.
Potash: Prices may recover
Prices for the fertilizer ingredient potash have historically moved in line with crop prices. But this industry has been undergoing some unusual dynamics. After the industry spent years adding capacity, a Russian potash producer last year dropped out of one of the cartels that helps to manage supply and maintain pricing power. When the potash cartel broke up, prices fell from $400 a ton to a little more than $300 a ton. On the day the cartel broke, potash stocks saw losses of 20% to 40%. Calhoun and Welo had avoided the sell-off, but when stock prices tumbled, they bought a low-cost producer from Canada, PotashCorp. (POT).
Since then, potash stocks have recovered some of their losses. But Calhoun and Welo believe a change in crop prices, and new industry dynamics, could lead to another leg of growth.
“The Russian potash company has new management that is working with the Belarusians again, and the cycle could be poised to turn,” says Welo. “So while you don’t know if the cartel will reform, you can start saying, ‘Wow, what happens if this gets a little bit better and product prices can go back up?”
Nitrogen: Look for lower-cost producers
Nitrogen producers are another potential beneficiary of a recovery in crop prices, because the fertilizer is tied to the financial condition of farmers. But just as Welo targeted specific potash producers, here, too, picking the potential winners requires analyzing the industry dynamics.
In the case of nitrogen, Welo has invested in CF Industries (CF). Many global nitrogen producers had been struggling because China was flooding the market with very cheap product, sending prices down. As the price went down, it hurt producers who relied on expensive natural gas to produce their nitrogen. But Welo says CF Industries has had a big advantage because of the low natural gas prices in the United States. Thanks to far cheaper costs than international competitors, CF has still been able to produce profits at the lower price points. Welo was also attracted by company plans to increase capacity in 2016, a strategic deal to sell its phosphate business, and a new management team that has been focused on share buybacks and dividends.
“Many investors are looking at 2014 earnings or 2015, and CF’s capital expenditures have been unsustainably high recently, but I’m looking beyond that time period,” explains Welo. “The capacity added by today’s investments could help drive the free cash flow going forward. In the meantime, I can sit here and reap the benefits from the dividend and a lower share count and dividend.”
The bottom line
Agriculture differs from many other parts of the economy because weather forces farmers to make strategic and operational decisions at the start of every cycle. That has the power to change prices quickly, and may produce opportunities for investors. But just calling the cycle may not be enough. You need to do your research.
“We try to find the right companies, where a management team or industry change can give us an opportunity to win, and that becomes the first leg; then the second leg could be the price cycle,” says Welo.
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