Russian wheat farmers have a tough life.
Having grown up on a working farm in Oregon, I understand this all too well. Those days taught me a lot about hard work and patience. Four decades later, as I read news stories about the current travails of Russian wheat farmers, the memories of getting up on wet winter mornings for the pre-dawn goat milking – or having to drive a tractor when I was only six years old – engender a lot of empathy for the difficult challenges the wheat farmers face.
Wild fires are racing through unharvested wheat fields, the result of a Russian heat wave that has destroyed more than one-fifth of that country's wheat crop. In addition to causing the farmers considerable pain, the crop losses have caused wheat prices to double this summer.
This has spawned an export ban in Russia, which effectively removes the third-largest exporter in the world from the market. It's also created a major profit opportunity for U.S. investors.
Let me explain.
Anatomy of an Export Ban
Russia initially banned exports of wheat, barley, rye, corn and flour from Aug. 15 to Dec. 31, and most observers now expect that ban to be extended into the spring. Russian officials have said they will reassess the ban on Oct. 31 – an announcement that caused a short-term buying imbalance known as a "lock-limit-up" situation (which had the shorts scrambling to cover their positions even as prices moved higher).
The grain markets are currently "backfilling," a normal condition that leads to a near-term price decline after a major move up by a commodity. I expect that, in a few weeks, we will start to see prices resume their advance – after the market has had a chance to digest a move unlike anything we have seen in 37 years. There is a real chance that this winter's crop will be a driver for higher prices. We want to be ready for that one.
In some locations in Europe, the summer heat wave has yet to break. This means that the heavy summer rains are running late, and are maybe just now starting. But what you really need to understand is that with a lack of rain soaking into the fields to prepare them for the next planting, farmers are stuck waiting.
This lack of precipitation and scorching sun left the spring crop unharvested and burning out of control, at times. If a large volume of rain doesn't arrive soon, it will start to impact the next crop of wheat, – the "winter wheat" – which isn't even planted yet. This will be a key determinant of grain prices for 2011.
In a forecast released earlier this month, the U.S. Department of Agriculture projected a Russian wheat harvest of 45 million tons or less – well below the original expectations of 53 million tons. The reality is even worse: Just yesterday (Monday), Russia said its grain harvest through last week was 40.3 million tons, down 38% from the year before.
It gets worse: Just to meet its own needs, Russia needs to produce 77 million tons of wheat. But Russia is now saying that, in the most optimistic of circumstances, it could produce 65 million to 67 million tons for 2010 – although a more realistic forecast is for only 60 million tons. With national stocks of about 22 million to 24 million tons – and winter sowing needs to consider – this puts Russia's supply/demand balance "on a knife edge," according to a Reuters report filed from Moscow that came out yesterday evening.
About 3.6 million tons had already been shipped abroad before Russia's Aug.15 export ban went into effect, analysts said. Now those forecasters are expecting Russia to import 1.5 million to 2 million tons of wheat. A report from the Vedomosti business daily last week said Russia could import at least 5 million tons.
"If the weather continues, the damage to the spring wheat crop is probably done at this point," grain analyst Brian Liedl stated during a press briefing at the Minneapolis Grain Exchange earlier this month. "The big threat now is getting the winter wheat crop in the ground."
This drop in current production – combined with those worries about next winter's wheat crop – prompted Russian Prime Minister Vladimir Putin to announce that the country was banning wheat exports at least until 2011.
"I think it is expedient to temporarily ban exports of grain and grain products from Russia," said Putin, who even suggested that neighboring countries halt exports, too. "We shouldn't allow domestic prices in Russia to rise, and we need to preserve our cattle and build up supplies for next year."
The USDA is now forecasting a drop of at least 10% – and possibly more – in grain output from the former Soviet Union breadbasket states of Russia, the Ukraine and Kazakhstan. Russian grain is a key ingredient in "unleavened" bread – a Middle East staple – with Egypt, Turkey, Syria, Iran and Libya ranking as the top importers.
With a total cutoff of supply, Egypt and other countries will have to find a new supplier of the soft wheat that's a Russian specialty – a tall order in a world that possesses few other exporters. And Japan – famous for its Kobe beef – is reportedly sourcing livestock grains from the United States to make up for the loss of the supply it usually gets from Russia.
The United States is expected to pick up the majority of the extra market share this year and next if the Russian export ban is extended. That means that U.S. farmers will profit from these additional supply disruptions.
The Looming Profit Opportunity
The good news is that, currently, world stocks of wheat stand at 174.8 million tons. Worldwide reserves of wheat stocks are projected to be 49.9 million tons higher than they were during the 2007-2008 period, when prices soared to record levels. However, if the winter crop is affected by continued extreme weather, do not be surprised to see new highs set in some of the must-have food staples.
Currently, the United States is the only country with a major surplus in grains, with expectations of historic production in domestically grown corn and soybeans. If there are any additional crises in the world grain supply, it falls to the United States to meet that market demand.
Luckily, the U.S. futures markets are the most transparent in the world. That doesn't mean that someone won't try to corner a market. Russia even did that in the 1970s – once. In fact, Putin's actions this month have those of us with a long memory and a healthy skepticism wondering if he isn't perhaps reaching back into history for a chance to make money today.
For three profit strategies involving the projected world wheat shortage, please see the "Actions to Take" section that follows.
There are three ways we can play this opportunity:
- Exchange-traded funds (ETFs).
- Options on futures.
- And commodity futures themselves.
Most major brokerages – including self-directed discount brokers – now provide futures accounts. Needless to say, take the time to do your own "due diligence." Make certain that these strategies have a place in – fit in with – you overall personal investment plan. And make sure that you understand the risks involved in trades that include unlimited potential risk. That said, this situation does pose a remarkable opportunity. So let's take a look at the strategies investors can use in each of the three areas we've outlined.
Exchange-Traded Funds (ETFs): ETFs such as the choices that we outline here provide investors with access to managed, semi-diversified pools of futures contracts. Those pools sometimes include "swaps" and other investments that are designed to mimic the anticipated percentage move. You will want to research each individual ETF you are considering in order to understand how much of a "weighting" it has in the grain(s) or food(s) you wish to be exposed to. ETFs provide the lowest risk exposure to futures available.
- PowerShares DB Agriculture Fund (NYSE: DBA).
- iPath Dow Jones-UBS Agriculture Subindex Total Return ETN (NYSE: JJA).
- E-TRACS UBS Bloomberg CMCI Agriculture ETN (NYSE: UAG).
- E-TRACS UBS Bloomberg CMCI Food ETN (NYSE: FUD).
- PowerShares DB Agriculture Long (NYSE: AGF).
Currently, there are also two ETFs that provide exposure to the global agribusiness sector: The first one is the Market Vectors Agribusiness ETF (NYSE: MOO) and the second is called the PowerShares Global Agricultural Fund (Nasdaq: PAGG). These funds have a lot in common, exposure-wise.
Options: We can use a number of successful strategies via options on ETFs, or options on futures. My favorite would be to buy options on futures for specific contracts of interest. So if you like the March 2011 contract, for instance, you would buy long "calls" on it in anticipation of a bullish move. A long call, or long put on a futures contract, gives you the right (but not the obligation) to convert. You will need to sell the position before it expires, or will be converted if it's in the money. This allows you to have direct exposure to the futures market, without any margin risk.
The options-on-futures markets are notoriously illiquid and extremely hard to trade through anything that is not "at the money." On the bright side, as long as you are only buying long "calls" or "puts," you get the leverage of a futures trade without the margin exposure that a futures position typically carries.
Futures: The third approach would be to buy futures directly. This opens up your risk levels, but it also gives you direct exposure to the underlying market without a lot of other variables. I would suggest that you get professional advice before placing trades in the futures pits. I like that you can play the difference between grain markets. These types of strategies are deployed if, for example, you think there will be demand for soft rice, but not for hard rice. Or, in the case of Egypt, you are expecting a real run on soft wheat, but not on hard wheat.
Let's look for the price of grains to pull back a bit, from these overbought levels. We can let Mother Nature be our guide, telling us when to position a trade or trades in anticipation of a second upward bounce in the wheat market. At that point, we'll know a little more about weather conditions in such other global locales as Russia. As far as timing goes, we could be looking to make these moves sometime between the last part of September to the first of November as we get a feel for how the winter wheat crop is coming along. If we have a short fall, with a late planting, we could have a less-than-expected crop again. This would be the catalyst for a historic move in wheat prices.
Watch Money Morning for a future update on the situation facing the Russian wheat farmers, and how we expect to capitalize on it.
[Editor's Note: Jack Barnes started his career at Franklin Templeton in 1997, working with the company's portfolio team in its fund-information department – just as the Asian contagion infected the Asian tiger countries. He launched his own RIA shop in 2003 just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008. Last summer, Barnes retired to the beach – which is where he writes from now.]
News and Related Story Links:
- The Kansas City Star:
Russian wheat crop in dire straits, while U.S. farmers expect bumper harvests.
WRAPUP 1-Imports hard to avoid as Russian harvest falters.
- U.S. Department of Agriculture:
Russian wheat crop could fall further.
Flatbread (Unleavened Bread).
- Minneapolis Grain Exchange:
- The Seattle Times:
Bad Russian wheat harvest boosts U.S. farmers.
- PowerShares DB Agriculture Fund:
- U.S. Department of Agriculture:
U.S Grains Update
- The New York Times:
Vladimir Putin Quotes.
- Bloomberg News:
Wheat Exports From Russia, Ukraine Are `Draining Out,' Flour Miller Says.
Russia's grain ban showcases Egypt's love of bread