Consolidation in the Agricultural Sector
In any sector of the economy, when business conditions are booming there is always plenty of room for competition. However, when the landscape changes, companies exit the market, and those who remain must make changes to lower costs, increase profit margins and become more efficient.
Many businesses are cyclical, and those cycles impact profitability. The fortunes of raw material markets often experience highs and lows over time. Therefore, there is a high degree of volatility in commodity-related enterprises. Commodities tend to rise to prices where producers increase output as profit margins increase. When prices move higher, demand tends to decline, and inventories build leading to an increase in stockpiles. At this point, a price will peak and begin to move lower. Then prices fall to a level where demand starts to rise and inventories drop at which point a bottom in price occurs.
Supply and demand changes are the essence of the pricing cycle in commodity markets.
Demand Is Rising
When it comes to the agricultural commodity sector, pricing cycles are a common phenomenon over time. However, while the amount of arable land available to grow crops is finite on our planet, the demand side of the equation has been growing at an exponential rate. In 1960, there were less than three billion people on Earth; in 2016 population was more than 7.3 billion. Therefore, more people required more food and the demand for agricultural commodities increased commensurately with the population.
The demand side of the fundamental supply and demand equation has been growing on a yearly basis. Supply is another story.
Each year the production of agricultural commodities is a function of many factors including weather, crop diseases, geopolitical and logistical events, as well as other exogenous issues that many influence the total production of the essential ingredients in many of the foods we consume. The three most important grain products produced around the world each year are corn, soybeans, and wheat.
Corn is a basic staple; it is a cereal crop and a member of the grass family. Varieties of corn are required to produce numerous food products and animal feed. High-fructose corn syrup, corn starch, corn oil, and lysine are direct corn products. Ethanol, a biofuel, is also a corn product. All gasoline sold in the United States contains a percentage of ethanol. The world’s leading producer and exporter of corn each year is the U.S.
Wheat is both gluten, or protein, and starch. Wheat is the primary ingredient in flour, required for the production of many foods, including cereals, breads, pasta, cakes and cookies, as well as many others. Additionally, straw particle board, paper wheat starch, adhesives, and many other household productions require wheat for their manufacture. The world’s leading wheat producers include Russia, the European Union, the U.S., and many other nations around the world. Each year the largest exporter of wheat depends on crop production around the world which can vary with weather and other conditions.
Soybeans are a multipurpose plant, and soybean oil and soybean meal raw soybeans are processed products of the oilseed. Soybean processing companies like Archer Daniels Midland (ADM), Bunge (BG), and others crush raw soybeans into products. Soybean meal is a high-protein fiber and major animal feed product while soybean oil is often required for cooking around the world and has uses in the production of margarine, salad dressings, mayonnaises, and other everyday food products. The United States is the world’s leading producer and exporter of soybeans, but South American production is also an important source of the crop each year.
The three top grains each have their supply and demand fundamentals however over time they tend to move up and down in price together. These grains have gone through many bull and bear market cycles over past years. The last cyclical bull market in grains occurred in 2012 when a drought descended on the fertile Plains of the United States. Dry soil as a result of arid conditions caused crop yields to drop and the resulting harvest created deficits in the three grain markets; global demand exceeded available supplies causing inventories to fall and prices to increase dramatically.
The price of corn rose to an all-time high of nearly $8.50 per bushel, while soybeans peaked at its all-time peak of almost $18 per bushel. Since wheat production is more spread out around the world, the price rose to just under $9.50 per bushel as production from other producing nations made up for shortfalls from the drought-sickened United States that year. Wheat had reached its all-time peak in 2008 when the price rose to over $13.30 per bushel as global weather conditions caused crop yields to decline dramatically resulting in shortages of the grain.
Bumper Crops Since 2012
Since the droughts of past years, the weather has cooperated with the grain markets and 2016 was the fourth straight year of bumper corn, soybean, and wheat crops around the world. A series of record-output years caused stockpiles to rise, and despite constant growth in global demand, surplus conditions in grains caused prices to drop. At the lows in 2016, wheat traded at the lowest price in a decade at just under $3.60 per bushel. The price of corn also plunged, dropping to lows of just over $3 while soybeans reached their nadir at $8.49 per bushel.
Low grain prices were good news for the consumers of the world as the overall cost of eating did not increase like it did in 2012 and there was plenty of availability. However, for those involved in the production of grain crops, the plunge in prices over a four-year period from 2013-2016 resulted in lower profit margins or losses and a decrease in capital and input spending in the industry. Price pressures caused marginal producers to exit the agricultural business, and the larger companies in the industry found themselves forced to make significant changes in their businesses to survive for the future.
In early 2016, two companies active in the production of products necessary for the agricultural industry, Dow Chemical, and DuPont agreed to a merger. During the year, two giant fertilizer companies, Potash Corporation of Saskatchewan and Agrium Incorporation decided to merge and join forces. At the end of 2016, Monsanto Company, one of the world’s largest seed manufacturers, was awaiting regulatory approval in the United States and Europe for a merger with Bayer AG, the giant German pharmaceutical company.
Additionally, Syngenta AG, a Swiss-based pesticide and seed manufacturer is in the process of merging with China National Chemical Corporation. All of these mergers are a response to a challenging business environment in the global agricultural sector.
Economies of Scale
As the prices of the three primary grain crops have dropped and surplus inventories have developed, farmers, processors, and producers of grains and grain related products have found themselves with less money to spend on crop inputs forcing prices lower. The consolidation in the agricultural supply businesses including, seeds, fertilizers, chemicals and other inputs required for growing the crops that feed the people around the globe is a response to lower profit margins. Mergers and acquisitions in the agricultural sector create economies of scale where production cost of the agricultural inputs will decline as a result of increased volume, management and marketing consolidation and less competition in the industry as fewer companies dominate the businesses.
Many farmers and others in the business of producing grain crops have objected that industry consolidation will result in efficiencies for the huge companies but will cause prices for products to increase as competition decreases in the future. Time will tell if the world’s farmers will wind up footing the bill for these mergers. Meanwhile, since many of these mergers involved companies domicile in different countries around the world, the mergers and acquisitions are subject to regulatory approval in more than one jurisdiction.
The process of approval was ongoing at the end of 2016, and it is not likely to be a smooth process. For example, Monsanto produces seeds in the United States that are genetically modified. Europe has outlawed these GMO seeds and the merger between Monsanto and Bayer will need to obtain approval in both the U.S. and E.U. presenting many challenges in the process. This jurisdictional issue is just one example of many, of the problems faced when attempting to put two companies that are major suppliers to the agriculture industry around the world together.
In the U.S., the issue of anti-trust or monopolies created by these mergers could result in a denial of regulatory approval.
Input Prices May Rise — Less Competition
The decline in profit margins and price pressures in the global agricultural industry has caused the need for economies of scale for survival. When it comes to the prices of grains and other agricultural commodities, an increase in the price of inputs into farming is likely to increase production costs for crops in the future. In the world of commodities, prices tend to fall to a level where production cost is higher than the market price for a raw material. When that happens, producers stop producing and shortages develop causing prices to rise.
As you can see the cyclical nature, raw material prices tend to make markets efficient over time. They rise to a price level where the cycle peaks and fall to prices where output becomes uneconomic. In both cases, the markets will react by repricing the commodity to an equilibrium level.
There was an increase in the merger and acquisition activity in the agricultural markets in 2016 as a result of market forces. However, the next time there is a bull market in the grain and agricultural sector, it is likely that new suppliers of seeds, fertilizers, chemicals, and other required farming inputs will burst onto the scene forcing competition on suppliers if they attempt to increase prices to uncompetitive levels. Capitalism is an efficient system for responding to pricing cycles and the events in the agricultural sector over recent years is an example of an industry responding to pricing pressures.
Consistent and exponential population growth and the fickle nature of weather almost guarantees that the grains markets will shift from feast to famine in the years ahead when it comes to available supplies and prices. Corn, soybeans and wheat futures trade on the Chicago Board of Trade (CBOT) division of the Chicago Mercantile Exchange (CME). Several years ago, these exchanges merged creating economies of scale. You can find out plenty of information about the grain market from the U.S. Department of Agriculture’s monthly WASDE report.